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Is Fast Track the Right Track for buy-out?

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The new funding regime is likely to make buy-out more attainable, but schemes need to be alert to avoid unintended consequences

Much of the perception of the Pensions Regulator’s proposals for its revised DB funding code of practice has been that the new regime will force many schemes to set higher funding targets than at present. A likely consequence for sponsors is an increase in contributions and/or the provision of other non-cash security.

Setting aside wider questions about whether such an outcome is always desirable, whether the Regulator’s overall objectives are appropriate or whether the balance it seeks between prescription and flexibility will be right, let’s instead focus on the less immediate issue of how the funding code might fit with a long-term objective (LTO) of buy-out with an insurance company or transfer to a commercial consolidator (or “superfund”).

Not every scheme is 15 to 20 years away from reaching this LTO. Many schemes already have an objective to buy-out and, in K3’s experience, schemes are often closer to this objective than they think, because their scheme actuary’s estimates of the buy-out funding position are too prudent, for example. For more mature schemes with an aim to buy out or consolidate, a direct comparison of the LTO funding measure to the cost of a transaction is going to be meaningful, perhaps very soon.

Full detail on funding parameters is yet to be consulted on, but under the more prescriptive “Fast Track” approach to funding, the Regulator’s initial consultation indicates that a “low dependency” discount rate would be somewhere in the range of Gilts +0.5% p.a. to Gilts +0.25% p.a. for an appropriate LTO in current market conditions. Sensibly, the Regulator recognises that this (and other assumptions) might need to be updated over time and that the cost of insurance or consolidation will be driven by other market forces, so will fluctuate relative to a gilts-based funding measure. Indeed, the Regulator has already acknowledged that the impact of the Covid-19 pandemic on market conditions could change what the Fast Track parameters look like.

Is there a risk of schemes setting an LTO which sees them ultimately fund to a level higher than the cost of insurance or consolidation?

K3 has advised on four recent pensioner buy-in transactions. By attracting several insurers to bid, competitive tension helped lead to pricing better than Gilts +0.5% p.a. in three of those cases.

No consolidator transactions have completed to date, so we can’t yet compare actual pricing to an LTO. However, the Regulator recently published its interim regulatory guidance for consolidators, which requires them to fund using a discount rate assumption no weaker than Gilts +0.5% p.a. This could present an inconsistency with a very mature scheme backed by sponsor covenant funding to Gilts +0.25% p.a., for example.

Therefore, it appears to me that schemes could inadvertently target a funding level greater than buy-out/consolidation. No bad thing in terms of protecting members’ benefits, but we know from conversations with insurers that they see schemes which have been overfunded at the point of buy-out and this does create issues to address, such as surplus recovery by the sponsor (which might not be tax efficient) or distribution to members.

In practice, however, we would expect well-governed and well-advised schemes to be able to either mitigate the risk of being overfunded or to be able to manage the consequences.

Of course, the LTO might be achieved in practice via several transactions rather than a full scheme buy-out, so being “overfunded” for an interim buy-in transaction is less problematic. Partial buy-outs have been rare to date given the difficulties of treating all members equitably, but the funding proposals raise a question as to whether doing so might become beneficial for a scheme or sponsor, i.e. by leaving behind less mature liabilities allowing a longer funding plan.

In theory at least, the less-prescriptive “Bespoke” approach to funding in the Regulator’s proposals would allow schemes to set an LTO more aligned and responsive to actual insurer or consolidator pricing. This route will not be attractive to all schemes though, smaller (sub-£100m) schemes especially.

Under either approach, as a scheme approaches an insurance/consolidator-based LTO, we see regular monitoring of the funding position and accurate estimation of actual pricing as being increasingly important, especially for smaller schemes more likely to rely on Fast Track and where insurer/consolidator pricing is less predictable. Specialist advice from those with experience in these transactions will prove valuable.

Thomas Crawshaw, Senior Actuarial Consultant, K3