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The defined benefit pension odyssey
Estimated reading time: 3 minutes
Defined Benefit (DB) pension plans are entering a new phase in their decades-long journey from valuable employee benefit to legacy financial arrangement.
Taking the analogy of a journey further than any firm had dared go before, we led delegates of the FT’s inaugural CFO Dialogues event, in November, on a space-themed tour of this peculiar universe.
"Data from the PPF and our own research shows that DB plans have shut their doors at a rapid rate - only 4% of the UK’s largest DB plans remain open to new employees."
Projections show that only about a third of the current liabilities across all DB plans in the UK (excluding public sector pensions) will remain in the plans in 20 years’ time. The remainder will be paid out in pension payments, transfer values and to insurers or, for an unlucky few, the PPF. We characterise this new phase in the life-cycle of DB plans as run-off: apart from a few exceptions, DB plans have a finite lifetime that will fundamentally change how they are viewed and managed.
Our belief is that trustees and sponsors need a clear view on a realistic end-game for their DB plan.
Insurance buyout is the obvious one. But while 2018 will prove to be a record year for bulk annuity transactions with DB plans, it is not obviously achievable for every DB plan over the next 20 or so years.
So what else can plans do and how to decide what your end-game should be?
Commercial consolidators are the new kids on the block and may provide a cheaper, but higher risk, alternative to a buyout. Crucially, they allow the sponsor to break the covenant link with the plan, severing all future obligations. Clearly attractive to the sponsor, this poses some difficult questions for trustees: take the option of entering a consolidator earlier or hold on for buyout later? Weighing these up will require a thorough understanding of the actuarial, legal, investment and covenant implications.
If not a consolidator or a buyout then you are left, by default, with the option of managing the DB plan in run-off yourself. This may be out of necessity if deficits are too large for the sponsor to bridge, or out of choice if the idea of handing over a significant profit margin to a third party does not appeal. Managing the increasingly large cashflow requirements from the plan without being a forced seller in market downturns will be a key challenge of this approach.
We believe in setting out a clear decision-making framework to help sponsors and trustees understanding the relative appeal of each option. This involves looking at likely outcomes for your DB plan beyond the current recovery plan and also taking into account wider factors which are of importance such as the interaction with a sponsor’s dividend policy.
Once set, a strategy needs executing. This involves aligning your investment strategy to your end-game objective, but also utilising the win-win nature of member option, or liability management, exercises. We have seen trustees increasingly embrace these as legitimate risk management tools that can provide members with a much wider range of options than they have had in the past.
Knowing when and how to weave these into your journey will give your own space odyssey a much-needed boost and bring this long and winding journey to a closer end.
WATCH THE VIDEO
Watch Barnett Waddingham's involvement at the FT’s inaugural CFO Dialogues event, in November.