Pensions white paper: looking at long-term funding objectives

Estimated reading time: 4 minutes

Last month, the Department for Work and Pensions (DWP) published its white paper on Protecting Defined Benefit Pension Schemes.

Although not offering much in the way of new legislation, it does encourage The Pensions Regulator (TPR) to make more of the current legal framework, in particular for Defined Benefit (DB) pension scheme funding.

Most schemes’ rules will point trustees towards a buy-out in the event of employer insolvency. That's why I think for schemes with 'weak' employers, they should continue to target getting as close to buy-out funding as possible, and should not be able to treat superfunds simply as a cheaper alternative. Though, in practice, superfunds maybe a more natural home for schemes whose employers fail at a time when they are in between PPF and buy-out funding levels. Where the likelihood of employer insolvency is lower, then buy-out does not need to be the primary funding driver, and so a superfund may be an acceptable funding target.

Similarly, a closed scheme that retains a strong covenant might be able to retain an ongoing funding objective. However, in this context, strong would be more than just a solvent employer with a healthy short-term business plan. It would need to mean indefinite support from either an entity whose balance sheet is very large compared to the scheme, or from a public body whose future covenant is not in any real doubt.

In setting an appropriate objective, I think it will be more appropriate to focus on the covenant strength than whether the scheme is still open. Arguably, an open scheme with only a 'tending to strong' covenant should still have a long-term target of (at least) self-sufficiency, and if the covenant is weaker than this it should not be open!

A link to employer covenant?

TPR has in the past also recognised a four-tier scale of employer covenant rating (strong, tending to strong, tending to weak and weak), and many covenant assessors use a similar scale. So I wonder if we may see a correlation between employer covenant strength and the four long-term funding objectives above.

For example, schemes with 'strong' employers could choose any of the objectives, whereas schemes with 'weak' employers would be expected to target buy-out, as set out in the diagram below:

The superfund entry funding standard should also therefore enhance benefit security for members, but not to the same level as the higher security under a buy-out. This would raise interesting questions for trustees considering superfunds – such as whether there is a short-term improvement in security, but also whether it enhances the long-term prospects of buy-out. I am envisaging here that a superfund would intend to transfer to a bulk annuity policy if a successful investment strategy caused it to exceed a buy-out funding level in future - in which case the superfund could then buy-out and 'start again' for future transferring schemes.

From the point of view of the PPF, and TPR, a superfund (if eligible for PPF) would represent a concentration of risk, but with a low probability of transferring to the PPF, compared to the underlying schemes which each represent a smaller risk but with a higher likelihood of transfer. However, most schemes would almost certainly need to top up their funding to meet the superfund entry funding standard, which means overall the risks to the PPF should be lower under the superfunds model.

As for these consolidator vehicles, or 'superfunds', the white paper says further research will be necessary, and identified Pension Protection Fund (PPF) eligibility as a key issue. I agree this will be paramount – and would go so far as to suggest that superfunds will only work if they retain PPF eligibility. Otherwise, they will fall between the protection of the PPF and the financial services compensation scheme that covers a bulk annuity policy following buy-out. I can't see how trustees would be comfortable transferring members into a vehicle that doesn't have either form of protection.

It also sets out four different types of suitable long-term funding objectives for DB schemes:

• To run-on with employer support (for open schemes).
• To reach self-sufficiency with a low-risk investment strategy, and run-off with minimal call on the sponsoring employer.
• To enter a consolidator vehicle within an agreed timeframe - where a newly created fund pools the assets and liabilities of smaller funds.
• To ‘buy-out’ by a set time.

Many schemes have already moved from 'ongoing' to 'self-sufficiency' long-term funding targets, by using a post-retirement discount rate based on a protection portfolio (as opposed to growth assets), which implicitly assumes a move to self-sufficiency as the scheme members retire. In future, we may see more of these funding objectives, as well as 'superfund' funding objectives, if that market is granted PPF eligibility in order to be allowed to take off.