The Pensions Pod S5:E1 – How should trustees and employers approach defined benefit risk transfer versus run-on?

Chris Brown, Director, Burges Salmon

Helen, yeah that’s absolutely right isn’t it it’s great to be back it’s been a really busy period since we did season 4 and yeah, great to be on episode one of season 5.

Helen

So in today’s episode, we’ll be discussing define benefit risk transfer market versus run-on and our guest today is Sarah Brown, principal and senior consulting actuary at the Gallagher Benefit services. So Sarah’s Gallagher’s UK Chief actuary as well as an experienced scheme actuary who’s been advising trustees and sponsors for well over 20 years. Sarah, thanks so much for coming on the podcast.

Sarah Brown, UK Chief Actuary, Gallagher

Lovely to speak to you.

Chris

Hi Sarah, thanks for coming on.

Helen

So Sarah, we met from me hosting one of the SPP’s events but can you tell listeners a bit more about your background?

Sarah

Yes so I’m a scheme actuary and I advise both trustees and sponsors on a range of matters and at the moment one of the things that they’re really interested in is whether they should be thinking of doing a buyout or whether they should be thinking of running on their schemes, so this is something that I’ve been looking at a lot and also with my chief actuary hat, thinking about how we help trustees and sponsors through that kind of decision and actually helping schemes decide whether it’s the right thing for them.

Helen

It’s definitely a hot topic at the moment and most of our listeners will be familiar with the recent changes in the pensions industry, by way of a recap Sarah could you explain why there’s such a focus on pension schemes objectives at the moment and what’s changed?

Sarah

Yes, so there are a number of catalysts for these discussions and there are also quite a lot of theoretical reasons why people should be thinking about it but in my mind actually the key driver is that schemes are generally better funded at the moment in particular due to the guilt crisis, yeah, so this together with innovation in the market means that they’ve got more options and they can actually start thinking about these questions as actually something tangible rather than an aspirational discussion.

So for some schemes what this means is that they are now able to consider buyout where they really just couldn’t consider it before so although they may have wanted to buy out it really wasn’t something that they were well enough funded to do. And for others it actually now that they are able to buy out it really brings the conversation and the debate to the four because although they may have thought they wanted to to transfer risk they actually do want to continue to run on the scheme and continue to accumulate excess investment return returns. So it’s interesting because different schemes have different reasons for the change in focus. And all this is against the backdrop of a new DB funding code so this new DB funding code requires trustees and sponsors to agree a long-term objective.

Now many well-run pension schemes have had a long-term objective in place for a long time and the majority that I’ve spoken to have at least talked about where they want to be but now it’s really something that they need to document, they need to agree and that’s put it into even more focus and against all that we have mansion house so the government is trying to promote investment in UK productive finance and that really represents a change in direction for DB schemes who over the years have really been nudged towards de-risking and indeed more than nudged in many cases.

So now we’ve got the government actually saying well we have been saying de-risk, but now actually could you consider re-risking and looking at different investment strategies so putting that all into the mix it’s never been a better time to think about where you want your pension scheme to be.

Chris

Yeah absolutely and schemes are, they’ve got lots of reasons in the moment to be thinking about their long-term strategy and what the solution for the scheme will be but sort of as we were chatting just before we press the record button it’s not a one and done decision is it so trustees can form a long-term strategy to run on perhaps as a step towards a risk transfer project or you know because they don’t want to risk transfer at the moment but that doesn’t preclude them from doing it necessarily in the future.

Sarah

Indeed and I think that’s sometimes we get very binary in this debate but actually run on can be a step towards buyout over the longer term maybe in 10 or 15 years, so it is very much, although the decision buy out on once you’ve committed to a buyout you can’t reverse that, but actually with run on it could be a temporary decision with people changing their mind perhaps as the circumstances of the sponsor change, perhaps as the funding and the scheme changes so run on is a single term that we actually use to embrace a whole load of different options.

Helen

Yeah absolutely, we’re definitely seeing more and more of our clients currently on the journey to buying in their schemes benefits with an insurer and Sarah, can you explain for our listeners what the benefits of buying in a scheme are?

Sarah

So it can really be seen as the gold standard so benefits are being secured in full with a third party that’s backed by a strong solvency regime, so that’s a great outcome for a lot of pension schemes and ultimately members are the reason for the scheme so buyout can be viewed as a successful end of the journey knowing that there’s a high level of security for those member benefits from an insurer.

It also can be really beneficial from a sponsor point of view because it reduces the distraction of having a defined benefit scheme so effectively by transferring it across to an insurer, it takes away that management time and all those ongoing running costs associated with the scheme and emotionally there is a reason for that being popular as well because over time many sponsors have been through a lot of pain with defined benefit schemes both dealing with volatile deficit and with ever evolving legislative requirements, such as dare I mention the need to equalize GMP’s so it just feels like these things keep happening and actually for sponsors having that moment that they can say right we’ve transferred the scheme on to somebody else, but crucially knowing our members are being looked after that can be a really really good result.

Chris

Yeah exactly and you can see you know sort of an FD of a DBC sponsor who’s been the FD for the last 20, 30 years it does take a sort of a shift in mindset to decide that actually the scheme might be doing something else other than risk transferring as soon as we’re able, but I suppose the thought there then that comes to mind is the importance of early dialogue, discussion with the trustees, with the trustees advisors, perhaps with company own advisors you know to really sort of map out the different options because risk transfer you know is the right solution for many schemes but doesn’t need to be the only solution.

Sarah

Absolutely and those conversations are really interesting as well because it gives an opportunity for everyone involved in the scheme to really set out what they think their expectations are for the future and what benefits the members the most within those expectations.

So I think it’s really positive to be able to have those discussions and I think it’s one of the really positive things coming out of the funding code for those who haven’t had the impetus to have those debates before, they’re now being required to so I’m seeing some great conversations happening and actually it’s really interesting to get down to the detail of what people want from their pension schemes.

Helen

It can be a great opportunity to forward plan as well and for example instruct your legal advisors quite early to produce the benefit specification because we have seen examples where that does bring issues out of the woodwork that would need to be resolved before you approach the market.

Chris

So, I mean that’s right and then it’s right for trustees to go and you know investigate issues and make sure that their benefit audit is in order before you know starting down the line and and approaching insurers or whatever.

We’ve also seen circumstances haven’t we Helen of schemes where we’ve looked at benefit specifications and sometimes they can help reduce liabilities because something’s come out would work the other way so actually it’s a case of that early planning gets your benefits in in order and if you can do that nice and early on then that feeds into the wider discussions about what your strategy might be.

Helen

And what I am saying is when people want to buy out they often want to move very quickly so yes getting everything lined up in advance really really helps with that because what you don’t want to be is in a situation where pricing is looking good with an insurer, there’s an opportunity and then you discover there’s an issue with the benefits so it’s really good to get everything lined up and have a good project plan and be clear about what you want early on.

Sarah

Definitely and insurers are at such a low capacity at the moment I would say because they’re oversubscribed because of the boom in buying in so it’s very interesting.

Helen

Sarah are you seeing a particular kind of scheme that would look to buy in rather than run on with your clients?

Sarah

So I I think I might turn that around a little bit so the ones that want to buy in often are the ones where there are reasons that they really want to secure the benefits, they’re concerned perhaps about all those things that I spoke about management time, about volatile deficits, they’ve kind of made that decision and they want to go on, yeah, the ones who are thinking about run on more are the ones with often strong covenants in particular because you are continuing to run on the scheme and have that reliance on the sponsor, so generally run on tends to be an option for those with the strongest covenants.

Run on also tends to be quite popular for the more well funded schemes so in this context I’m really talking about almost a conscious run on where you want that to happen over a long period of time. Some might be running on over a short period of time because they’re not quite there with buyout funding yet, but what I’m thinking more is the ones who are saying actually we would like to continue to run on because we think there are benefits of not going to an insurer and actually continuing to run our scheme ourselves.

And reasons for that I think in some cases it’s where trustees want to control actuarial factors so they might think that actually the terms that they can give members are better than those that they could get from insurer or there may be some element of discretionary benefits, for example discretionary pension increases and they may want to keep control over those so that they can pay them when the funding is good enough to pay them and that can give better outcomes for members and there may also be paternalistic reasons where the sponsor wants some element of control over those as well, the members of the pension scheme may be you know staff that they’ve looked after for many many years and they really feel a kind of connection to that pension scheme and we can also see that actually where we’re measuring member outcomes, not just by the benefits they get but by the service they receive, for example what I see is schemes you know spend a lot of time giving things like member portals, really good strong administration and indeed very long running relationships with members. I’ve worked with schemes where the people serving the schemes know the members individually by name now giving that away to a third party is quite an emotional decision and I think actually they often want to keep that connection with their members.

Also there are schemes that are open and run can allow for continue to accrual of benefits for example which wouldn’t generally be possible under a buyout.

Helen

There’s a change in actuarial standards isn’t there that trustees are now required to consider alternative solutions to buying in with an insurer can you tell our listeners a bit more about that?

Sarah

Absolutely and it’s not often that I’m asked to talk about technical actuarial standards so as an actuary this is brilliant for me and actually I’ve had a lot of people asking me about these technical actuarial standards recently, so one of our technical actuarial standards now requires when we’re advising on buyout that we should also advise on alternative options, in particular including things like run on, and the reason for this is is to make sure that if people are in are going to risk transfer that they are thinking about it and understanding the other options available and whether there could be better outcomes by doing something different so yeah you will see trustees and sponsors will see their advisors coming to them and giving them a lot more advice around this because it is a requirement and also that advice will also cover things not just how member benefits could be changed but also considering things like financial benefits.

So securing benefits with an insurer can involve paying a significant premium and that may be significant over and above the cost of running the scheme scheme themselves so run on could be used to generate surplus and that surplus could then be used to benefit members and sponsors and in particular for some overseas parents in particular those in the US a surplus generated in the scheme can appear as a positive item in their profit and loss, even if they never actually see the cash, it can be sitting there in the pension scheme but actually be coming through within the accounting standards as a profit.

So there are financial benefits as well as those member benefits to run on, but at the same time trustees and sponsors need to consider the risks and in particular that increased reliance on the sponsor covenant which would need to be carefully managed at the same time so that’s why there’s no correct answer on which is best risk transfer or run on, it really depends on the individual circumstances of the scheme and the circumstances of the sponsor and that’s why both trustees and sponsor need to have a conversation rather than just making a decision without that consultation.

Chris

Yeah absolutely I think that’s a really good point that trustees and employer need to plan early need to collaborate and work very closely together so for example thinking about sort of legal powers in their scheme deed and rules, schemes because of the way they’ve been drafted in the past can frankly have a bit of a lottery on what their return of surplus powers are. Now of course you know we’re waiting on further information from the government and who knows whether we’ll get some changes or overrides or whatever to the return of surplus rules but actually at the moment what an employer or a scheme, trustees of a scheme wouldn’t want to do is design a run on strategy to try to extract surplus to say send some back to the employer if actually the surplus rule didn’t allow that to happen.

Or similarly you wouldn’t want to be an employer you know telling your trustees yes I definitely want to run on in circumstances where the trustees would prefer to wind up and the trustees have a windup trigger so understanding the powers in your rules for both trustees and employers is an important part of that that planning process I think. But what you were saying there are benefits potential benefits for the right scheme and the right circumstances for members but also for employers you know that there are reasons why particular schemes you know might want to run on run rather than buying out.

Helen

And knowing who the surplus should go to is such a difficult question for trustees to determine where they do have the power in their rules, I’ve seen lots of clients at the moment seeking advice around this and how they should or what factors are relevant for them to consider. Sarah how do you think people should approach considering how to receive surplus and who should it get paid to?

Sarah

It’s a really interesting area because I don’t think there’s one size fits all on this one it really depends on once you’ve looked at the rules there’s also a huge number of other factors to consider, for example what what are the discretionary increases within the scheme what happened in times of deficit what was the member contribution rate did you increase member contributions through difficult times.

So there’s lots of kind of questions of fact around it but also if a scheme is giving out surplus many sponsors worry about the impact of for example granting discretionary pension increases as that increase isn’t just the payment of that extra increase but it increases liabilities going forward and by increasing future liabilities you also increase future risk and the chance that those benefits can’t be paid in the future.

The other issue with granting discretionary increases as a way of distributing surplus is that many deferred members won’t see that discretionary increase until they retire which could be many many years from now, so what I’d really like to see to kind of help this debate and make things a little bit easier is a new type of HMRC authorized payment where schemes would actually be allowed to pay surplus to members straight away now as a tax lump sum.

So that would mean that any surpluses that arise could be treated as a win fall both on the sponsor and to the members and that could be shared with everybody without further promises needing to be accumulated and I actually think that could be a real game changer for these debates because I think the real concern is that kind of compounding liabilities by giving bigger benefits, but then causing problems further down the line.

Something else that is very interesting and that can be done at the moment is using surplus to fund future acral or indeed to fund DC contributions for members within the scheme now technically if you’re using the DC contributions for other members that’s not going to your existing members and so that could be seen as a refund to the sponsor by another route but it is going into pension provision so it is helping achieve the objective of increasing retirement saving and I think that’s quite a powerful argument that effectively you are using that surplus to build retirement benefits.

The optimist in me thinks it could even be used to fund new DB accrual, I think especially referring back to my previous comments around sponsors having long memories about those difficult times with volatile deficits, I don’t think many will be thinking of using surplus for increased defined benefit accrual but the optimist in me kind of hopes that perhaps we could see a resurgence of DB even if it was only one or two schemes opening I think it could completely change the landscape but perhaps that’s me being a little bit too optimistic about the future.

Chris

What you say about all of these developments, if there is surplus to be generated in existing DB schemes that can be used to either provide DB or one off payments directly as an authorized payment to members or DC in the same trusts or perhaps by taking money out of the employer and then letting the employer use it for other DC provision you know there is it feels like we’re in a real time of innovation at the moment and there must be some changes are coming to you know to really innovate and encourage saving. Not least on the day we’re recording of course by the time this goes out it will be a few days later now but today as we’re recording we’ve had the news of the new Royal Mail collective plan which is the UK’s first collective define contribution scheme so you know sort of right right on topic on point and a sort of a new innovative way of of saving in UK pensions.

Sarah

Indeed with the DWP or also consulting on options for how you can use defined benefit scheme surplus so we’re very much kind of waiting to see what policy might emerge from that and as mentioned earlier some of the trustees and some trustees and sponsors are waiting to see what will come from that before finally formalizing what they want to do.

I think actually enabling employers to access surplus on an ongoing pace basis with controls in place might actually encourage employers to fund their schemes to a stronger level and that could be in the interests of both those sponsors and in the interests of members.

It will definitely make sponsors more engaged with their schemes as well and I think at the same time though that engagement could mean sponsors are much more thinking about investment strategy and it could lead to a lot of change within how to find benefit schemes are run but at the other end of it many schemes are still very much committed to their de-risking journeys they’ve you know years of kind of de-risking getting to that fully funded on a buyout possession and I think for those, it would seem too far to do a complete U-turn when they finally got to their destination and say no we think run on is best for us because they have worked so hard to get where they are.

Helen

There’s so much we could cover today, I mean we haven’t even touched on consolidators such as Clara or a possible public consolidator but that will have to be in a later podcast episode, if our listeners do want to hear more about defined benefit consolidation we did an episode on that season two, episode two of the podcast, but Sarah do you have any final takeaways for our listeners?

Sarah

I think my final thought is just there is so much to think about at the moment and I think there is no right answer whether it’s risk transfer or run on either could be right for your scheme.

I think the key thing is to engage with the decision and to think about what you want to achieve and engage with those things about if you had a surplus what would you do with that surplus and really really test the decision and discuss trustees and sponsors working together to get a good outcome.

Chris

I think that’s a good final message that I would agree with that wholeheartedly work together and it’s the collaboration that brings about the good solutions I think.

Helen

Thanks so much for coming on the podcast Sarah and giving us your valuable insights.

Sarah

Thank you, it’s been really interesting talking to you.

Helen

So thank you for listening to the Burges Salmon Pensions Pod, our next episode will cover define contribution use of liquids and productive finance, in particular looking at long-term funding targets.

If you’d like to know more about our Pensions team and how our experts can work with you, you can contact myself, Chris or any of our team via our website. All of our episodes are available on Apple, Spotify or wherever you listen to your podcasts. Don’t forget to subscribe and thanks for listening!