For many Trustees and employers, reaching the point where you can secure your pension liabilities with an insurer seems like an impossible task.
The Pensions Regulator publishes ‘Scheme Funding Statistics’ each year based on various ‘tranches’ of pension schemes. As at May 2015, the average buy-out funding level was 58% for schemes with a valuation date between September 2012 and September 2013.
For the majority of schemes , the path to buyout is not an easy one but it is important to understand that there are measures you can take to move towards this goal.
I have set out below our ‘five steps to buy-out’:
Know what your liabilities are
Pension benefits are complex due to various changes in legislation over the years. It is important that Trustees and employers understand the benefits that have been promised to members and the estimated cost of providing these.
I have seen many cases where Trustees reach a position where buy-out is in sight, but a legal review of the scheme rules unearths an additional benefit that members are entitled to, and as a result, the scheme liabilities increase by as much as 40%.
In addition to the benefits secured, it is also important that the data used to value these benefits is correct and robust.
It is worthwhile investing the time now to carry out a legal review of the scheme benefits, a benefit audit to ensure members are being paid and are entitled to the correct benefits, and a data audit to ensure the data on which the valuation numbers are based is correct.
Only at this point can Trustees and employers implement a strategy to target buy-out. If these steps are not carried out, the scheme funding plan could be targeting a liability that is significantly different to the true cost of buy-out.
Completing these steps also makes administering the scheme much more efficient.
Manage your liabilities
Liability management exercises help to reduce the cost of providing benefits in the scheme. They also reduce risk and volatility in the funding position, and potentially pave the way for buy-out.
These exercises are driven employers with input from trustees. There is a Code of Practice that I would advise is followed to ensure any exercise is carried out fairly and transparently.
Employers can offer members various options for taking their benefits:
- Transfer value to another registered pension arrangement (this can be on an enhanced basis or on an unenhanced basis);
- Trivial commutation lump sum (if eligible);
- A pension increase exchange option (where an increasing pension is swapped for a higher initial pension that does not increase in payment);
- Early retirement.
In April 2015, the pension landscape changed dramatically with members of defined contribution schemes having much more flexibility in how they choose to take their benefits. This flexibility is not available in defined benefit schemes.
Liability management exercises are a tool for reducing and controlling pension scheme liabilities but I also believe that given the introduction of these pension flexibilities, trustees have a duty to advise members of the options available to them at retirement and how to access these flexibilities if desired. Many organisations are currently running these types of exercises with this as the main driver.
Have a look at our case study to see how these exercises can impact.
Make your investments work for you
Investment returns have been relatively strong over the past few years with almost all asset classes performing well. This has fallen away in recent months with equity returns in particular falling significantly in the last quarter of 2015 and into 2016. Schemes with high equity exposure may therefore see a significant deterioration in funding.
Going forward, I believe that asset returns will be more difficult to achieve. Trustees and employers moving towards buy-out should therefore consider their investment strategy and whether or not it is appropriate given their long term goal.
The level of risk that can be taken should reflect the covenant of the employer and any downside risks should be managed to ensure that contributions are not eroded over time and the funding position is gradually moving towards target.
Stochastic modelling methods can add significant value by determining the ‘optimal’ asset strategy that maximises success and minimises failure.
Investing time to develop an appropriate strategy based on the Trustees and employers long term objectives can add real value, and is likely to significantly contribute to the ultimate goal.
Monitor your position over time
It is important that Trustees and employers have access to up to date information to monitor the position over time.
Trustees and employers should have access to real time, daily funding levels based on live administration data and asset information to understand the funding position at any point. This will give real control over funding and will allow the Trustees to make quick decisions if required – for example if the Trustees decided to de-risk and ‘lock-in’ investment gains at a high point in the market.
Without access to this information, Trustees are exposed to the risk of making decisions based on out of date information (or being unable to make quick decisions at all).
Trustees and employers should also have access to real time market information on the cost of buy-out to ensure that when the opportunity to secure terms approaches, the Trustees and employer are ready to act on this in a timely manner. Acting quickly at this stage can often save a significant amount on your buy-out price – this is why it is important to have everything in order at this point (and why steps 1 and step 4 are so important).
Don’t accept the status quo
Pension scheme liabilities are long term, as will be any strategy to remove them. It is important to understand that there isn’t a magic wand. Any strategy will be long term in nature (possibly 15-20 years) and will require commitment and dedication from Trustees and sponsors to reach the desired goal.
It can be a difficult ‘sell’ to invest time developing a funding strategy that does not deliver real results until 15/20 years down the line, however doing nothing will almost certainly yield no results. Do something today that you will look back on as a positive move and as the beginning to the end.