27 April 2022
With their schemes increasingly well-funded, a key goal for many sponsors will be managing either a journey towards insurance or how best to manage surpluses that arise.
This article was first published in our Leading the Way report.
LCP's latest research suggests that, for around half of the UK's largest sponsors, their schemes may already be fully funded using the kinds of prudent long term "low-reliance" funding requirements we expect to emerge from the Pensions Regulator later in the year. Given this, we expect an emerging goal for many sponsors will naturally be to find ways to complete journey plans, without significant additional or unexpected cash strain.
Robust contingency plans will clearly be a key to achieving this. But what does that mean for sponsors in terms of the funding and investment strategies they would prefer their schemes to adopt and what financial risks are worth running?
Of course, the answer will be very scheme dependent, but I think sponsors of well-funded schemes will eventually want to be in one of two camps (and which will drive a breadth of investment strategy decision making):
Prefer to buy-out when possible: aiming to pass liabilities to an insurer when it is cost-effective to do so (eg when additional contribution required to fund the insurance premium needed is low or zero).
Prefer to run-off over time: as they believe this will ultimately be most financially rewarding. For example, this could be either to benefit from indirect accounting effects (eg under USGAAP), or because they hope to recover a “trapped surplus” from the scheme in future (which reflects assets building up in the scheme in excess of prudent assumptions).
A further set of sponsors may be considering emerging Superfund solutions in the near term, for example where sponsor covenant is especially weak, or potentially in unique situations such as around transactions. These cases are likely to be especially complex and for example, if significant "one-off" additional cash funding is available at the time of entry into the Superfund, this could make a Superfund solution very attractive to members and trustees. We discuss some further developments below.
There may also be a further Camp that may wish to "run-off" the pension scheme but don’t expect to get anything back. In my view this camp will shrink in size as I believe this isn’t a very appealing approach compared to the two options above.
Camp 1: Buy-out strategy
Those in the first camp will want to make sure they are working effectively with trustees to achieve the following in their investment strategy:
Arrange hedging and risk management policies with an eye on insurance pricing and being mindful that:Allocating lots of funds to long-dated cashflow matching credit might be problematic if credit spreads increase (as insurance pricing won’t necessarily follow suit); and
Having more diversified, liquid and shorter-dated investments will be beneficial.
Have a framework in place to insure sub-sets of liabilities, either to phase risks over time or capture opportunities. But also being mindful that:At times the market could be very competitive (expensive) as others in your camp may want to take these actions at the same time; and
There are positives to building relationships early on with insurers that are increasingly capacity constrained.
Make sure to generate enough returns to bridge the gap to buyout:Drifting too slowly towards buy-out could mean an additional cash payment is still needed at the end.
Camp 2: Run-off strategy over time
For those in the second camp, this is where I think we’re likely to see the most investment innovation, in addition to the more traditional contingent asset approaches.
For example, from an investment perspective, we’ve seen, and expect to continue to see, developments in the following areas:
Co-investment vehicles or flexible capital arrangementsFor some of the largest schemes, we’ve already created innovative examples of co-investment vehicles, that are designed to flexibly guard against trapped surpluses and build on more traditional contingent asset models. For example, in a co-investment vehicle, money gets invested for the mutual benefit of both parties and if it then transpires it’s needed by the scheme it is paid in. Otherwise, money can return to the sponsor. A recent example where we have supported this kind of structure being put in place was for BT and its scheme - read more about this structure here.
For sponsors that still have significant contributions left to make, they should consider investing them in flexible arrangements (of course the tax implications of any solution will also be a key consideration).
The rise of third-party capital and profit sharingFollowing TPR’s approval of the first Superfund structure with Clara, we expect to see a diversity of new options emerge. For example, private equity could also be a natural partner for pension schemes and their sponsors. That's if they were able to efficiently use capital to underwrite downside risks associated with a scheme’s journey plan as part of structures that are expected to ultimately generate a surplus in the scheme.
This type of structure could also be a win-win for sponsors and trustees if the third-party capital helps support a “right sized” investment strategy that continues to efficiently generate strong returns all the way to the end of the journey plan, and so helping to mitigate the risks of unexpected sponsor cash requirements in later years.
We are helping several clients to investigate innovative options and you can read more about consolidator and third party capital solutions here.
Innovation in investment structuresA key challenge is how to ever recover a "trapped surplus". Trustees ultimately control investment strategy decisions and so are likely to favour buy-out when it is affordable (so “spending” the surplus that a sponsor might prefer to emerge in the future). As such, building a structure in which a sponsor can access a surplus would likely require a combination of highly attractive security for the trustees and contractual mechanisms around timings for future buy-out. Possible areas for innovation in this space could include:
a). Investing scheme’s assets, plus sponsor "contingent" assets in a common investment vehicle, with the funds then being “tranched” at a later date according to pre-agreed rules (similar to how asset-backed securities are structured) with the pension scheme having the most senior tranche and receiving all funds if needed. Sponsors could hold the equity tranche and access all surplus fund; or
b.) Contracts for difference. Pension schemes currently pay out huge sums of money to investment banks when inflation falls (and they’re happy to do as the value of their liabilities has fallen) in return for having downside protection. Given current volatility in this area, and provided sufficient safeguards are in place, might the same approach work for a scheme’s funding position rather than just the component parts?
c.) We are currently helping several clients to investigate innovative solutions in this area.
Set up your own insurerThere is of, course, one very well-trodden path for accessing surplus from pension schemes in return for underwriting the risks; bulk annuity providers have been doing it for years. For the largest of pension schemes, self-insuring is a solution that could be on the table. The key question in my mind would be how to most efficiently transition from the pensions' regime into the insurance regime, and planning needs to start well ahead of time, ie pretty soon!
With schemes increasingly well-funded, we expect to see a diversity of strategies emerge that seek to answer the question of how to efficiently complete journey plans, whilst managing downside (and upside) risks. Will insurance solutions continue to dominate these outcomes? Or will innovation in the market continue to broaden opportunities for sponsors? With so much capital available and potentially attractive returns, we think it is almost certain the market will continue to develop innovative new solutions to support sponsors and trustees.