Those running defined benefit schemes need to determine their end-goals – and how they will get there, says Costas Yiasoumi
As UK defined benefit pension schemes mature, it is becoming increasingly important to determine such schemes’ long-term targets and the journey plans for getting there – indeed, this will soon be a legal requirement. The Target End-States for Defined Benefit Pension
Schemes Working Party was tasked with developing a framework for determining the long-term target, which we call the target end-state (TES).
For most schemes, the TES will involve achieving and maintaining a state of low dependency on the sponsor covenant, or the transfer of benefit entitlements to an insurer or superfund (once they are established). The plan for achieving the TES assumes the employer remains solvent in the interim, but there needs to be a Plan B if the employer fails, as shown in Figure 1.
We decided on the term ‘target end-state’ rather than ‘long-term objective’, which has been widely used within the industry, because we wanted to distinguish the TES as the more detailed articulation required to create clear strategic direction and action plans.
Defining the TES
A TES needs careful definition if it is to be useful. For example, describing ‘buyout’ as ‘the purchase of an insurance policy’ is not sufficient, as the insurance policy is a means to an end. ‘Buyout’ would be better described as ‘the robust winding up of the scheme and discharge of the trustees’ duties, with benefit entitlements being met in accordance with scheme rules’. We then need to consider how to deliver this outcome, with the purchase of an insurance policy being one part of the process.
Our description of the low-dependency TES differs from definitions that are simply expressed as the discount rate used to calculate scheme liabilities or technical provisions. We need to describe the associated investment strategy, contingent security to support the employer covenant, longevity risk management, member options strategy and so on.
It is crucial to analyse member outcomes to support identification of an appropriate TES and its associated journey plan. The three TESs described in the first column of Figure 1 deliver member entitlements in full, assuming they are successful. However, they each have a likelihood of being unsuccessful, either because of employer insolvency during the journey or, in the case of transfer to a superfund, because the superfund subsequently fails.
The way priority orders operate for insolvent schemes on wind-up is complex. For example, although a scheme’s aggregate buyout funding level might be, say, 85%, some members may get no benefit reductions on insolvent wind-up, while others may see reductions of as much as 50%. When we model the projected outcomes for representative member cohorts, we can clearly see the impact of different TESs and their associated journey plans. A process for evaluation of the TES and journey plan is shown in Table 1.
What about ‘Plan B’?
For schemes where there is a high likelihood of employer failure, member outcomes might best be improved by focusing on a failed employer TES, rather than working towards an unattainable traditional TES (see Figure 2). However, sponsor covenants can fail quickly and unexpectedly, so even well-funded schemes with sound sponsors should consider their Plan B.
When considering what’s best for the membership as a whole, there are many challenges for schemes whose sponsor is weak or fails – such as having to make trade-offs between outcomes for different member cohorts.
To date, where an employer becomes insolvent, PPF+ buyouts have been almost universally adopted. However, other options become available as schemes become better funded and the solutions open to them more sophisticated.
Dynamic discount rates
For schemes that adopt a cashflow-aware asset strategy, a gilts + x% type discount rate to value the liabilities can create short-term volatility between the value of liabilities and assets, even if the x% is subject to update at triennial actuarial valuations or annual funding updates.
Bulk annuity insurers universally adopt ‘dynamic’ discount rates, by which we mean those that are not based on a fixed addition to a gilt yield; this can materially improve alignment of day-to-day changes in asset and liability values. We believe the profession needs to support the development of methodologies for dynamic discount rates.
Each TES may have several different potential journey plans that need consideration from various angles, including member outcomes.
For example, consider a scheme that is progressing towards buyout. If it takes too much investment risk and the sponsor subsequently fails during a market downturn, there may be deep and unpalatable benefit reductions for some of the scheme’s member cohorts. A lower-risk investment strategy may therefore be appropriate, even if that means a longer period of exposure to sponsor failure risk. In other words, the trustees may decide that member outcomes will be improved through a lower risk investment strategy because, even if the likelihood of sponsor failure is higher over the longer journey, the quantum of the benefit reductions resulting from a downside scenario would be smaller, and ultimately more equitable across members.
The opposite may also be true, such as for a scheme that is targeting a transfer to a superfund and is in a race against time due to the high likelihood of employer default; here, a higher risk investment strategy may improve member outcomes. This is a consequence of the binary nature of affordability where, if a superfund transfer is affordable, members can receive full benefits; if it is not, even by a small amount, then some members may see significant benefit cutbacks on employer insolvency, following a PPF+ buyout.
Opportunities for actuaries
Many actuaries have taken the opportunity to move from technical specialist roles into strategic advisory roles. Broad generalist skills become vital here, and deep, technical precision must be replaced by more agile, rounded thinking: the ability to facilitate multidisciplinary collaboration, quickly weigh up options and play out scenarios.
The TES for Defined Benefit Pension Schemes Working Party has made eight recommendations that we believe would help improve member outcomes:
- Actuaries should press trustee boards to take legal advice on their powers, and to clarify and confirm members’ legal entitlements.
- Schemes should clearly define what their TES means in practice, not adopt sanguine definitions.
- The profession should sponsor research into the use of dynamic discount rates for calculating a scheme’s liabilities, or technical provisions.
- Strategy and journey plan is sometimes strongly influenced by a drive to avoid adverse impacts on an employer’s financial statements, which can be bad for member outcomes. This is an area for further work by the profession and the Pensions Regulator.
- Schemes should develop and understand their Plan B in the event of employer distress or insolvency.
- We recommend actuaries help clients focus on member outcomes.
- Member outcomes analysis is very dependent on assumptions and models. The actuarial profession should sponsor research into this area.
- There is a need for clear and consistent legislation and/or detailed guidance on running a scheme as a SWOSS in the event of sponsor failure.
We hope these recommendations are taken forward. Early signs are good – a Member Outcomes Working Party is being established, and one on dynamic discount rates is on the list, so watch this space.
A longer version of this article can be found at bit.ly/DirectionOfTravel
Find the TES for Defined Benefit Pension Schemes Working Party’s sessional paper, Report of the target end-states for defined benefit, at bit.ly/TES_WorkingParty
Costas Yiasoumi chairs the TES for Defined Benefit Pension Schemes Working Party
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