There is a curse: “May you live in interesting times”. We, in the UK are coming to understand the truth of this following the Brexit vote and snap General Election. Businesses face uncertain futures, while markets can react unpredictably. What’s an employer sponsor of a defined benefit (DB) pension scheme to do?
This blog highlights key insights from our Employer Conference, which focused on the impact of change on companies’ pension strategies. We explain how to set a dynamic pension strategy that will be resilient in the face of changes in markets, whilst remaining cost effective over the longer term.
Pension strategies have evolved
Current levels of deficits arising from low gilt yields may have felt like a bolt from the blue, but this was no meteorite to kill the DB dinosaur. Instead, it has been the impetus for schemes to start to take small steps out of the water.
A traditional buy-out can seem like an unreachable goal for employers struggling to fund deficits. Instead, companies are now focusing on reducing risks to a comfortable, but not excessive, degree. A scheme can then pay pensions as they fall due as originally envisaged. The scheme will shrink over time, and further options can be considered if and when they would be of benefit.
This means that cash payments into and out of a scheme are becoming increasingly important. As more members retire, it’s unlikely that the employer’s contributions will be enough to cover the payroll. Schemes are looking for alternative ways to use their scheme investments to meet cashflow needs. This is a particular issue where a scheme has seen an increase in requests for transfer values, as transfer values can be a significant chunk of a scheme’s assets.
Employers therefore now focus on core investment and funding issues, rather than looking for the silver bullet that will solve their pensions problem. There are also ways that employers can accelerate the winding-down of their scheme in small steps, through liability management such as pension increase exchange and commutation exercises.
This unpredictable world
Companies want stability to allow them to plan. Yet we have had two referendums and two general elections in the last few years. Overseas, as well, change is afoot following the election of President Trump in the US.
All this has affected business, the financial markets, and hence pension schemes. Change is not necessarily always a bad thing. Brexit is a prime example - many schemes with overseas assets in foreign currencies may have seen great returns recently.
Life expectancies, too, are not exempt from change. Life expectancy is still forecast to improve over time, but the rate of that improvement appears to have slowed over the last few years. It seems that this trend coincided with a period during which government spending on healthcare did not increase (as a proportion of GDP) – an interesting correlation, even if not definitely the cause. While companies will want their employees and pensioners to lead long and healthy lives, the impact of this slowdown will be to reduce the pressure on DB deficits slightly.
"Life expectancy is still forecast to improve over time, but the rate of that improvement appears to have slowed over the last few years."
Pressures of regulation
DB deficits do no-one any good as they scare members and they look bad on a company’s balance sheet. The Pensions Regulator appears to be getting tougher on funding, requiring more of trustees in negotiating employer contributions to clear deficits. The treatment of the pension scheme compared to that of the company’s shareholders will be a key focus. The Regulator is particularly interested in the ratio of deficit contributions to dividends paid.
Companies can also expect the Regulator to intervene more and earlier, where there is an underfunded DB scheme – particularly in the event of a corporate transaction.
Employer covenant is at the forefront of both the Regulators’ and trustees’ minds. Where there is a deficit, trustees are effectively hoping that this can be made up by a combination of investment returns and the employer’s support. The new Integrated Risk Management framework puts even more focus on importance of employer covenant and employers should be willing to discuss this with trustees in order to support funding talks.
Meanwhile, some regulation has had an unanticipated impact on DB schemes. The pension flexibilities available from defined contribution schemes can be attractive as they allow members to access their benefits in a more flexible way. Employers can take advantage of this opportunity to de-risk the scheme significantly.
Rowan Harris contributed to the writing of this blog post.