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FTSE 350 pensions: Capitalising on the
DB market opportunity
Last year, our analysis of the FTSE 350 Defined Benefit (DB) pension schemes charted the dramatic improvement in DB scheme funding levels over the 2022 calendar year. If that analysis captured a year
of transformation, the picture this year is one of stability and the
DB market taking stock from a position of strength.
While scheme funding levels appear to have found some level of stability (for now at least), the same cannot be said for the regulatory environment. There are two key DB reforms anticipated this year (although it is of course worth noting that the general election could derail the regulatory agenda). Firstly, the Pensions Regulator’s new DB Funding Code is due to land later this year, overhauling
the DB funding regulations that have been in place for two decades.
Secondly, we are expecting the Government’s response to the “Options for Defined Benefit schemes” consultation, where the proposed reforms are aiming
to make it easier to extract value from well-funded DB schemes for the benefit
of both companies and members.
In this analysis of the DB pension schemes of the FTSE 350 companies,
we examine how the FTSE 350 DB schemes have fared over the last year
and assess the economic opportunity that could be unlocked from
DB scheme surpluses if some of the proposed reforms are implemented.
Lewys Curteis
Principal and
Corporate Actuary
Funding level stability
Compared to the turbulence of the 2022 calendar year, the last 12 months has been a relatively benign period for DB scheme funding. The funding level gains that materialised over 2022 for most schemes have held up well as bond yields have remained elevated, short-term inflationary pressures have subsided and growth assets have performed strongly.
The relative stability in funding levels is illustrated by our DB End Gauge index,
which provides a measure of the average time to achieve full funding on a buyout
basis for the FTSE 350 DB schemes.
While last year’s analysis recorded a fall
in the index of over three years, the index
this year has only reduced by two months compared to the value at 31 May 2023.
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DB End Gauge Index
The strength in the funding levels of the FTSE 350 DB schemes can also be illustrated by the deficit contributions paid by the FTSE 350 companies, which have fallen to the lowest
level for a decade.
The estimated £4.7bn of deficit contributions paid in respect of the 2023 financial year is just over half of the figure paid in the previous year, reflecting the strong improvement in funding positions. For the first time, the contributions paid by the FTSE 350 companies into DB schemes (£8.1bn) was lower than the amount paid by these companies into Defined Contribution (DC) schemes (£10.0bn).
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Deficit Contributions
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For some, this will continue to be a case of seeking the right balance of investment risk and cash contributions to achieve a stronger funding position. While for schemes where the funding level is already strong, the potential merits of running on the scheme, as opposed to targeting a short-term buyout transaction, is now an option that should be given genuine consideration.
For trustees and sponsoring companies, this period of relative stability provides an excellent opportunity to take a step back and reassess DB scheme funding strategies to ensure these remain appropriate in the significantly altered funding and regulatory environment.
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Buoyant buyout market
2023 was a record year for the bulk annuity market, with both the number (226)
and value (£49bn) of transactions exceeding any previous year. These figures included bulk
annuity transactions by a number of FTSE 350 companies who decided to transfer some or
all of their DB liabilities to the insurance market during their 2023 financial year, including:
Close Brothers
Redrow
Cranswick
Mitchells & Butlers
Whitbread
Land Securities
Rio Tinto
Smith and Nephew
Close Brothers
Redrow
Cranswick
Mitchells & Butlers
Land Securities
Whitbread
Rio Tinto
Smith and Nephew
We estimate that around 35% of the FTSE 350 DB schemes were fully funded on a buyout basis at 31 May 2024, which is a small increase compared to the 33% calculated last year. The FTSE 350 DB schemes estimated to be fully funded on a buyout basis represent liability values
of around £175bn at 31 May 2024, which is over three times the bulk
annuity business written in 2023.
We are also expecting a further 20% of the FTSE 350 DB schemes
to reach full funding on a buyout basis over the next three years, representing additional liability values of around £140bn.
It should be noted though that not all of these schemes are likely to be
transaction ready (for example, with regard to data and benefit issues), and
it will be interesting to see how the market develops (both on the advisory
and insurer side) to meet this potential demand over the coming years.
For companies that are eager to reduce risk by transferring their scheme to the insurance market, demonstrating transaction readiness and a coherent execution strategy will be important to stand out in a competitive market. However, for an increasing number of schemes, a viable alternative option may be to defer an immediate buyout transaction and assess the potential economic value that could be obtained through running on the scheme over the short to medium term.
Opportunity cost of buyout?
The reappearance of DB scheme surpluses has ignited a debate about the economic value held in UK DB schemes and how this should best be deployed. The traditional option for well-funded schemes has been to transfer the responsibility for benefit payments to an insurance company via a bulk annuity transaction, enhancing security for members and reducing risk for the sponsoring employer – but in return for a large premium payment.
While we expect this will remain a popular option for the majority of the UK’s DB schemes, there is a growing recognition that a bulk annuity transaction results in an irreversible flow of the economic value from the scheme (and therefore members and the company)
to the insurance company. Indeed, the Pensions Regulator noted in its recent annual funding statement “the potential to generate additional surplus to benefit members and employers by running on”.
To provide an indication of the potential opportunity cost associated with these transfers of economic value, the chart to the left shows our estimate of the liabilities of the FTSE 350 DB schemes on a buyout basis and a best-estimate basis.
In the theoretical case that all of the FTSE 350 DB schemes transferred to the insurance market at 31 May 2024, this analysis would suggest that around £125bn of “surplus” would be passed over to insurance companies, being the difference between insurer pricing (which includes margins for capital requirements, expenses and profit) and the best-estimate cost of providing scheme benefits over the long term.
This is not to say that a bulk annuity transaction represents an inequitable exchange of value – many will view the cost as a fair price for the associated reduction in risk, and we think immediately buying out benefits once schemes are able to will remain the preferred option for the majority of schemes.
However, it is important that companies and trustees approach this decision with
a full understanding of the alternative options, particularly with the anticipated
shift in the regulatory framework potentially making it easier to use surpluses
for the benefit of companies and members. This is particularly important for
larger schemes, like many of the FTSE 350 schemes, where running on for
a period of time prior to buying out is likely to be more financially attractive.
DB surpluses – quantifying value
One of the key issues addressed in the Government’s “Options for Defined Benefit Schemes” consultation is the funding measure beyond which it is deemed to be safe to extract surplus. The consultation suggests that a low dependency funding measure plus a margin could be appropriate, or otherwise maintain the existing buyout funding measure.
If we assume that the Government decides to set the eligibility criteria based on a low dependency funding measure plus a margin, this could result in an immediate benefit for some of the FTSE 350 companies.
Our analysis suggests that around 62% of the FTSE 350 DB schemes (covering 87 companies) are currently fully funded on a low dependency funding basis. For the schemes that are fully funded on this basis, the surplus potentially available for extraction is around £45bn.
Determining how best to share surplus between members and companies will be a key point of discussion for trustees and companies. Providing value to members through discretionary benefit payments will be one option for distributing surplus. However, in cases where the company has paid in material deficit contributions over the years, there is a very strong case to be made that the company should be the main beneficiary of any share of surplus.
1
1 Gilts+0.5% discount rate with expense reserve and 5% prudence margin
The value for companies will depend to some extent on the size of the DB scheme (and associated surplus) relative to the size of the company and the way in which the surplus funds would be used. To provide an indication of the potential value for the FTSE 350 companies, we have considered two ways in which surplus funds could be used:
From 5 April 2024, the Government reduced the tax payable on the repayment of surplus from a DB scheme to a company from 35% to 25%. Based on this new rate, if the estimated £45bn low dependency surplus in the FTSE 350 schemes was refunded in full, this would result in around £36bn being paid to the FTSE 350 companies, with the remaining £9bn paid
to HMRC.
For 13 of the companies with a surplus on a low dependency basis, the potential surplus refund payment (net of tax) is equivalent to over two years of the dividends paid in the most recent financial year.
Direct surplus refund
Using DB surpluses to fund DC pension contributions for current employees is already a viable option in the UK market (an issue we explored in this blog). Again,
the feasibility of this will depend on the size of the scheme surplus relative to the company’s pension costs for existing employees.
For the 87 FTSE 350 companies estimated to have a surplus on a low dependency basis, the chart below shows the number of years of DC contributions that could potentially be funded by the DB scheme surplus above the low dependency liability benchmark.
Paying DC contributions
The chart shows that there are around 33
FTSE 350 companies that could fund over
five years of DC contributions from their existing DB scheme surplus, with over
half of these potentially able to fund
DC contributions for a decade or more.
Given the concerns in the pension market about the adequacy of the DC contributions being paid, this could represent a real opportunity for companies to improve the pension outcomes for its current employees
by paying a higher DC contribution rate.
Strategy review
In line with the Pensions Regulator’s most recent annual funding statement,
we would encourage all schemes to review their funding and investment
strategies to ensure these remain appropriate in the significantly altered
DB funding environment in which we now find ourselves.
While the challenges for less well funded schemes remain similar, i.e. seeking
the right balance of investment risk and cash contributions to reach a stronger position, the choices facing better funded schemes have broadened.
The vast majority of schemes will buy out benefits with an insurer at some point – the key question is therefore whether schemes choose to do so immediately once they are able to, or whether they choose to delay approaching the market in the hopes of generating greater surpluses and retaining economic value. We believe that an immediate buyout will remain the preferred option for the majority of
DB schemes, but would encourage companies and trustees to properly assess
the benefits that could be obtained from a run-on strategy before making the irreversible decision to transfer to the insurance market.
Calculation details
The data used for this analysis has been collected from the accounts of FTSE 350 companies for their 2023 year ends (i.e. up to and including the year ending 31 December 2023). Liability values on a buyout basis have been estimated by approximately updating these results and using Barnett Waddingham’s view of average buyout pricing. Asset values have been estimated using index returns and the asset split disclosed in the pension disclosures. The current level of deficit contributions has been estimated based on the information set out in the pension disclosures. The funding of DC contributions has been estimated assuming that the surplus on a low dependency basis would achieve a return of 2% p.a. above the growth in DC contributions.