Defined Benefit (DB) pension schemes are complex and of long duration. They may appear to be a simple two-party contract between member and company. But in reality they have the potential to impact on a wide range of interests. A DB scheme in deficit represents debt on the company’s balance sheet. Indeed, any DB scheme represents a potential debt. Such debts are highly volatile and, by contrast with other debts, increase very significantly in the event of insolvency. Accordingly a DB scheme may dilute the security of other creditors, obstruct realisation of share value through corporate restructuring and transactions, and may complicate company borrowing

 

DB schemes are also exposed to major credit risk and are often the largest creditor on companies’ books. The Pensions Regulator is, quite rightly, reminding trustees to take this into account when determining contribution requirements and deficit restoration programmes. No board of trustees can feel happy when the future income of their members - stretching out perhaps 60 years into the future - depends on the continued viability of a sponsor whose BB rating implies a risk of failure within 10 years in the range 10-20%.

 

The exposure of the different parties to this credit risk can differ significantly. Shareholders are largely concerned with the cost and cash-flow consequences of putting right deficits, although these can be attenuated by up to 10 years or so under current regulatory guidance. DB scheme deficits rarely, if ever, cause sponsors to fail but the loss following failure to shareholders is likely to be  extremely severe since, on insolvency,  the value of DB liabilities increases to a full buyout valuation.

 

 Other creditors are in a similar position to shareholders in the sense that while the probability of loss is not directly impacted by DB deficits the loss following default is increased significantly in the event of sponsor failure.

 

 Parties to corporate transactions are faced with highly volatile debts and uncertain cash outflows. Where the transaction involves a change in the covenant of the employer, trustees are strongly encouraged by the Pensions Regulator to seek offsetting improvements in the security of the scheme which can in the extreme block such transactions altogether.

 

It is not surprising therefore that the search is on for ways to reduce the volatility and impact of DB schemes, on their sponsor’s balance  sheet while ensuring that the pension benefits can be paid in full over extended periods of time.

 

The options currently available can be broadly divided into four categories:

 

■ Full buyout, by which the sponsor’s and trustees obligations and responsibilities are passed to a regulated insurer achieving full finality. While a comprehensive and complete solution, for many sponsors the cost is wholly unaffordable.

 

■ Progressive build-up of surplus in the scheme making it more resilient to adverse developments and thus reducing its dependence on the sponsor. Such an approach may in time allow the purchase of a full buyout, which is to an extent pre-funded. However, this approach requires increased contributions and is likely to lead to surplus assets being trapped in the scheme which could have been put to better use in the business

 

■ Managing the risks of the current scheme through various programmes of liability driven investment. This can effectively reduce some of the risks to which the scheme is exposed - though critically not the risk posed by future increases in longevity. 

 

■ Reducing the liabilities, by providing incentives to members to transfer out at less than the FRS17 equivalent cost. Trustees must ensure that the value transferred does not unfairly disadvantage those who remain. Sponsors need to ensure that the saving to the scheme - and hence the reduction in their own debt - is substantially less than the cost of funding the enhancement.  Both sponsors and trustees also need to consider the reputational risks involved since there must be some concern about fairness issues with such solutions.

 

The common theme with all these approaches is that they involve a current cost for elimination of risk in the future. To this extent, they are similar in economic terms to purchasing insurance. In this context, the direct purchase of whole scheme insurance is a viable additional strategy to manage DB risk.

 

A new form of such insurance has been developed specifically to provide for cost effective risk management in DB pensions schemes. It does so by transferring risk from sponsor and trustees to a regulated insurer for a defined period.

 

The key characteristics of the insurance are a 10-year contract between scheme sponsor, trustees and the underwriter under which the trustees remain responsible for the administration of the scheme but transfer the existing scheme assets to the insurer at the inception of the policy.

 

In addition, the sponsor undertakes to pass to the insurer all the deficit rectification payments as agreed between sponsor and trustees and pays the insurer a risk premium.

 

The insurer provides funds to meet all pension payments during the policy period and undertakes that, at the end of the policy, assets to at least the value of liabilities will be returned as valued at that time.

 

 The insurer additionally guarantees that in the event of sponsor insolvency trustees will receive not less than 104% of PPF protected liabilities.

 

The contract also contains experience sharing arrangements such that any surplus of assets over the liabilities can be returned to the sponsor minimising the build up of stranded assets within the scheme.

 

The principle benefits of such cover are:

■ Full stabilisation of balance sheet reporting of the scheme since all sources of instability including longevity are covered by the policy

 

■ Provision of an ‘AA’ underpin for the scheme in the event of sponsor liquidation

 

■ Minimisation of stranded surpluses within the scheme.

 

■ Full flexibility. Trustees can cancel the  policy before the end of the term if an alternative strategy appears more attractive. At or before the end of the term they can roll the policy over into a new contract for a further period, take back full control of the scheme and scheme assets, or move to full buy out.

 

In many ways, the insurance cover acts like temporary additional capital, that is, its impact is equivalent to the sponsor introducing additional capital into the scheme but at significantly less cost.  However, the key distinction is that the increased capital is not locked into the scheme until completion of the last liability. Given the nature of existing remedies available to sponsor and trustees, what is fundamentally new about insurance-based solutions? The key differences appear to be comprehensiveness, direct costs, opportunity costs and flexibility.

 

The cost of DB insurance can be highly flexible in the sense that it is determined by the volume of protection purchased  and the extent to which subsequent experience is shared between scheme and insurer. For example, a DB insurance providing cover of 10% of liability deterioration is likely to be in the range 5-10% (subject to deductibles) for 10 years cover. By way of contrast, a scheme buyout might be in the range 30-40% of total liabilities after any deficit had been fully  rectified.

 

In practice, an insurance approach reconciles the need for investment outperformance and the need for balance sheet reporting stability. The nature of the year 10 obligation to return assets to the value of the liabilities as determined at that time represents a complete hedge against inflation, fluctuation in asset values and interest rates as well as longevity  The level of risk sharing between scheme and underwriter can be pre-determined through the adoption of deductibles. For example, the scheme might take the first 2.5% of any downside risk but would receive 95% of all upside performance.

 

It is probably fair to say that insured solutions are less effective at mitigating risk than buyouts but more effective than LDI programmes. Insured DB solutions integrate elements of both approaches in whatever combination appeals to scheme sponsors and trustees. The corollary is that the cost of DB insurance is also likely to be between that of buyout and swap programmes.

 

DB insurance is likely to be of interest to either relatively mature schemes whose liabilities relate primarily to deferred members and pensioners or schemes whose  liabilities are large in respect to the net worth of their sponsor in as far as changes in these liabilities can have a significant impact on sponsor net worth.

 

It will also interest schemes with an  excess of assets over liabilities as a means of protecting such a surplus as a potential move towards eventual buyout. Finally, it will also be of benefit to schemes with material but containable deficits relative to the sponsor’s net worth and in transactions where the scheme trustees are concerned about the strength of the sponsor’s financial strength following the  transaction.

 

In conclusion, DB insurance can be structured on a highly flexible and cost effective risk sharing basis relative to other alternatives. It is clearly not appropriate in all circumstances but seems a new and potentially highly useful approach to add to the existing toolset available to sponsors and trustees to manage DB scheme and deficit risk.

 

Andrew Campbell-Hunt is a director of Pensions Risk LLC