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DB consolidators pose covenant trade-off questions for trustees: study

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Trustees of defined benefit (DB) schemes must weigh up loss of control over investment strategy against a stronger convenant when considering transferring to a commercial consolidator, according to a new report.

‘The Road Less Travelled’, from the Redington Ampersand Institute, said possible drawbacks of consolidators – also known as superfunds – included loss of control over investment strategy and the risk that assets would not be built up to a sufficient level to provide economies of scale.

Furthermore, members would not benefit from any future increase in the sponsor’s covenant quality, for example from increased profitability. It was also possible that the consolidator’s own return requirements would cancel out the economic benefits for the scheme.

Marian Elliott, head of integrated consulting at Redington and co-author of the report, said: “Moving a scheme to
 a consolidator will be a very big decision for
 any group of trustees, and what is most needed in this situation is a framework for making the decision… a compact series of questions and metrics that capture the key principles that govern the decision, from an investment, funding, covenant, and legal perspective.”

Trustees would need to consider the trade-off between the strength of the sponsor covenant being given up, and the strength of the financial covenant built into the solution.

The strength of the existing covenant could be measured from the sponsor’s credit rating and hence the probability of default over different timeframes. This could then be incorporated into a long-term risk model to arrive at what Redington called a “probability of paying pensions” (POPP).

The strength of the consolidator’s covenant, meanwhile, could be assessed from the funding level of its structure and the size of any additional capital reserve, relative to the investment risk being run in the structure. A long-term risk model could also be run with these capital reserves built in, to assess POPP.

According to the report, DB scheme consolidators are a developing market providing a third option to scheme trustees planning their endgame, in addition to an insurance buyout or a long-term run-off where the scheme is self-sufficient.

They provided the ability to sever ties to a corporate sponsor at a price that is less than full buyout.

Until recently, consolidators had generally been seen as a way in which pension funds could achieve cost savings from economies of scale, enabling more effective investment strategies and improving governance. Two commercial DB consolidators have launched – Clara Pensions and The Pension Superfund – in the past 12 months in order to offer these benefits to trustees.

However, Elliott said: “We think the main tangible benefit of a consolidator fund will end up being the exchange of a corporate covenant for a financial covenant.”

The UK’s Department for Work and Pensions is consulting on a legal framework for consolidators; the consultation closes on 1 February.

 

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