Consolidation: Panacea or pipedream?
Legislative changes will be necessary to enable consolidation
• The UK’s numerous small pension schemes could gain from consolidation.
• Consolidation could take place through asset pooling or multi-employer superfunds.
• Current law presents obstacles to this process.
Earlier in 2017, the UK government in its Green Paper on private sector defined benefit (DB) pensions1 , asked whether it should encourage, or even mandate, the consolidation of small schemes into vehicles with greater scale and better governance. Its reason was the need to reduce the risk such schemes pose to their members, in terms of failing to provide them with the benefits they are due.
The UK’s Pensions and Lifetime Savings Association’s (PLSA) DB taskforce has suggested the creation of superfunds, run on a 90% probability of delivery of full benefits and regulated robustly by the Pensions Regulator.
Most recently, the Financial Conduct Authority (FCA) has recommended that the department of work and pensions “continue to review and, where possible, remove barriers to pension scheme consolidation and pooling”.
The case for consolidation
The FCA considers that small schemes could benefit from consolidation. It concludes that size prevents schemes from exerting pressure on asset managers because:
• it tends to mean they have fewer resources for governance and monitoring performance of advisers;
• typically, it makes them less attractive to asset managers than larger pension schemes and, as such, less able to negotiate competitive fees.
The FCA’s study suggests consolidation will help schemes that wish to benefit from economies of scale. This should drive competitive pressure on asset managers’ fees – a primary focus for the FCA.
Furthermore, it believes that consolidation may improve oversight, particularly among smaller trust-based schemes.
Economies of scale and improved governance are also key issues identified by the PLSA’s DB Taskforce.
What does consolidation mean?
Consolidation could encompass anything from asset pooling through to superfunds that can absorb existing schemes, relieving employers and trustees of their obligations. Asset pooling has already started for the investments of the Local Government Pension Scheme in England and Wales which is in the process of creating eight asset pools. This is intended to drive down costs but also to enable infrastructure investment.
This transition to asset pools is not without challenge, but the government can exert control in the public sector. In contrast, in the private sector, there are additional hurdles in respect of alignment of interest among unconnected schemes and employers, as well as concerns around control.
It is also questionable whether – given the benefit structures, liability profiles and cash-flow requirements of private sector schemes – existing investment strategies can be unravelled or combined and scaled-up in the manner that an asset pool suggests.
As it stands, the legislative framework for private sector occupational pension schemes presents barriers to consolidation.
• Benefit design: There is no consensus on whether a consolidated vehicle would only create economies of scale if it were able to harmonise benefits. What is clear is that current pensions legislation would make it difficult for this to happen. Future benefits can be changed, but this would not help the many schemes already closed to accrual. Rights that have been accrued cannot be altered unless members consent.
• Employer debt: Broadly, employer debt legislation attributes liability for a multi-employer scheme’s deficit between its participating employers at the earlier of exit, insolvency or winding-up. While it does permit liability to be apportioned, an employer in a consolidated unsegregated scheme would become liable for the other participating employers’ buy-out deficits.
• Scheme funding: Similar challenges are formed by the scheme funding regime. Without segregation, one actuarial valuation would be carried out for the scheme as a whole. One of the bases on which participating employers’ contribution levels are calculated is the employer covenant (an employer’s obligation and financial ability to support the scheme now and in the future). Why would an employer with a strong covenant join with weaker employers? Not only could it be left with a greater deficit than its own, but it may also have to bear higher contributions from day one.
• Transfers: It is not currently possible to transfer members from a DB scheme that used to be contracted-out of the State Second Pension to a scheme which has never been contracted-out. As contracting-out ceased on 6 April 2016, this prevents a new scheme being used as a consolidating vehicle.
In addition, under pensions legislation, a bulk transfer can only be made without members’ consent if: the transferring and receiving schemes both relate to persons who are or have been in employment with the same employers; or the transferring and receiving schemes relate to persons in employment with different employers and the transfer is either a consequence of a financial transaction between the employers or the employers are related for the purposes of the legislation.
Employers will be related for the purposes of the legislation where, for example, they are part of the same corporate group.
The government is considering whether to make changes to these provisions to allow for the development of scale, but only with respect to defined contribution schemes.
• Trustee duties: Depending on the balance of powers in a scheme, trustees may be required to consent to a transfer to a consolidated vehicle.
Trustees have a duty to safeguard benefits and must act in the interests of the whole membership. In order to agree they are likely to want to be satisfied that benefits would be at least as secure in the consolidated vehicle as in the existing scheme. This will require analysis of the funding levels as well as, potentially, sponsor covenant and investment strategy. It is unlikely that this will be straightforward.
A move to scale in some form seems to be gaining traction. However, there will need to be some fundamental changes to pensions legislation before a significant consolidation of schemes becomes a reality.
Ian Cormican is a partner at Sackers
1 Security and Sustainability in Defined Benefit Pension Schemes, www.gov.uk/government/consultations/defined-benefit-pension-schemes-security-and-sustainability