Identifying the funding horizon means balancing objectives and expectations, particularly given likely prescriptive new funding rules
- Buyouts in the short or long term are the only realistic goal for a UK pension fund
- Identifying the right horizon means minimising covenant risk and optimising contributions and investment risk
- Extending the horizon allows trustees to manipulate investment risk
Corporate pension funds are not expected to continue indefinitely. With closure to new members and (possibly) future accrual, the fund is seen by sponsors as a liability to be secured before the risks become burdensome. We are likely to see more prescriptive funding rules being proposed by the Pensions Regulator in 2019. These influences mean that pension funds need to be clear about how they will secure their liabilities and encapsulate this in a clear funding objective.
There are a number of possible outcomes for a closed pension scheme:
- secure with an insurance company through a bulk annuity buyout
- secure through a consolidation vehicle;
- pay all the benefits as they fall due, until the costs of governing the scheme become too great in comparison to the remaining benefits;
- insolvency and secure a portion of the benefits with an insurer, if funded above the PPF level;
- insolvency and entry into the PPF.
Clearly, no scheme should be (or allowed to be) planning to enter the PPF. Therefore, the only viable objectives for a pension fund relate to whether it will seek a buy-out in the near future or after a period of paying down the liabilities to reduce the cost of purchasing a bulk annuity.
What are the objectives?
The first question is whether the immediate objective should be to secure a level of funding to:
- secure the liabilities with a bulk annuity; or
- enable benefits to be paid without additional sponsor contributions (self-sufficiency).
Even if the second objective is chosen it is unlikely that any pension fund would persist until every last pension payment has been made. So the first conclusion, is that any objective that is not directly linked to securing the liabilities with a bulk annuity will have to consider renewing its objective in the future. Such a review may be years away. However, it is with absolute certainty that achieving full funding on self sufficiency will lead to a further objective of funding to purchase a bulk annuity being set in the future.
Whatever the objective, the pension fund will require some time to meet it, through a combination of sponsor contributions and investment returns. However, the longer the time horizon, the increased risk that the sponsor covenant will deteriorate and make potential sponsor contributions less reliable. Taking too long to meet the objective increases the risk that it may never be met. Conversely, the longer the time taken, the more opportunity to produce returns.
Conversely, targeting too short a period will increase reliance on contributions as the main tool to improve funding. Hence the period being chosen has to find a ‘sweet spot’ where:
- the covenant will not be exposed to significant deterioration;
- the contributions expected to be received are not burdensome on the sponsor;
- the investment risk to be taken is within the tolerance of the trustees and the sponsor.
What is acceptable risk?
Of course, there is no simple answer to how much investment risk should be absorbed. What we can say is that the risk should be affordable to the sponsor and is dependent on the strength of the covenant. If the covenant is strong, then the trustees may wish to take more investment risk at the start of the journey, in case the covenant could not support investment risk later. If the investment risk is successful, this means that risk can be reduced later, or sponsor contributions reduced.
Inevitably, once a pension scheme has a strong funding position, there will be a reluctance from the trustees to take any investment risk above the minimum required to satisfy the objective over the required timescale. This is the right approach given that the downside of taking too much investment risk is a deterioration in funding, pushing back the timescale or forcing an increase in sponsor contributions.
Therefore, most pension schemes will seek to keep the investment risk low, while keeping the contributions at an affordable level. Eventually, many funds may no longer receive sponsor contributions and rely solely on investment return to drive funding improvements. In this situation, there is little incentive to absorb significant investment risk as the sponsor would not wish to re-commence contributions if it had previously met its obligations.
With increasing regulatory oversight, pension funds need to be clear where they are heading. All pension schemes will eventually secure their liabilities through an insurer or third party consolidation vehicle. The key question is how long before declaring that an achievable objective, especially when running a closed scheme for longer will make the buy-out target easier to achieve.
By extending the time horizon, schemes are able to either take less investment risk throughout the period, or target investment risk to when the sponsor is able to bear the potential negative consequences. In either case, it is difficult to see reasons as to why either the trustees or the sponsor would wish to target investment returns greater than the minimum needed to reach their objective.
Danny Vassiliades is principal at XPS Pensions Group