Viewpoint: Consolidation in UK pensions market – what are the options?

Recent market volatility has put defined benefit (DB) pension schemes firmly in the spotlight.

At a time when corporate sponsors are looking to manage the risk of an impending recession, deal with a cost of living crisis and manage increasing operational and workforce costs, uncertainty around their DB pension liabilities is an unwelcome issue, particularly for those with liability-driven investment (LDI) portfolios.

The new DB regulations and DB funding code – expected by the end of 2022 – and requirement for trustees to seek a low-risk, low dependency investment strategy are further elements of uncertainty, prescription and potential costs.

With such political and socio-economic uncertainty, corporates are expected to start thinking seriously about whether they want to continue managing their DB pension liabilities. Now could be the time to consolidate them.

Broadly, there are three consolidation options for DB pension schemes in the UK market – apart from softer consolidation options such as sole trusteeship.

First, there is buyout with an insurer where all pension scheme liabilities are transferred to the insurer. This is often viewed as the ultimate form of risk management as it removes the pension scheme liabilities from the employer’s balance sheet and discharges trustees from liability.

The liabilities are consolidated with the other annuity liabilities of the insurer and the assets backing these liabilities are managed within the insurer’s portfolio. In the UK more and more schemes are moving towards buyout and the proposed new DB funding regulations may further accelerate the push towards this option.

However, capacity in the market is a potential issue and buyout is still too costly and unattainable for a significant proportion of the DB market.

Super funds are the second option and in the current environment, may start to demand serious consideration from corporates and trustees.

This option severs an employer’s liability to a scheme, allowing sponsors to remove DB pension liabilities entirely from their balance sheet. The sponsor’s financial support for the scheme – known as the “employer covenant” – is replaced by a special purpose vehicle employer with a capital buffer.

In exchange for an upfront, fixed payment (similar to the “premium” paid to an insurance company on buy-out), a sponsor employer can remove the uncertainty surrounding its DB pension scheme.

In November 2021, Clara Pensions became the first vehicle to pass The Pension Regulator’s superfund assessment process which marked a key step forward for superfunds. However, they are still in their infancy and a transfer to a superfund should only be considered if a scheme has no realistic prospect of buy-out in the foreseeable future.

Lastly, there are DB master trusts which are multi-employer occupational pension schemes for unconnected employers which seek to achieve economies of scale by pooling scheme operations. This includes investment, governance and administration functions.

The big difference with a master trust compared with an insurer buy-out or superfund is that the sponsor remains exposed to the scheme’s liabilities. This means the sponsor will want to retain a degree of control over investment strategy and manage assets in line with liabilities.

Would more pension scheme consolidation lead to increased investment in alternative ESG assets?

In principle, more pension scheme consolidation should lead to increased opportunity for alternative forms of investment and potential investment in ESG and impact assets – assuming they reflect trustees’ fiduciary duties and financial factors.

The largest DB schemes, particularly those with regulated asset management functions, already have direct exposure to infrastructure assets and new forms of renewable energy. Greater levels of pension scheme consolidation should enable more schemes to replicate the opportunities and investment sophistication of these largest schemes.

But, the position ultimately depends on the type of consolidation and there is a limit to how far consolidators can innovate in an investment context.

Superfunds have the potential to use economies of scale and asset pooling to increase the overall investable amount of pension scheme assets. Whilst this could open up a broader range of asset classes (including ESG assets and illiquid assets), it is worth noting that these vehicles are primarily run to provide security for members’ benefits and ultimately a return for the investors. As such, investment decisions are likely to be made with these two goals in mind.

The scale and experience of DB master trusts increases the opportunity for ESG investing whilst maintaining member and market confidence in pension schemes. However, whilst master trusts could drive different liquidity profiles by pooling assets on a larger scale, the sponsor remains exposed to the scheme’s liabilities and will likely want to manage the assets in line with the liabilities – meaning they may prefer a liability driven investment strategy.

This ultimately means it is less likely to result in a targeted move to ESG-based or illiquid assets unless it is compatible with the sponsor’s risk appetite and financial strength.

Buyout with an insurance company provides exposure to a diversified asset pool. However, insurers are subject to Solvency II requirements, which means more schemes reaching buyout is unlikely to change the overall type and focus of their investments.

The driver for consolidation in the UK DB market is predominately to de-risk schemes by transferring the liabilities away from the balance sheet of the employer sponsor or to provide a more effective governance model to reduce the burden on the existing trustees or sponsor.

Although these models do provide for a means of pooling assets, the real opportunity for alternative ESG, infrastructure and impact investing in UK pension schemes is likely to come through the rapid growth of defined contribution (DC) schemes and consolidation in the DC market.

DC master trusts have significant assets under management, are rapidly growing and with government backing can really start to offer opportunities for wider socio-economic investment in UK pension schemes. Their size means the need for liquidity for all their assets reduces and they have to market opportunities for their growing investment pool.