Pensions Perspective

September 2020

Has endgame planning finally come of age?

Journey plans or glide paths have been around for a long time now, but over the last year  there has been increased focus from companies and trustees due to the emerging views of the Pensions Regulator on how schemes should be funded.

Whilst the impact of the Covid-19 pandemic may slow down formal implementation of the new funding code, it seems inevitable that “endgame” planning will be enshrined in future funding standards.

In this Perspective, I look at how long-term funding and investment plans are evolving and explain why companies are increasingly taking the lead in designing an endgame strategy for their schemes.

What has changed?

In the early years, the concept of a long-term de-risking plan which brought together funding and investment strategy was only taken up by a minority of (mainly larger) defined benefit (DB) schemes. There was perhaps a slightly cynical, but not wholly unreasonable, view that the main beneficiaries of such plans were the consultants paid to develop, implement and monitor these frameworks. However, journey plans have gradually become more mainstream, with many schemes now having some sort of long-term plan in place, even if it only covers de-risking of investment strategy.

Most DB schemes are now maturing rapidly, partly due to the simple passage of time since closure to future accrual but also because of increasing volumes of transfers out and the various liability reduction exercises many schemes have been undertaking over the last five years. At the same time, solutions allowing sponsors to pass over their legal responsibilities to another financial institution have developed quickly, specifically the traditional bulk annuity insurance market and also the new DB consolidators.

This has created an increased focus on what the endgame is likely to be for a particular scheme – will it be long-term run-off, insurance buyout or transfer to a consolidator? Almost as important as the endgame, what is the planned timeframe for reaching it? The answers to these questions can have a profound effect on future investment strategy and the pace of sponsor funding.

Designs being implemented in response to these developments usually have some key features in common – features that look quite different from “first generation” journey plans.

If implemented as currently envisaged, TPR’s new funding framework will provide helpful guidance for developing strategies that will support what it has termed Fast Track approval. However, whilst there is still likely to be scope for design flexibility within Fast Track, some schemes will want to choose the Bespoke route.

New interest from companies

In the past, the main stumbling block to implementing journey plans has been company concerns about being locked into a strategy that could create unwelcome cash and accounting issues at some point in the future. Companies have naturally wanted maximum flexibility to manage their finances. However, recent market conditions, in particular the low level of bond yields and corresponding large deficits, have led a number of companies to accept that there is a worthwhile price to pay for a structure that produces more stable pension costs (both in terms of cash and accounting) over the medium term.

Additionally, as we enter a period of increased Regulator interest in the relative levels of deficit contributions and dividends, volatile scheme funding levels have never looked less attractive to sponsors. The Covid-19 crisis and the resulting medium-term economic consequences are only likely to enforce that mind set.

The challenge is to find a solution that balances the higher cash contributions or accounting pain against the reduction in volatility. New approaches to setting funding targets and designing recovery plans can help with finding this balance.

Of course, this does not mean that companies will develop solutions that appeal to their trustees. Companies tend to want flexible designs that can adapt to changing business needs over a much shorter timeframe than trustees usually think about. However, the growing level of corporate engagement in the endgame debate is helping trustees and companies to see how much common ground there is and to develop a strategy that reflects a consensus position.

A key consideration for companies will be their appetite to comply with the Fast Track approach, as inevitably that will offer less flexibility for companies in designing their endgame strategies as compared with those schemes which pursue the Bespoke route.

How have solutions evolved?

Investment strategies

Historically, some companies have not wanted to engage on a long-term investment de-risking strategy because of a concern that very low gilt yields were a short-term aberration and they did not want to lock into the resulting deficit. However, over time the weight of economic evidence has led many sponsors to accept that a quick and significant rise in gilt yields is unlikely to happen.

In the main, the debate has now moved on to address the following questions:

  • what is the endgame for the scheme – insurance buyout, run-off or somewhere in between?
  • based on the answer, what is the optimum endgame investment strategy?
  • how do we get from the current investment strategy to that optimum strategy?

The second question can lead to some very interesting discussions. If the sponsor and trustees agree a scheme is heading towards insurance buyout in about 15 years’ time, what view do they take about the portfolio of assets which an insurer is likely to want some 15 years from now? If the decision is to run-off the scheme for the foreseeable future, then is this very different from operating the scheme as a quasi-insurer, albeit outside the insurance regulatory framework?

These debates have led many schemes to consider alternative investments to the main asset classes – for example other forms of high-quality debt, multi-asset credit, infrastructure and other illiquid assets. Through the use of various credit and illiquidity premiums, these strategies can typically expect to achieve returns of gilts plus 50-100 basis points a year.

On the one hand, there is a big prize here for any trustee board that has previously failed to gain traction with the sponsor on de-risking targets. Conversely, from the company’s perspective, whilst de-risking still comes at a cost, it has the comfort of knowing that its cash is being invested intelligently to target a return in excess of gilts.

However, one word of warning. These alternative investments can be attractive and helpful, but they are not always easy to sell quickly (at least without a significant haircut). A few schemes have been caught out in recent years when, for whatever reason, they suddenly have an opportunity to transact with an insurer in a short timeframe, only to find that they are locked into assets that are not acceptable to the insurer. The lesson is to be very clear on what you are invested in and read the small print!

Finally, a well thought-through long-term investment de-risking plan will help demonstrate to the Regulator that all parties are taking that all important long-term view towards the management of the scheme. The introduction of de-risking guidance as part of the new funding framework will provide a useful reference point for company thinking.

Funding targets

A long-term low risk funding target, reflecting an expected investment return in excess of gilt yields, can have a profound impact on the affordability of adopting a secondary funding target. As a result, it can greatly increase the likelihood of the company being prepared to sign up to a long-term de-risking plan.

However, the adoption of an investment and funding strategy that does not simply reflect gilt yields will present the trustees with two key concerns, which the company needs to address:

  • how to quantify the additional investment risk that the scheme is taking
  • a weaker funding target means the scheme will be further away from being able to afford a buy-in or buyout.

The first concern needs to be addressed by good quality investment advice and sound risk modelling. For example, some forms of high-quality debt could only really default in a scenario where it would be equally likely that the UK Government would be defaulting on gilts (or at the very least the credit rating on UK debt would have collapsed). This sort of analysis requires a mature discussion about real world versus model risk, an area where some investment consultants are much better than others at guiding their clients.

The second concern presumes that, when fully funded on a basis designed to reflect some out-performance relative to gilts, there is still a significant shortfall relative to bulk annuity pricing. In reality, with the majority of large schemes closed to future accrual, a plan that targets being fully funded on a low risk funding target after, say, 15 years is likely to comprise mainly current pensioner liabilities at that time. Although no one can be sure how the insurance market will develop in the future, it is likely that insurers’ terms for securing pensioner liabilities will not be significantly stronger than the funding basis.

However, even if the proposed long-term funding target does result in a shortfall against an insurance solution, the trustees need to weigh up the benefit of agreeing a long-term funding and investment strategy with the company now, compared with holding out for the “ideal” but actually not reaching any agreement to manage long-term risks at all.

It is helpful that the Regulator has suggested an LTO discount rate in the range from gilts + 0.25% to gilts + 0.5% in its first consultation, as this provides a useful reference point for companies and trustees.

Technical provisions or secondary funding target?

The introduction of any long-term funding strategy requires a decision to be made as to whether the endgame target should become the new technical provisions or be a secondary funding target. This is not an entirely straightforward decision and will be scheme dependent, with relevant factors including:

  • accounting implications
  • legal structure of the long-term funding commitment
  • provisions within the scheme’s trust deed and rules
  • any flexibilities built into the long-term funding target (see below)
  • how the company wishes to disclose information to the wider market.

The new funding consultation, if implemented, would support an approach whereby the technical provisions gradually converge to become the secondary funding target.

“…. It should be possible to keep de-risking strategies on track within a framework that significantly increases the chance of the company’s costs remaining affordable and reasonably stable over time.”

Use of flexibilities within setting of funding targets and recovery plans

The solutions described above are effective at managing down expected costs but in the short term, whilst the scheme is probably still running significant investment risk, volatile contributions remain a serious issue. Without finding a way to manage this volatility, companies will be concerned about signing up to a long-term strategy. Possible flexibilities are as follows:

  • if funding targets reflect planned investment de-risking, design them to contain margins for prudence that can be flexed depending on whether actual investment de-risking happens quicker or slower than planned
  • develop a flexible recovery plan, under which the recovery period and the allowance for asset out-performance over the discount rate can be flexed in a pre-defined manner to help stabilise contributions.

These two areas of flexibility can be powerful if correctly designed. However, because of scheme-specific funding, such flexibilities will require the low risk funding target to be introduced as a secondary funding target, rather than the technical provisions. For companies with weaker covenants, they can be supplemented by contingent asset/funding structures.

For an illustration of how using one of these flexibilities has helped a company in real life, see the case study in the box.

The trustees of a £5 billion pension scheme were keen to introduce a long-term investment de-risking strategy with an associated secondary funding target. The trustees proposed a de-risking strategy involving switching from equities into long-dated gilts and a secondary funding target based on unadjusted gilt yields and a 12 year recovery period.

This proposal resulted in expected company contributions of £100 million a year, which was more than the company was prepared to pay. However, of at least equal concern to the company was the exposure to the risk of much higher contributions if scheme experience was poor. In broad terms, there was a 1 in 20 chance of annual contributions increasing to £160 million at the next valuation, if the company signed up to the trustees’ proposals.

Faced with not securing any type of longer-term funding deal, the trustees were open to exploring alternative de-risking strategies, overlaid with derivatives in the early years to increase interest rate and inflation hedging. With our support, the company reached an agreement with the trustees that the secondary target would use a discount rate of gilts + 0.3%, reducing expected annual contributions from £100 million to £60 million over a 15 year period. However, the risk of highly volatile contributions remained, so the next step in the design was to introduce a flexible recovery period.

The design involved the following features:
  • the company committed to always pay at least £60 million a year, until the secondary target was fully funded. This meant that, if investment experience was favourable, the scheme would be fully funded within 10 years
  • the company committed to ensuring the secondary target was met within 18 years, so the initial 15 year period could be “flexed up” if there was poor experience in the short term.
With this investment and recovery plan design, the 1 in 20 risk was reduced from £160 million to £100 million.
The trustees of a £5 billion pension scheme were keen to introduce a long-term investment de-risking strategy with an associated secondary funding target. The trustees proposed a de-risking strategy involving switching from equities into long-dated gilts and a secondary funding target based on unadjusted gilt yields and a 12 year recovery period.

This proposal resulted in expected company contributions of £100 million a year, which was more than the company was prepared to pay. However, of at least equal concern to the company was the exposure to the risk of much higher contributions if scheme experience was poor. In broad terms, there was a 1 in 20 chance of annual contributions increasing to £160 million at the next valuation, if the company signed up to the trustees’ proposals.

Faced with not securing any type of longer-term funding deal, the trustees were open to exploring alternative de-risking strategies, overlaid with derivatives in the early years to increase interest rate and inflation hedging. With our support, the company reached an agreement with the trustees that the secondary target would use a discount rate of gilts + 0.3%, reducing expected annual contributions from £100 million to £60 million over a 15 year period. However, the risk of highly volatile contributions remained, so the next step in the design was to introduce a flexible recovery period.

The design involved the following features:
  • the company committed to always pay at least £60 million a year, until the secondary target was fully funded. This meant that, if investment experience was favourable, the scheme would be fully funded within 10 years
  • the company committed to ensuring the secondary target was met within 18 years, so the initial 15 year period could be “flexed up” if there was poor experience in the short term.
With this investment and recovery plan design, the 1 in 20 risk was reduced from £160 million to £100 million.

The last word

Whether or not the Pensions Regulator forces companies to adopt long-term funding targets over the next few years, the need to plan for the endgame in terms of both funding and investment strategy is compelling. Schemes’ liabilities are maturing and the financial risk to sponsors of not having a long-term game plan is correspondingly growing. The impact of Covid-19 is only likely to increase this risk. There is also the likelihood that, if companies are not proactive now, in future they may be forced to do something from a position of negotiating weakness.

By adopting some of the more creative approaches described in this Perspective, it should be possible to keep de-risking strategies on track within a framework that significantly increases the chance of the company’s costs remaining affordable and reasonably stable over time. And to do so within the constraints of the proposed new funding code.

The prize for getting this right is simply too big for either the company or the trustees to ignore. For more details on how bac can support you cost-effectively in developing a flexible long-term strategy, please contact one of our senior team here.

The last word

Whether or not the Pensions Regulator forces companies to adopt long-term funding targets over the next few years, the need to plan for the endgame in terms of both funding and investment strategy is compelling. Schemes’ liabilities are maturing and the financial risk to sponsors of not having a long-term game plan is correspondingly growing. The impact of Covid-19 is only likely to increase this risk. There is also the likelihood that, if companies are not proactive now, in future they may be forced to do something from a position of negotiating weakness.

By adopting some of the more creative approaches described in this Perspective, it should be possible to keep de-risking strategies on track within a framework that significantly increases the chance of the company’s costs remaining affordable and reasonably stable over time. And to do so within the constraints of the proposed new funding code.

The prize for getting this right is simply too big for either the company or the trustees to ignore. For more details on how bac can support you cost-effectively in developing a flexible long-term strategy, please contact one of our senior team here.

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