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CHOOSING AN ENDGAME OBJECTIVE

WHAT IS THE ENDGAME? In short, it’s not the journey but the destination that matters. If we use the analogy of a flight plan, the plane is close enough to the destination to request a landing slot and hopefully lower the undercarriage. If you don’t want to be locking into a holding pattern somewhere over the home counties you need to know exactly where you want to go, when you want to go there and that there is sufficient capacity for you on arrival.

For defined benefit pension schemes there are three distinct destinations (although the third is new and relatively untested): self-sufficiency, insurance and consolidation.

SELF-SUFFICIENCY Self-sufficiency involves running a scheme for the long term, with a low (but not zero) risk investment strategy that has a high likelihood of meeting member benefits without additional sponsor support.

Historically, self-sufficiency has only been possible if the sponsor continues to be in business, even if no further contributions are required from it. On sponsor failure, a scheme would either have to enter the PPF or, if affordable, secure benefits in excess of that provided by the PPF through a (partial) buy-out. To go back to the aircraft analogy, this is when the fuel gauge is flashing red and the plane has to land at the nearest airport, even if it is not the intended destination.

What has changed recently: SWOSS (Schemes Without a Substantive Sponsor) framework

The introduction of SWOSS, which allows schemes to continue running in a self-sufficient way even after their sponsor has gone. Schemes need to be relatively well funded and risk managed in order to do this, as the PPF will charge an additional

IT’S NOT THE JOURNEY BUT THE DESTINATION THAT MATTERS

By Mathias Rasmussen – Director, Investment Consulting

THE SWOSS FRAMEWORK MEANS THAT SELF-SUFFICIENCY IS NOW AN OPTION FOR SCHEMES WITHOUT A STRONG SPONSOR

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risk-based fee to offset the risk of the scheme calling on the PPF in the future as a sponsor backstop no longer exists.

The better funded the scheme and the lower the risk it runs, the lower the fee will be. For schemes with lower funding levels and/or higher risk profiles, the fee is designed to be prohibitively high and make continuing with a self-sufficiency target unrealistic.

There is no guarantee that SWOSS will be available in the future – schemes with weaker sponsors at risk of failure may wish to opt for a more prudent endgame objective.

INSURANCE Buy-out

A buy-out involves transferring all of a scheme’s assets and liabilities to an insurer, legally discharging the liabilities and removing all exposure to the sponsor covenant. Seen as the “gold standard” endgame for pension schemes in terms of maximising member security, we might liken this to flying a private jet that comes with a guaranteed landing slot and pre-clearance through passport control in our aircraft world.

This, naturally, makes buy-out expensive – insurers need to run a low-risk asset allocation, reinsure longevity risk and make a profit, so a scheme needs to be fully funded on a very prudent basis to make buy-out possible.

Full buy-in

For schemes with a strong sponsor, a full scheme buy-in (where the link to the sponsor is not severed) offers

the combination of the longevity and investment return hedge afforded by a buy-out combined with the backstop guarantee of the scheme sponsor. In the event of sponsor failure, the buy-in can be converted into a buy-out, with the cost of doing so agreed in the buy-in contract.

What has changed recently: Better pricing and capacity for deferred pensioner liabilities

Historically there has been relatively little capacity for insuring deferred pensioners, and pricing has been unattractive compared to the expected return on an investment grade corporate credit or even gilt-only investment portfolio. This has meant that schemes targeting a buy-out or full buy-in have had a strong incentive to wait, often decades, until almost all their members are pensioners.

However, increased competition, insurers’ improved ability to source long-dated matching assets and cheaper reinsurance means that pricing and market capacity for deferred pensioners has improved to the stage where the buy-out target date for well-funded schemes has moved from a few decades to a few years into the future.

CONSOLIDATION Consolidation involves a bulk transfer of a scheme’s assets and liabilities to a new sponsor where it will be pooled (but potentially sectionalised) and run with other schemes. Rather than rely on a going concern sponsor, the backstop is instead a limited capital buffer that gets transferred into

the scheme in a downside scenario.

This should make consolidation cheaper than buy-out but also less secure. In the aircraft analogy, we are now flying commercial – likely to end up at our target destination, but at risk of delays, diversions and cancellations.

As the sponsor backstop is arguably the most valuable asset a scheme has, trustees should satisfy themselves that the consolidator (and backing capital) represents a stronger covenant than what the scheme currently benefits from before going down the consolidation route.

What has changed: Consolidators now exist

In the last year, consolidators have moved from theory to near-practice, with vehicles being set up and attracting capital. However, they remain unproven with respect to long-term outcomes, and the first transfer in the market has yet to take place. Overall supply and appetite for taking on schemes of different sizes likewise remains unknown.

INSURANCE PRICING FOR DEFERRED PENSIONERS HAS IMPROVED – FOR MANY SCHEMES, FULL BUY-IN OR BUY-OUT MAY NOW BE WITHIN REACH IN THE NEAR FUTURE

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HOW TO CHOOSE BETWEEN THE THREE CATEGORIES OF ENDGAME We set out a framework below – a simple decision tree that uses strength of sponsor covenant as the starting point – that can help narrow down the choice of endgame objective:

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From this we can observe that:

• Larger schemes with weaker sponsors can now target self-sufficiency with SWOSS, an option previously available only to schemes with strong sponsors

• Schemes with failing sponsors now have an additional option in consolidation that offers the possibility of paying benefits in full

• It is difficult to narrow down the choice of endgame objective to a single category without a detailed look at scheme-specific factors

So what?

The range of endgames has widened in recent years – this is a positive that gives trustees and sponsors more ways to improve the likelihood of paying benefits in full and, potentially, sever the link between the scheme and the sponsor balance sheet.

However, it also makes setting an objective more complex. A simple decision-making framework can help narrow down the range of options, but making a final choice will require trustees and their sponsors to articulate – and agree – what is ultimately important to them.

End Game Options• Buy-out• Self-Su�iciency

(SWOSS)

End Game Options• Buy-out• Consolidator

End Game Options• Buy-out• Full buy-in

End Game Options• Buy-out• Full buy-in• Consolidator

Desire/need to get scheme o�

the sponsorbalance sheet?

NoYes

Does your scheme have the scale and infrastructure

to run without a sponsor?

Yes No

End Game Options• Buy-out

End Game Options• Full buy-in• Self-Su�iciency

(SWOSS)

NoYes

Desire to get scheme o� the sponsorbalance sheet?

End Game Options• Full buy-in• Self-Su�iciency

(sponsor-dependent)

Is your sponsor covenant iron clad

(e.g. crown guarantee)?

Can you a�ord buy-out in thenext 3 years?

Yes NoYesNo

Do you have a strong sponsor

(i.e. investment grade)?Yes No

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