By Alex White, Head of ALM Research at Redington
For many de-risked, hedged, well-funded schemes, it is likely that they will run off with a material surplus, holding more assets than are needed to pay pensions. And this money could, from first principles, be put to use in one of three ways:
1. It could be used as a buffer to further increase security
2. It could go back to the sponsor
3. It could be used to increase member benefits
4. It could go to the government in a nationalization of DB schemes
At the moment, only option 1 is on the table; the consultation opens up options 2 and 3. Given that trustees retain control, and have a duty to act in members’ best interests, option 2 is unlikely to be viable on its own- but that doesn’t make it unviable. In particular, we see 2 major cases (as well as other, subtler possibilities) when it may be useful.
The first case is a very well-funded, secure scheme. Paying money out of the scheme, on its own, can only increase risk. However, if a large benefit can be gained from a small increase in risk, it’s probably worth doing. At the extreme, if a scheme were 500% funded, say, then it could double benefits, pay the same amount to the sponsor to use productively, and still be 200% funded. This case is hugely unlikely, and for a scheme 103% funded, paying that 3% away could meaningfully increase the odds of failing to meet benefits.
However, it demonstrates that there is a point at which the trade-off makes sense- if the scheme is safe enough, its members are better off marginally increasing risk for a meaningful increase.
The subtler, second option would be an increase in security. A scheme can only fail if either its sponsor fails or if its sponsor is too small to cover the scheme’s deficit. That means that a stronger, larger, and more secure sponsor is a benefit to the scheme. This is indirect and imperfect, so a scheme is better off with £1m on its own balance sheet than on its sponsors, so there’s no case for directly handing over money. However, there are many ways to get improved security from a sponsor, many of which may be worth paying some of the surplus for.
For example:
• If a sponsor is a small, vulnerable firm that has a huge multinational parent, the parental guarantee may be more valuable to the scheme than some extra surplus
• If the scheme can get ring-fenced contingent assets, or a super-senior call, these could be, in effect, bespoke options to cover tail risk, which may be far more effective.
In all cases, there are trade-offs, and neither option is automatically better. But so many more doors are opened, not least the possibility of better incomes in retirement for members, that should this go through they can’t be ignored.
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