FUND YOUR LIABILITIES
Matt Charman
Senior Consultant
The funding regime is undergoing its biggest overhaul since 2005 when the existing regime came into force, with the 2021 Pensions Schemes Act paving the way. There is more information expected from the Pensions Regulator by the end of the year following on from last year’s consultation, and a new regime coming in force for 2023 valuations and beyond.
Read more about the current state of play of the new funding code in our section on the 2021 Pension Schemes Act
Whilst we wait for more clarity on the direction of travel, trustees are rightly focusing their resources on other matters including:
- Grasping the nettle of GMP equalisation and moving forward
- Assessing their mortality assumptions in the light of Covid-19
- Considering member options, possible liability management and IFA support
- For those schemes that are already well funded, what the final leg of their journey might look like
GRASPING THE NETTLE OF GMP EQUALISATION
TACKLING LONGEVITY RISK
MEMBER OPTIONS, LIABILITY MANAGEMENT AND IFA ADVICE
THE FINAL PHASE OF THE JOURNEY
GRASPING THE NETTLE OF GMP EQUALISATION
For all but a lucky few, GMP equalisation is something that schemes will have to tackle in the next few years on their travel to their end destination and we are seeing many schemes move forward actively in their GMP equalisation projects. Indeed our survey showed that for a large number of schemes, data matters including GMP equalisation was one of their top priorities for the year ahead.
One of the key questions to determine is whether to use a dual record approach to GMP equalisation (the default approach) or to agree with the sponsor to convert the uplifted value into a pension (conversion). The right solution is very scheme specific - as shown in the chart - and depends on a number of scheme features including how complex the benefits are, the size of the scheme, the profile of your membership and the options offered to members.
Thinking about using conversion?
Tackling GMP equalisation may seem a daunting task. Find out more about:
- how GMP conversion is being used in practice,
- which schemes might find it attractive,
- the opportunities for simplification and
- some of the pitfalls to watch out for
in the new GMP Equalisation Guidance on Conversion, produced by the GMP conversion sub-group of the PASA GMP Equalisation Working Group, chaired by LCP’s Head of GMP equalisation, Alasdair Mayes.
You can also find out more about the different methodologies on our GMP Insights.
Employers' likelihood of using "method C" (year on year calculations and dual records) or "method D2" (GMP conversion) when equalising pensions
This may seem a daunting task, even knowing where to start. However, once broken down into smaller tasks the whole process becomes much more manageable.
Discover our six steps to achieving GMP equality to help you navigate through this complex project.
TACKLING LONGEVITY RISK
As investment risk becomes more modest, this inevitably means that longevity risk increasingly becomes a key risk yet to be addressed.
Longevity risk as a percentage of total risk
There are well-established ways of addressing longevity risk in tandem with reducing investment risks. This can be through a series of phased buy-ins which reduce the longevity risk in stages over time. For the biggest schemes a longevity swap can be an economically viable approach to tackling longevity risk.
For all schemes it is important to understand your longevity risk and decide whether it is a risk you wish to tackle and, if so, when to do so on your journey plan. A key place to start is to review your current mortality assumptions. Our LCP Life Analytics tool can both help you with setting your mortality assumption as well as understanding your longevity risk.
These are challenging times for setting a longevity assumption with the devastating impact of the Covid-19 pandemic introducing more focus on these assumptions at a time when there is undoubtedly more uncertainty on the trend in the medium to long term.
For further information on phased buy-in strategies and insured solutions look out for our de-risking report in September or speak to one of our de-risking specialists. Click here for more information.
Very few of our survey respondents have updated their mortality assumption in light of the Covid-19 pandemic, with 97% of respondents having maintained the current assumption (for now at least).
Have you adjusted your mortality assumption?
Our latest longevity report can also help you understand the risk to your scheme by considering a range of plausible future mortality scenarios, along with providing insights into the impact of Covid-19 on pension scheme members.
MEMBER OPTIONS, LIABILITY MANAGEMENT AND IFA ADVICE
At the end of the day, the scheme exists for its members and it's important to consider the member experience. This includes regularly reviewing the options available to members, how and when they are communicated and if IFA support is provided. It is also helpful from time to time to consider the merits of a bulk exercise, whether that is a trivial commutation exercise, a pension increase exchange or something else, such as simply writing to deferred pensioners over the age of 55 with details of their retirement or transfer options. Such exercises can be a helpful way of tidying up a scheme on the journey to its destination, and may even accelerate that journey. We set out below our four key questions to help you consider what might be appropriate for your scheme.
1. Have I analysed my membership to understand who exercises which options and at what age?
When considering member options, it is key to understand your membership so that you can make informed decisions to ensure their needs are best met. This includes analysing past experience such as what age members retire at, what percentage transfer out and at what age, what is the take up rate of various options and more.
2. Are the options offered to members and the way they are communicated appropriate?
Increasingly schemes look to give members access to online communications and potentially retirement and/or transfer value modellers so that members can log on when it suits them and find out the information they need about their benefits at the click of a finger. This is particularly relevant given the eventual rollout of the pensions dashboard.
As at 30 June 2021 the average LCP Sonar Scheme had just over half of their liability still to be come into payment as shown in the chart on the left. Schemes are also fast maturing - around one third of current non-pensioner liabilities are projected to come into payment over the next 5 years for the average LCP Sonar Scheme, increasing to over 60% within the next 10 years as shown in the chart on the right.
With such large numbers expected to start to consider their retirement options over the next few years, ensuring that these are communicated clearly and appropriately is key.
Percentage of liability yet to come into payment
Percentage of current non-pensioner liability projected to come into payment within x years
There are a range of options available to members and different ways these can be communicated.
3. Would any bulk exercises be right for my scheme?
Many of the options can be provided or communicated as part of an exercise. In considering whether this is right for you its important to understand the profile of your membership and the possible impact on funding, depending on take-up levels. This is assessed against the costs of undertaking such an exercise.
LCP Focus can help you visualise your membership, as well as quantify the potential impact of a range of liability management exercises depending upon the assumed take up rate and members in scope. This analysis then helps consider the impact on the scheme's future journey.
4. Do I provide my membership with enough financial support and is there any more I should do to help them?
One potential way trustees and sponsors can support members to make informed decisions is to help ensure that members are receiving appropriate financial advice. This could include:
- helping members to find a financial adviser firm which is FCA-registered (including having advisers who have the necessary transfer advice qualifications or perhaps has signed up to the DB transfer ‘gold standard’ set out by the Personal Finance Society); or
- identifying one or a small number of advice firms who members can use if they wish (with some schemes/sponsors even subsidising, or paying in full, for the costs of this advice).
Click here to find out more about helping members with financial advice including the pros and cons of appointing an adviser firm.
Watch our webinar about our joint paper from LCP and Royal London on the future of DB transfer advice.
This paper includes the results of a survey of advisers active in the DB transfer market and case studies from LCP.
Whereas in the past some trustees may have been concerned that putting in place an IFA might put them at risk of being seen as encouraging transfers, the industry practice and thinking has shifted and an increasing number of trustees see real benefits of appointing an IFA (and indeed see real risks of not doing so).
THE FINAL PHASE OF THE JOURNEY
Actions for schemes that are well funded and considering buy-out
1. SET YOUR GOAL
Before starting the final stage of your journey it is important to ensure that you are on the path to the right destination. Click here to read more about the different potential end games other than buy-out. Whilst you may already have in your mind that buy-out is the right decision for your scheme, it can be worthwhile re-examining the options and confirming that buyout remains the right decision for all stakeholders before you venture too far down the path.
Whilst entering into a full buy-in (the first step before moving to buy-out) is an investment decision that could be made by the trustee without the support of the sponsor, in our experience these processes work most effectively when there is engagement with the sponsor at an early stage and a collaborative plan is put into action. Some sponsors may have a preference for the scheme to be ran-off on a self-sufficiency basis rather than transferring to an insurer. In these circumstances the trustee may wish to consider the sponsor covenant and what additional security (such as contingent funding) could be provided.
2. UNDERSTAND HOW CLOSE YOU ARE AND ESTABLISH YOUR JOURNEY
Once you know your destination it is important to understand your current position as this could impact the decisions you take along the way. Therefore, once you have confirmed your destination is buy-out, it is important to get an understanding of how far away from buy-out you currently are. Solvency estimates are only required every three years as part of a triennial valuation meaning that the latest estimate you have could be very out of date and might only have been calculated very approximately.
The insurance de-risking market is constantly changing, both with the wider financial markets and insurer appetite. Additionally, your scheme’s assets will move differently to insurer pricing (although you can look to minimise these differences). This means that the funding level is constantly fluctuating, which could mean that you are a lot closer to your end goal than you think. Once you understand where you currently are you can start to consider the likely timescales to reaching buy-out and what levers you plan to use to get you there and what preparatory actions you can take along the way.
However, it is not only important to know where you are at the start of the journey, but also monitoring the position along the way and having appropriate actions in place if the journey is going better or worse than expected. Also by keeping an eye on how the funding level is evolving you can look to take advantage of periods of favourable pricing and reach your end goal sooner.
Whilst it may be possible to track LCP’s estimate of the buy-out cost daily, it is only by approaching the market that the actual cost of securing the benefits with an insurance company will be known. However, LCP’s specialist de-risking team can help you identify the right time for your scheme to engage with insurers.
It is important to understand the funding position is impacted by changes to key assumptions, such as how the funding level changes if the insurer took a different view on mortality or if the percentage of members married differs from the central assumption. For a more detailed look at your scheme’s specific circumstances then LCP’s market leading specialist insurance de-risking could undertake a feasibility study.
Example of how the buy-out funding level has fluctuated for an illustrative scheme
LCP clients can track the estimated position daily using LCP Visualise.
LCP schemes who were estimated to be over 90% funded on a buy-out basis as at 31 December 2019 were on average 3% better funded as at 30 June 2021
3. THE INVESTMENT JOURNEY TO REACHING FULL INSURANCE
One of the key levers you will have to help bridge the gap to buy-out is investment returns. However, you not only need to consider the assets that will get you to full funding but also how suitable your investment strategy will be in facilitating a transaction once affordable. As a result, your investment strategy when you are around 10 years from buy-out could be different to that when you are ready to transact.
Some sponsors become increasingly concerned about over-funding in the last leg of the journey to buy-out. We sometimes see contributions paid into escrow accounts, and only paid into the scheme if needed or returned to the sponsor if not. Click here to find out about LCP's streamlined escrow solution.
In our view, the key considerations can be boiled down to the following four categories:
- Asset allocation
- Interest rate and inflation hedging
- Liquidity
- Strategy for phased buy-ins
You can find out more about why these four categories matter in our latest de-risking report due to be released in September.
4. GETTING TRANSACTION READY
Buy-out funding levels are constantly fluctuating. Schemes that are well prepared are able to move quickly can capture short lived opportunities as a result of volatile market conditions or increased insurer appetite.
Look out for our de-risking report in September for details on what your scheme can do to get buy-out ready or speak to one of LCP’s de-risking specialists.
5. THE WIDER JOURNEY
Being over 90% funded on a buy-out basis is a strong position to be in. However, it is important to consider how the gap to 100% funding could be bridged. Potential options include:
- Investment outperformance – as set out in step three, working the assets can be one of the tools to help get you to full funding.
- Allowing the position to naturally improve with time. Historically, pensioner members have been cheaper to insure than non-pensioners, meaning all else being equal, the buy-out funding level is expected to improve with time as the scheme matures. Additionally, schemes can typically expect the funding level to improve with time as members transfer out or take cash at retirement.
- Company contributions – are any contributions expected along the way to help reach the end destination? If the scheme approached the market and pricing resulted in a small shortfall would the sponsor be willing to meet this or would a period of monitoring be entered into? This may impact when to make the initial approach to the market.
- Liability management – used in the right situation this can be a way of improving affordability. For example, a PIE can be particularly effective at improving the insurability for a scheme with unusual pension increases. Find out more about liability management here.
- Market opportunity – insurer pricing moving favourably compared to the scheme’s assets would improve the funding position.
It is likely that a combination of the above will be used to bridge the gap. It is important to understand both the opportunities, but also the potential downside for each of the above and put in place plans to mitigate the downside risks if they occur.
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