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Sponsors of large UK defined benefit schemes have good reason for optimism. Whilst the current climate has new uncertainties, after the challenges of the pandemic, markets finished 2021 strongly and LCP’s research showed combined accounting surpluses for FTSE100 companies of £60bn as we moved into 2022.
Better still, for around 50% of FTSE100 companies, our latest research suggests their schemes may already be fully funded on a more prudent set of "low reliance" assumptions, that could be consistent with the new longer term funding requirements we expect to see from the Pensions Regulator later in the year.
In addition, most schemes are yet to consider making formal allowance for the potentially longer-lasting impacts on life expectancy of the pandemic in their funding assumptions. This remains uncertain but, for example, we estimate the wider healthcare impacts of the pandemic could reduce longer term contribution requirements for FTSE 100 companies by around £5bn. This might correspond to around a £1bn p.a. reduction in contributions if it were possible to feed directly into recovery plans, for example by making efficient use of contingent asset or contribution approaches.
Whilst this appears good news for sponsors, these developments come with a fresh set of challenges for those entering into funding discussions with Trustees today. In particular, new funding regulations mean companies and schemes will now need to agree a formal long-term funding target, with around half of schemes in our "Chart Your Own Course" survey identifying this is their key challenge for the year ahead.
Wider Pension Schemes Act 2021 considerations also put these decisions in fresh context with company directors now needing to give schemes increased consideration in a wide range of company decision making and activities.
For some sponsors, this combination of factors could make an insurance solution more attractive than they had previously considered and, for all sponsors, means the pensions strategy decisions they make today could have profound impact on how their schemes evolve.
For sponsors of schemes there is an increasing diversity of potential long term funding and investment approaches. However overall these split into two camps:
However, a range of factors mean this gap may not be as great as sponsors currently assume. For companies wanting to target buy-out, we predict that managing this transition in as cost-effective a way as possible will become a key strategy goal in coming years, for example encompassing a range of innovative contingency planning, investment, and liability management measures.
Low reliance
Target full funding using “low reliance” or “self sufficiency” assumptions and pay benefits as the fall due.
Transaction approach
Target a (generally more expensive) transaction solution for their scheme. This will typically be an insurance buy-in solution but in some cases there may also be additional options involving a Superfund or other new innovative third party capital approaches.
Trustees are likely to favour a long-term insurance approach (and our sister report, "Chart Your Own Course", looks in detail at trustee considerations). This approach might also be favoured by companies concerned about the wider constraints of the Pension Schemes Act 2021, for example if they face constraints around dividend policy or with wider financing arrangements.
However, even if a scheme is fully funded using “low reliance” assumptions this could still mean a buy-out shortfall of around 10% of liabilities or more. For companies wanting to target buy-out, we predict that managing this journey in as cost-effective a way as possible will become a key strategy goal in coming years, for example encompassing a range of innovative contingency planning, investment, and liability management measures.
Our research suggests that around half of major schemes may continue to prefer a run-off approach, at least for the time being. For these schemes, we predict innovation will also continue, for example as third-party capital models begin to emerge alongside more traditional contingency measures.
A further set of sponsors may wish to consider emerging Superfund solutions in the near term, for example where sponsor covenant is especially weak, or potentially in unique situations such as around transactions (and we discuss some of these considerations later in our report).
For sponsors of well-funded schemes, this means major decisions lie ahead that will need to be incorporated into their planning:
- Once you have reached full funding using “low reliance” assumptions, do you want to target an insurance transaction, and when?
- How affordable is buy-out and could there be a business case for progressing sooner rather than later?
- How might potentially onerous requirements of the Pension Schemes Act 2021 on wider corporate activity feed into this decision?
- Under either approach, what investment measures should be put in place to maximise cash efficiency and protect the current funding position?
- How can contingent funding be used to support efficient pensions agreements?
- Could the potential longer-term effects of the pandemic mean schemes are better funded than we think, and how might this be reflected in funding agreements?
In this report we provide fresh views on how sponsors could seek to reflect these challenges in their pensions strategies. This will be a joint effort between sponsors and trustees. But, given the levels of materiality and uncertainty involved, this is an area where we believe sponsors should increasingly seek to Lead the Way.
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