Written by:
Board Advisor, Brightwell
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13 minutes
Published:
04 / 03 / 2025
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DB Pension Scheme convergence with buy-out model
The forthcoming Pension Schemes Bill is likely to contain legislation to make it easier for defined benefit pension scheme surplus to be returned to sponsors. The Government believes employers can use these funds “to increase the productivity of their businesses – to boost wages and drive growth or unlock more money for pension scheme members.”
The question now is what is the right model for running on a pension scheme with surplus extraction as an option?
The insurance industry provides a potential answer as, for many years, it has been providing security to policyholders at the same time as extracting value for its shareholders from DB schemes.
With the addition of the potential for surplus extraction added to the DB model, a DB scheme’s objectives could converge towards those of an insurer, providing an additional profit incentive for the sponsoring employer, akin to a shareholder. The primary aim would remain the payment of pensions to members, but the DB approach can be developed to include an additional objective to generate surplus, through prudent capital management. This objective is similar to the return on equity of an insurer but could include different parameters and time horizons.
Furthermore, as many schemes mature, their portfolios are trending closer to those used by insurers; looking towards credit, cashflow generating real assets, inflation-linked instruments and in some cases longevity reinsurance to match cashflows and mitigate key risks.
What can we learn from the insurance regime?
In 2020, the government announced a review of the Solvency II regulatory regime for insurers. The government set three objectives to underpin the review:
- to spur a vibrant, innovative, and internationally competitive insurance sector
- to protect policyholders and ensure the safety and soundness of firms
- to support insurance firms to provide long-term capital to underpin growth, including investment in infrastructure, venture capital and growth equity, and other long-term productive assets, as well as investment consistent with the Government’s climate change objectives.
It’s interesting to contrast these objectives with the DB industry where the focus is on protecting members and protecting the PPF. Should access to surplus, together with the improved funding position of many schemes, change the balance and lead to a re-think for DB schemes? After all, we are talking about the same members and the same assets.
As with DB pension schemes, one of the key elements of Solvency II is the discount rate used to calculate the present values of estimated liabilities. Discounting in Solvency II is based around the idea that if insurers can build a portfolio of assets that generate predictable cashflows to match predictable liabilities, then because these assets are held to redemption the insurer is not exposed to illiquidity risk and so should be able to make an addition to the underlying risk-free rate of return. This addition is called the Matching Adjustment. The discount rate then becomes the risk-free rate plus the Matching Adjustment.
As this Matching Adjustment is not observable, the credit spread is deconstructed into its components and then something called the Fundamental Spread is deducted to arrive at the Matching Adjustment. The Fundamental Spread is an estimate of the return needed to compensate for expected credit losses plus a risk premium to reflect the possibility that losses may be higher than expected.
This is estimated using long-term averages and as a result is very insensitive to movements in market conditions, including credit spreads. As a result, as credit spreads widen / tighten the Matching Adjustmentfollows suit because the Fundamental Spreaddeduction is largely fixed; the value of the credit portfolio will fall/ rise, but this will be close to fully offset by a corresponding decrease/ increase in liabilities due to the change in the Matching Adjustment (note however that actual asset losses through default/insolvency etc should not be netted out with a movement in liabilities).
The advantages of this approach are that movements in asset prices due to credit spread changes net out with corresponding movements in liabilities, leading to reduced balance sheet volatility which in turn reduces the need to sell assets when credit spreads widen (i.e. avoids the insurance industry reinforcing market downturns through forced selling).
As the use of the Matching Adjustment requires the cash flows from an investment to be reasonably certain, this approach incentivises the holding of asset categories with low default and downgrade probability, but high illiquidity premia – for example infrastructure. As a result, the objective referenced as part of the 2020 review to support long-term economic growth is supported. Insurers have become major investors in long-term assets as they are a good match for long-term liabilities with significant investment in areas including social housing, infrastructure projects and student accommodation.
Of course, actual credit losses could exceed what might be expected from historic averages, so to protect policyholders, insurers are required to hold reserve capital to cover a 1-in-200-year-event.
Contrast with DB schemes
Many DB schemes can only dream of having a discount rate which would result in losses in assets from market movements netting out with movements in liabilities . Of course, many DB schemes have investment portfolios with a significant allocation to asset types which don’t provide the predictable cash flows which underpin the rationale for the approach used to set the discount rate in Solvency II. And for DB schemes the equivalent to the reserve capital insurers are required to hold is the sponsor’s covenant, which in many cases will fall short of protection against a 1-in-200-year event.
But what if a DB scheme invested predominantly in credit and credit-like instruments and had a surplus on a buyout basis (TPR has published new figures on DB funding that show that DB schemes had in aggregate a combined £7bn surplus on a buyout basis and that about half of schemes were in surplus on this basis), and had ongoing access to support from a strong sponsor and/ or other forms of security?
How close could a DB scheme get to the equivalent to 1-in-200-year protection, particularly if alternative forms of security (e.g. an ABF provided by the sponsor) are provided?
Perhaps the way to think about this is to see it as a trade-off between funding, covenant strength, investment risk, different forms of security and perhaps even the pace at which surplus is paid out. Maybe circumstances for a particular scheme could justify an insurance like discount rate to calculate technical provisions, i.e. such that asset and liabilities move in step, with a level of funding that is less conservative than buy out, to calculate the funding level at which surplus can be extracted.
From a member perspective, one advantage for DB schemes over the insurance model is that trustees retain their discretionary rights within the scheme rules. For some schemes there may be potential for members to share in any surplus in the form of one-off payments, with the support of regulatory change, or channelled into accruing DC pots. In addition, any concerns over the potential for surplus being paid out only for a deficit to appear could be mitigated by payouts being made on an incremental basis year-by-year, even where the accumulated surplus is substantial.
What next?
The government will share details of its proposals in the spring, when it is due to respond to the previous government’s DB consultation. While the protection of member benefits must remain a core consideration, we believe that for medium to large scheme the question of how to bring some of the benefits of the insurance model into the DB industry, once surplus extraction becomes an option, should be considered. This could include:
- Fully embracing a dynamic discount rate approach to calculating liabilities that rewards schemes for holding cashflow matching assets and incentivises a robust and objective approach to securely paying benefits whilst mitigating balance sheet volatility. Mitigating balance sheet volatility would reduce systemic risks, as well as value leakage in the form of management costs and unnecessary portfolio rebalancing. Greater balance sheet stability may also allow sponsors to commit to a long-term pension’s surplus strategy.
- Having an approach similar to Solvency II that incentivises schemes, when combined with point 1 above, to account for illiquidity premia as a component of the dynamic discount rate would incentivise investment in productive assets with predictable cash flows. This would be a reasonable reflection of pension scheme’s ability to deploy capital patiently as long-term investors.
- Allowing surplus to be extracted based on a low dependency basis, where there is an appropriate combination of covenant and other forms of security, supported by a well-matched investment strategy.
- Finally, the introduction of a code that offered clear guidance on how to facilitate run-on and for how to safely extract surplus. This would remove the potential for conflict between trustees and sponsors that could arise due to the subjectivity of discount rate setting, whereby, for example, sponsors may be incentivised to maximise the discount rate to extract surplus sooner and trustees may be incentivised to be overly prudent.
If you are interested in finding out more about how Brightwell can develop innovative solutions for your scheme, please contact us at hello@brightwellpensions.com.
Disclaimer:
This article has been prepared for information purposes only, does not constitute an analysis of all potentially material issues and is subject to change at any time without prior notice. Brightwell does not undertake to update you of such changes. It is indicative only and is not binding. Other than as indicated, this article has been prepared on the basis of publicly available information believed to be reliable but no representation, warranty, undertaking or assurance of any kind, express or implied, is made as to the adequacy, accuracy, completeness or reasonableness of the information contained in this article, nor does Brightwell accept any obligation to any recipient to update or correct any information contained herein. Views expressed herein are not intended to be and should not be viewed as advice or as a personal recommendation.
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