19^th April 2024

In response to the Department for Work & Pensions’ consultation on the Options for Defined Benefit (DB) Schemes, please see our summary below.

The measures that Department for Work & Pensions (DWP) and the Government are proposing would “open up” the DB market and make other options more achievable. These more flexible options should be thought of as:

1.           Within the current DB operating environment

2.           Under a commercial consolidator

3.           Under a public sector consolidator

This consultation seeks to address the first and third on the list (with the second arguably already addressed as part of previous reviews of consolidator operating parameters).

The DWP’s proposals could improve scheme member outcomes as well as have a positive impact on the UK economy. However, we remain to be convinced that they will achieve the main stated objective of ensuring DB scheme assets work harder for the UK economy.

DB schemes need viable alternatives to buyout

Many DB schemes are well on their way to achieving full funding on a buyout basis, an option which has long been seen as the ‘gold standard’ destination for mature DB schemes. Whilst this route is well established and is often the right, prudent choice for many trustees, the options for DB schemes that the DWP is consulting on provide challenge to the notion that a bulk annuity purchase should be the ‘default’ endgame solution for all schemes.

The insurance option is expensive and insurers operate with far tighter solvency requirements than DB schemes and as a result are limited in the extent of productive investments they can make in the UK economy. In addition, with the huge scale of DB pensions (market predictions of c. £350 billion) estimated to transfer to the insurance market over the next five years or so, there could be unintended systemic risks – further making the case for viable alternative endgame options.

We believe it can be possible to deliver a safe outcome for members outside the insurance regime that also delivers a good outcome for corporates and the economy as a whole.

DB schemes’ surpluses unlocked

The consultation focuses primarily on whether certain changes would make it easier to extract surplus from DB schemes, and whether such changes would achieve the consultation’s objectives.

Sponsors of DB schemes have generally provided significant funding to DB schemes, which are now in surplus. It would therefore seem reasonable to allow surplus funds to be returned and used by sponsors to invest in their own growth, which would benefit the UK economy. This should rebalance risk and potential rewards between sponsors and trustees, fostering sponsor commitment to continue running their schemes, thus extending the schemes’ time horizon and opening up longer-term investment opportunities. Indeed, we have seen amongst our clients some sponsors who are already changing their perspective to support modest re-risking –more detailed thoughts on which we share in the main document.

With the right safeguards, members could also benefit – through sponsors being willing to keep schemes open and / or surplus sharing arrangements allowing provision of discretionary benefits.

However, trustees of DB schemes have fiduciary duties relating to the security of members’ accrued benefits, so will need to carefully consider the extent to which release of surplus is consistent with their duties. Without material changes to trustees’ underlying fiduciary duties, it seems unlikely that rule changes to facilitate return of surplus will have a material impact on the industry.

100% underpin at too high a cost

In our view, a 100% PPF underpin does not appear a practical solution to underpin the security of members’ accrued benefits given the high cost and limitations of the proposed approach. Accordingly, while we are supportive of the intent to facilitate surplus distribution (with the right safeguards), we do not believe it will achieve the objectives of the consultation (increasing investment in UK productive assets).

A public sector consolidator for small DB schemes

We can see how a public sector consolidator (PSC) could be useful for very small schemes (<£20m of assets) that are currently not able to access the commercial consolidator or the insurance markets. In a recent Cardano survey of UK Chief Financial Officers (CFOs) on this topic, 30% of CFOs thought that the PPF can act as a consolidator for small schemes. 

A government-backed entity would provide improved security and remove the governance and regulatory burden for these schemes and their sponsors. However, the scale of activity for a PSC is unlikely to be that significant in the context of the £1.3 trillion DB pension fund market. By our estimates, around £30bn (just over 2% of the existing DB market assets) could reasonably be candidates for PSC activity. Even if the PSC made a meaningful allocation to UK productive assets, that’s unlikely to have a material impact on the British economy.

To minimise potential distortion of the superfund and insurance buyout market, we strongly believe that a PSC should be subject to similar regulatory parameters as the commercial consolidators. In particular, a PSC should be subject to similar Gateway Tests as those that apply to commercial consolidators. The Gateway tests are an important protection in the superfund regulatory regime that ensures both insurance and commercial consolidator solutions remain competitive.

Fiduciary management provides small schemes with an existing and efficient route to improve investment governance. Indeed, small funds are just as capable of accessing fiduciary management as large ones and, as sole trusteeship gains ground, this is rapidly becoming the norm. That said, we do believe that small funds could benefit from a PSC providing an alternative viable option for risk transfer.

Unlocked surpluses and a PSC unlikely catalysts for a material increase in UK venture capital

We continue to stress the importance of looking abroad to the Canadian, Nordic and Dutch pension systems for examples, and that a more obvious route, in our view, would be to consider the partial funding of public sector pension funds or the state pension. Funded public or state pension assets would likely adopt similar investment strategies followed by their global peers. Measures to encourage the bulk annuity market to invest further in private debt and ways to use the PPFs unowned surplus for the benefit of the UK economy should also be considered.

Our full consultation response can be read here.

• Defined Benefit (DB)