Funding for Defined Benefit Pensions
Funding Objectives for Defined Benefit Pension Schemes
The key objective of a DB pension scheme trustee is to fund and invest in order to ‘pay all pensions in full as they become due’.
However, to be certain that pensions will be paid in all circumstances, a trustee must, at all times, hold enough assets to secure pensions with an insurer.
Few sponsors are willing or able to fund in their DB schemes in this way and trustees have not generally demanded this level of benefit security. Most are willing to accept funding plans that leave pensions less secure and less valuable.
This is not unlawful. Sponsors and trustees are allowed to embrace a degree of risk for ongoing funding. While they must fund prudently, sponsors and trustees can lawfully agree a funding plan that leaves pensions exposed to an element of risk. Indeed, the funding plans for almost all DB schemes have some exposure to covenant, investment and demographic risks and few sponsors and trustees fund on a risk-free solvency type basis.
Given this acceptance of risk, a goal of ‘paying all pensions as they fall due’ seems ill-defined and doesn’t recognise the trade-offs and compromises that real-life trustees must make, especially if their schemes are underfunded and / or they are supported by sponsors with affordability constraints.
A more precise funding objective, and one we hope few would disagree to, could be to fund and invest in order to ‘maximise the probability of paying all pensions as they fall due’.
Maximising benefit security
DB failure begins with corporate insolvency. Without a solvent sponsoring employer, the trustee moves to wind up the scheme and use its assets to secure pensions with an insurance company. Pensions will not be paid in full if the scheme has insufficient assets.
This could happen fora number of reasons;- the sponsor and trustee may never have intended to hold enough assets to secure pensions in extreme circumstances, the sponsor could not afford to fund on a risk free solvency basis and / or, the scheme was exposed to investment risk and its assets under-performed in comparison to the risk-free portfolio.
To maximise the security of their members pensions, sponsors and trustees need to put in place a funding strategy with the perfect balance between covenant, investment and funding risks.
Before they can know what this strategy is, they need to gain a thorough understanding of all of:
· The likelihood of sponsor insolvency and the timescales over when this could occur
· Investment risks and the volatilities and correlations between the main asset classes
· The current funding position and how this could develop in the future
· Demographic risks, in particular mortality risk
· The inter-relationships between all of these items
Despite a widespread running of risk, few sponsors and trustees carry out integrated analyses of risks to use in their decision making. If covenant, investment and funding risks are considered at all, they are looked at on a ‘stand-alone ’basis.
The investment consultant, for example, will traditionally advise on options to reduce ‘One Year Value at Risk’, a narrow measure that doesn’t look at risk over the lifetime of a scheme and doesn’t consider potential losses to DB pensions. In turn, the scheme actuary uses ‘actuarial judgement ’to transpose imprecise covenant scores like ‘moderate’ or ‘tending weak’ and into suitable technical provisions and sponsor contributions.
Under this approach important correlations and risk transfers are missed and the overall level of risk and its impact on pensions remains unknown. The resulting funding plans are arbitrary. Different actuaries can, and will, recommend different technical provisions and deficit contributions to the same DB scheme.
The Pensions Regulator wants sponsors and trustees to work collaboratively, but it’s not uncommon for funding negotiations to be difficult, with mutual incomprehension on both sides. For example, the trustees to a scheme with a weak covenant may want a conservative, gilts-based investment strategy with correspondingly large sponsor contributions. On the other hand, the sponsor, recognising the debt this would place on this business, may be more willing to have a funding plan that embraces risk.
As their focus is on narrow, short term risk measures like VaR, instead of potential losses over the lifetime of the scheme, neither have any understanding of the trade-offs involved and the sponsor and trustee have no way of knowing what would be best for the business and the pension scheme.
Changes to DB Funding
In its consultation document, the Pensions Regulator highlights the need for greater clarity, transparency and accountability around the risks to DB pensions.
The Regulator proposes a new regime which gives sponsors and trustees the option of a ‘Bespoke’ route to compliance but warns that decisions taken under this route need to be fully articulated, backed by evidence and will likely mean higher regulatory involvement.
Given this changing regime, this seems an opportune time for sponsors and trustees to ‘up their game’, with stochastic IRM modelling for more informed, evidence-based decisions that demonstrably improve the security of members pensions.
Please contact us if you would like to discuss this further.