What’s been happening and what’s on the horizon in the world of pensions
The £1.5tn asset pool of the UK’s 5,000+ increasingly well-funded corporate defined benefit (DB) schemes, is attracting considerable attention from a variety of interested stakeholders. Notable amongst these are bulk annuity providers, for whom a now widely anticipated buy-in and buyout bonanza lies in prospect. However, against the backdrop of widespread regulatory-driven and buyout‑targeted investment de-risking, an alternative and almost diametrically opposed direction of travel for UK corporate DB has been proposed by consultants LCP and WTW — each of which seeks to benefit multiple stakeholders. This edition of Pensions Watch considers the key facets of these proposals and asks whether they could realistically reverse a deeply entrenched de‑risking mindset and the notion of a swift transition to buyout being the only end game in town.
A swift transition to buyout has seemingly become the only end game in town…
On 22 September 2022, then Chancellor, Kwasi Kwarteng unveiled the biggest tax give away since the “Barber Boom” of 1972. Targeting a growth plan akin to Chancellor Anthony Barber’s “dash for growth”, the gilt market was immediately spooked by the unfunded and uncosted nature of these gargantuan tax cuts, culminating in unprecedented fixed income market turmoil, as gilt yields recorded their biggest ever one day move and soared to 14-year highs. However, despite the consequent significant losses incurred by Defined Benefit (DB) scheme liability driven investment (LDI) portfolios, what immediately became apparent was that DB funding levels had, in the main, improved to such an extent1 that buyout had, almost overnight, become a viable proposition for many — at least for those in an appropriate state of preparedness.
In fact, over the weeks and months that followed, a swift transition to buyout began to be framed as the only end game in town, despite the obvious capacity constraints of bulk annuity providers and the general lack of readiness of many well-funded DB schemes to progress to buyout in the short to medium term. Indeed, although accepting that for most, if not all, schemes, buyout is the natural ultimate end game,2 such is the momentum that has been building around more immediate buyouts, it’s recently been suggested that, by end-2026 up to £300bn of DB assets and liabilities could transfer to insurers, while by 2029 more than half of UK corporate DB assets could be in the hands of insurers.3
…yet further reinforcing the regulatory-driven move to de-risking
Prior to this dramatic improvement in scheme funding ratios, which have since been bolstered by an equally dramatic tightening of monetary policy to suppress persistent price inflation, most of the UK’s 5,000+, mainly
closed, corporate DB schemes were assuming investment risk and chasing returns, commensurate with their
funding position and the strength of their sponsor’s covenant, in order to plug the longstanding gap between
the value of their assets and projected liabilities. However, that’s not to say they all were. Indeed, well-funded
schemes, although in the minority, were, in moving to a low dependence funding and investment strategy, derisking
into lower risk and returning assets. In fact, some had been doing so for years. That said, with buyout some way off for most, buyout and run off, or DIY buyout, were fairly evenly matched as the formally targeted end
game of UK corporate DB.
However, with more widespread improvement in funding has come even more widespread investment de-risking, compounded by an increasing number of schemes liquidating their, buyout unfriendly, illiquid assets in preparation for meeting insurers’, increasingly discerning, entry requirements for the buying out of member benefits.4 Ironically, while these insurers, principally as a consequence of regulation, tend to invest predominantly in bonds and other relatively low risk/low-return bond-like assets, illiquid assets do feature quite prominently in their portfolios.5
So why do well funded schemes de-risk?
In short, because of the prudence and focus on security built into pensions regulation and the
restrictions and punitive taxation applied to the withdrawal of scheme surpluses. To explain. Central
to a trustee’s fiduciary duty is ensuring that members’ accrued benefits are paid in full and on time.
However, this is juxtaposed with typically less than 100% of a member’s accrued benefits being covered
by the Pension Protection Fund (PPF),6 the corporate DB pension scheme lifeboat, in the event of a
scheme sponsor failing. Therefore, once a scheme is at or approaching full funding, not taking some
investment risk off the table could be detrimental to member security if things go belly up. Moreover,
if implemented in their current iteration next year, the Department for Work and Pensions (DWP) draft
funding and investment strategy regulations could well exacerbate this state of play.7
This regulatory-driven de-risking is further compounded by another regulatory hurdle — the inabilityof sponsors to non-punitively access scheme surpluses. Currently, for most of corporate DB, only the surplus in excess of the amount required to buyout the scheme’s liabilities with an insurer is
accessible and only at wind up and only then at a punitive tax rate. The draft DWP regulations are
unhelpful here too — frustrating the generation and distribution of surpluses. Therefore, scheme
sponsors remain understandably reluctant to continue underwriting investment risk when full funding,
even on a low risk basis, is reached or is in prospect. After all, they face the asymmetry of being unable
to easily and non-punitively access, what is effectively, trapped surplus if thing go well and picking up
the tab if things go badly.
A third reason for well-funded schemes to de-risk is to address the cash flow negative position that typically arises from an increasingly mature membership profile at this point in the funding journey.
With more cash being paid out by almost three-quarters of corporate DB schemes in regular pension
payments than is being received as cash contributions and investment income, the focus gravitates
to generating a predictable and sustainable stream of secure income to plug this gap. Failing to do
so risks being a forced seller of volatile assets in unhospitable markets. Therefore, this cashflow
driven investment (CDI) typically adopts a buy-and-hold policy, in principally targeting those secure,
mainly shorter-dated, lower risk income generative assets to assist in meeting pension payments
as they fall due.
Is the de-risking narrative a fait accompli or is there another way?
Recognising that an increasingly significant percentage of corporate DB assets, in being systematically derisked could, with the appropriate regulatory changes, incentives and protections, be invested more productively
over longer timescales, consultants LCP and WTW has each started to socialise their respective propositions.8
LCP formally launched its “Protection Supporting Prosperity” (PSP) proposition, via its “Powering Possibility in
Pensions” white paper,9 in April, with WTW following suit with its equally thoughtful “Six changes to seize the
pension surplus opportunity” proposals,10 in July. Crucially, both have already had extensive engagement with
those policymakers and regulators who have the power to make their respective proposed new regimes a reality.
LCP’s and WTW’s proposals
Designed to balance the needs of multiple stakeholders, each of which are poorly served to varying degrees
by the inherent risk adversity of the current system, both LCP and WTW seek to reverse the deeply engrained
de-risking mindset that increasingly characterises the corporate DB landscape. How? By incentivising well-funded
DB schemes to adopt more growth-oriented and sensibly risked longer-term-focused run-on portfolios, with
appropriate stakeholder protections in place. Here’s exactly how.
With trustee and sponsor agreement, and subject to meeting a minimum, actuarially certified, qualifying funding level, appropriately well-funded schemes with strong sponsors, whether open or closed, would be explicitly (LCP)/
effectively (WTW) opted into a dedicated longer-term run-on regime.11 Within LCP’s proposed run-on regime,
PSP, two principal changes are proposed. One is to increase member security by raising PPF coverage — via
additional PPF levies, labelled PPF super levies, based on the usual metrics of scheme size, sponsor strength,
funding and level of investment risk being run — to 100% of accrued member benefits. LCP calls this 100%
PPF underpin, PPF super-protection.12 Indeed, the 100% PPF underpin is considered by LCP as fundamental
to providing trustees, who ultimately have a right of veto over any re-risking, with the appropriate incentive and
comfort to move away from the current default position and engage in a conversation around re-risking.
While not dismissive, WTW is less convinced of the feasibility and equity of applying 100% PPF coverage to those schemes that opt into a long-term run-on regime, given the risk of adverse selection, questions over the
equitable apportionment of PPF reserves between existing, new core and enhanced compensation claims and
the inequity enhanced compensation creates for those members whose schemes are already in the PPF. Indeed,
although acknowledging the merits of conducting a deeper dive into 100% PPF coverage, WTW believes that
its six proposals (please see the breakout box below) will collectively be a more effective trigger in changing
well-funded scheme investment behaviour. Notable here is its fifth proposal to revise the draft DWP funding and
investment strategy regulations and sixth to create a broader regulatory remit for the Pensions Regulator (tPR),
akin to that of the Financial Conduct Authority’s (FCA’s) new secondary objective.13 That is, one that, rather
than just protect DB members’ accrued benefits, more generally “supports adequate retirement outcomes for
members of workplace pension schemes” and “promotes wider UK prosperity”.
In a counter to this position, LCP remains resolute in its belief that, in applying the 100% PPF underpin to the cream of well-funded schemes, there is unlikely to be any material adverse selection risk to the PPF or potential
contagion to other PPF levy payers. In fact, LCP suggests it would be a net positive for the PPF and its finances, in generating both a new source of revenue — the PPF super-levy — and in prolonging an existing source of
revenue — the regular levies from those schemes which would otherwise have been bought out.14
WTW’s six proposals to seize the pension surplus opportunity
1. Create a legislative mechanism by which a DB scheme’s surplus can be used to finance contributions to benefit DC members in a different scheme.
2. Reduce the tax rate on refunds of surpluses to an employer, ideally to align with the corporation tax rate.
3. Amend legislation to more readily allow refunds on surplus while a scheme is ongoing.
4. Remove some tax barriers to sharing surpluses with DB members.
5. Ensure that the final DWP funding and investment strategy regulations do not funnel schemes into obsessive de-risking, and that they allow open DB schemes to thrive.
6. Revisit the Pension Regulator’s statutory objectives to encourage an approach to regulating DB pension schemes that considers members’ broader interests beyond solely protecting accrued pensions.
The other LCP proposal, which aligns with WTW’s view, is to facilitate non-punitive, ongoing sponsor access to
scheme surpluses, once a stipulated level of “super surplus”, to coin LCP’s terminology, has been achieved.
Both suggest a trigger point of being fully funded on a low dependency basis — for instance 105% funded on
a gilts + 0.5% per annum basis15 — rather than the currently high bar of typically only allowing access once
the actuarially-estimated buyout/solvency basis has been achieved. Of course, these distributable surpluses
would be subject to strictly prescribed uses and limits, with the trustee and sponsor agreeing a surplus-sharing
mechanism in advance.
WTW, in particular, is very prescriptive in its second and third proposals as to what needs to change here, in
calling for a reduction in “the tax rate on refunds of surpluses to an employer, ideally to align with the corporation
tax rate” and “amending legislation to more readily allow refunds of surplus while a scheme is ongoing”.
Notwithstanding the need for a continued focus on secure income generating CDI assets and, of course, the need to allocate sufficient hedging and collateral assets to sustain a desired level of interest rate and inflation
hedging, the expected result of these regulatory revisions would be to extend the lifetime of eligible DB schemes
by incentivising and enabling those opted into the new run-on regime, to partially reverse, or slow the pace of,
their de-risking and more immediate focus on buyout, by adopting a more growth-oriented run-on portfolio.
The characteristics and benefits of adopting growth-oriented run-on portfolios
Given these other moving parts, and factors such as the strength of the sponsor covenant, this would likely
see anything between around 20% and 50% of the asset allocation of a typical long-term run-on scheme being
devoted to public equities and more patient capital opportunities — notably UK infrastructure, assets supportive
of the transition to net zero and productive capital16 — all to the benefit of multiple stakeholders — ultimately
the UK economy.17 LCP suggests this refocused asset allocation could realistically be expected to add 1-2%
per annum to investment returns, while WTW reminds us that such opportunities can prove more defensive to
downside scenarios than supposedly lower risk, lower returning assets. LCP also suggests that a long-term
run-on regime would be supportive, indeed more supportive than the buyout market, of the economically-crucial
gilt market, at a time when new gilt issuance is likely to remain robust and quantitative tightening by the Bank of
England lies in prospect.
By prolonging the lifetime of some of the UK’s largest and safest DB schemes and facilitating the generation of a distributable surplus, should enable sponsors to deploy more capital into their businesses over time and help satisfy the Treasury’s desire for pension scheme assets, more generally, to support economic growth.18 The just
transition to net zero, alongside the management of other ESG risk factors and impact goals, would also likely
benefit, not least from schemes’ longer-term investment horizons. Additionally, the potential enhancement of DB
member benefits (think providing fuller inflation-indexation) would be high up on trustee agendas if investment
risk was continuing to be run, with the fourth of WTW’s proposals calling for the removal of those tax barriers that
frustrate sharing surpluses with DB members.19
What measure really stands out in both proposals though is the desire to help address the intergenerational inequality inherent in the UK pensions system. That is, by using distributable surpluses to tax-efficiently augment
the, typically inadequate, contribution rates of most UK workplace Defined Contribution (DC) schemes, even
when the DC scheme isn’t in the same trust as the DB scheme of the same employer group. WTW quite rightly
suggests that in funding a DC scheme, “DB benefits remain funded to an appropriate level of benefit security”.
Buyout remains an option and the ultimate end game
Crucially, opting into a long-term run-on regime would not preclude a scheme from bulk annuity purchase, if at any time that route was felt by the sponsor and/or trustee to be appropriate. Indeed, as noted earlier, for most,
if not all, schemes, buyout is the natural ultimate end game, typically once a scheme is much more mature
and much smaller in size. Moreover, as LCP notes, entering this regime could well enhance the probability of
a scheme achieving funding to the ultra-high bar of the buyout basis, without the sponsor having to dig deeply
into its pockets. Indeed, for this reason, LCP believes its PSP regime would enable a more orderly transition
into the buyout market over the next couple of decades, thereby obviating the very real systematic risk of
hundreds of billions of pounds flowing into the bulk annuity market over a relatively short timeframe in a relatively
uncontrolled manner.20
Safeguards
Of course, for a long-term run-on regime to work effectively, certain safeguards would need to be retained with others put in place, not least to sidestep any potential moral hazard and systemic risks. The former would
typically include the continuation of regular prudent actuarial valuations and stricter recovery plans to a defined
secure level of funding if deficits were to emerge and continued regular assessments of covenant strength. This
would be supplemented with protections such as prescribing maximum allocations to particular asset classes
so as to protect the PPF from ultimately underwriting all manner of risks. Of course, just as now, excessive risk
taking would be disincentivised by the PPF levy, while trustee and sponsor agreement on asset allocation would
be crucial, as the sponsor would continue to underwrite the investment risk being taken to generate and grow
a distributable surplus.
Why does this matter?
In short, despite their differences in a couple of areas, what LCP and WTW propose could be a genuine game
changer. After all, the immense opportunity cost of regulatory-driven de-risking and restricting access to surpluses is proving detrimental to multiple stakeholders, ultimately denting the productive potential of the UK
economy as a whole.
There is a better way, a much better way, and thanks to the exceptional thinkers at both WTW and LCP and their
continued interactions with those policymakers and regulators who have the power to make these proposals a reality, we could soon witness a viable challenge to the long-established and deeply entrenched mindset of derisking
once full funding is achieved or is fast approaching.21
We might also see a more orderly transition into the buyout market, as well-funded schemes decide to run their
schemes on over an extended time horizon rather than opt for what has rapidly become the consensus and highly unproductive default. Of course, trustees must adhere to the central tenet of fiduciary duty in ensuring
pensions are paid in full and on time but not in a way that is to the detriment of all else.
