As the market for commercial consolidation vehicles (‘superfunds’) rapidly develops, the Pensions Regulator (TPR) recently issued its guidance to defined benefit scheme trustees and employers considering a superfund transaction. This is a welcome step towards giving schemes the support they need to evaluate this option.
In a previous article, my colleague Adam Davis commented on TPR’s prior guidance to the operators of superfunds, questioning whether the interim regulatory regime in place could stifle innovation and limit the differentiation between superfunds and bulk purchase annuity insurers needed for superfunds to offer value to schemes and their members.
Does the guidance to trustees and employers help to differentiate between schemes that should insure and those which should transfer to a superfund, and therefore are superfunds complementary to insurance or purely competition?
The headline feature of the guidance is confirmation of the ‘gateway principles’ that trustees and employers must demonstrate have been satisfied:
- A transfer to a superfund should only be considered if a scheme cannot afford to buy out now.
- A transfer to a superfund should only be considered if a scheme has no realistic prospect of buy-out in the foreseeable future, given potential employer cash contributions and the insolvency risk of the employer.
- A transfer to the chosen superfund improves the likelihood of members receiving full benefits.
The principle that a buy-out with an insurer should be preferable to trustees given the increased security offered to members’ benefits is clearly sensible. Assessing whether a buy-out is achievable is the thornier issue, more so when looking into ‘the foreseeable future’.
TPR states that trustees should provide an up-to-date estimate of the buy-out funding level from their scheme actuary, as well as details of any approach to the insurance market or quotes received over the past year. I would suggest that in the vast majority of cases, a scheme that has approached the insurance market within the last year would already be one that has a realistic prospect of buy-out in the foreseeable future, since insurers generally don’t entertain speculative approaches. I also think that trustees should use a buy-out specialist, not necessarily the scheme actuary, in obtaining the estimate of the funding position. We often work with schemes that are provided with ‘up-to-date’ estimates that can be little more than a roll forward of the position at the last triennial valuation and don’t take account of membership movements nor current competitive factors in the buy-out market. If the right decisions are to be made, it is critical that the buy-out estimate is robust.
As TPR indicates, trustees will likely also need professional advice around future investment returns and, especially, employer covenant, given judgment on how long ‘the foreseeable future’ is will depend strongly on the period over which trustees have certainty around the covenant.
In assessing the second principle, trustees are expected to discuss with the employer ways in which scheme security can be improved without transferring to a superfund. Crucially, however, while the guidance refers to assessing the employer’s ‘ability’ to meet previously agreed deficit contributions, it only refers to its ‘willingness’ to improve security beyond this.
In the situation where an employer could afford to buy out but is only willing to fund a lower cost superfund transaction, it appears the gateway principles could be met, provided the transaction improves member outcomes. A concern, however, is that there is still not a clear distinction between this situation and buy-out being truly unaffordable, so there is an overlapping market for superfunds and insurers, contrary to TPR’s intentions.
K3’s view is that a large number of schemes will potentially find themselves in this grey area, i.e. schemes which most likely would have eventually ended up at buy-out if the superfund market didn’t exist, but now could transfer to a superfund. Such schemes having access to this new market is not necessarily a problem but there seems to be no acknowledgement that, as it stands, insurers and superfunds will compete against one another for some schemes, which was not meant to be. We think this regulatory arbitrage is undesirable.
To avoid this, we think one of two things needs to happen:
- Avoid regulatory arbitrage by having clearer, less subjective, guidance as to how a scheme determines whether a superfund is a viable option for them; or
- Level the playing field by allowing insurers the flexibility within their regulatory environment to offer alternatives to a pure insurance buy-out and to compete with superfunds.
We believe that if time is spent now getting this critical element right, then superfunds should be complementary to the existing buy-out market and serve an important role in improving the security of thousands of members’ benefits.