By John Herbert
The relationship between many defined benefit pension plans and their sponsors has changed significantly over the past 10 years. Very few current employees in the private sector continue to benefit from these arrangements, and they are now largely viewed as a financial legacy rather than part of current remuneration policy.
Existing structures and solutions appear to be under significant stress, with sponsors paying in substantial amounts of cash, yet, in some cases, members are still not getting their full benefits. Consequently, changes over the next 10 years may be even more significant as challenges emerge to deliver better solutions for both members and sponsors.
The consensus view is that a process of ‘consolidation’, such that the number of defined benefit plans reduces significantly, may provide a suitable solution. However, there are diverging views on how this should be done and the timescale over which it can be achieved.
A number of solutions have been proposed as summarised in the table below. Most aim to reduce both operational costs and financial risk.
Full services providers
|Combining all services with one single provider|
|Plan mergers (associated companies)||Merging plans that have been adopted through business acquisition|
|Collective investment solutions||Investing through mutual funds or fiduciary solutions together with other plans|
|Sectionalised master trust||Managed alongside other plans but assets and liabilities are ringfence|
|Non-sectionalised master trust||Managed alongside other plans but assets and liabilities are combined|
|Insurance buyout||All responsibilities and liabilities transferred to insurer|
|Superfunds||Pooling assets and liabilities with other pension funds and exchanging the employer covenant for an immediate settlement cash sum (below full buyout)|
With the exception of superfunds, many of these solutions are already available, so why are they not being used more extensively? The main reasons are probably a reluctance to change, owing to either inertia, uncertainty or, possibly, the upfront transition costs.
In addition, the scale of the risks, both financial and reputational, are yet to fully emerge. Recent high-profile corporate failures have highlighted pension issues and the likely reduction to member benefits. Further ahead, the human resources required to continue to provide these services is likely to come under severe strain.
Once the risks of maintaining the status quo and taking no action become clearer, these products and solutions are likely to become widely adopted by many pension plans. So the question is when rather than if, and whether one single option will prevail or whether there will be a range of solutions to choose from.
Typically, smaller plans have higher operational and management costs (compared to their asset size) and are likely to see the greatest savings from ‘consolidation’. Increased scale may also lead to stronger governance and better risk management.
Smaller plans also face other issues, such as access to insurance buyout solutions at a competitive price and possibly access to some specialist skills around investments. For very small plans, the issue of adequate service provision at an affordable price may already be starting to emerge.
The master trust solution has been widely adopted for defined contribution plans, providing economies of scale, access to a wider range of investments and stronger governance. These benefits can also be provided to defined benefit plans.
The defined benefit master trust is a medium/long-term consolidation solution that reduces both governance risks and operational cost for the sponsor. There are some upfront costs involved, but operational costs (both direct and indirect) should be greatly reduced. In most cases, the break-even point should be relatively short.
The sectionalised master trust ringfences assets and liabilities for each employer, so that there are no cross-subsidies and no risk that one employer may need to contribute towards the liabilities of any other employers. Each section has its own funding plan and investment strategy, so the employer retains overall strategic control of the pension plan.
Unlike the non-sectionalised master trust, it remains very straightforward to move all the assets and liabilities to another consolidation solution without incurring significant exit penalties.
It should be viewed as a change of management (or governance) structure rather than a transfer of risk. In nearly all cases, these master trusts are run by professional independent trustees, who take on the responsibility for compliance, governance and management and use their expertise to find the most efficient solution for the participating employers.
In summary, the sectionalised defined benefit master trust offers the following features:
|Governance||Operational activities and oversight are delegated to experienced professionals to meet all compliance and governance requirements
|Operational costs||Adviser and investment costs will be significantly reduced owing to more efficient management and using the economies of scale available
|Sponsor role||The sponsor role becomes purely strategic in relation to investment strategy, pace of funding and risk management
|No cross-subsidies||No risk that one employer will need to contribute towards the liabilities of any other employers
|Improved risk management||Risks can be managed more efficiently and economies of scale will apply for risks that are similar to those of other employers
|Modest exit costs||
Exit can be achieved at modest cost, eg to settle the liabilities in full, transfer them to another plan, or for any other reason
While the benefits to sponsors are clear, what will be the likely impact on the members of a plan choosing to join a defined benefit master trust?
Overall, this should be very limited. There may be a new service provider and possibly some new contact details, but the member should not see too many changes. Potentially, service will improve as a result of being part of a larger pension plan with stronger governance and controls.
Financial security will remain unaffected, with the same sponsor and covenant, while the funding level will also be unchanged because all the assets and liabilities will be transferred across. Lastly, the Pension Protection Fund (PPF) remains in place as a backstop if needed.
Over the medium term, security for members would be expected to improve more quickly as a result of lower operational costs, so more of the contributions can be used to improve the funding level. Furthermore, economies of scale mean that the investments are likely to provide better risk-adjusted returns.
The UK has seen the number of defined benefit pension plans fall by around 20% over the past 20 years through mergers, insurance buyouts and entry into the PPF. This is fairly typical where there has been a passive approach and no positive action on consolidation.
In some countries, such as the Netherlands and Australia, where positive consolidation steps have been taken, the number of defined benefit pension plans has reduced by 70% or more. This has been achieved through master trusts, industry-wide schemes and buyout solutions, but changes to legislation and simplification of benefits have also played a significant role in the process.
The focus has moved very quickly on to the costs of managing legacy defined benefit pension plans and the additional financial burden this places on UK companies. For many sponsors, the cost of an insurance buyout is simply too high or does not represent efficient use of capital.
Other solutions, such as full-service providers, are unlikely to make enough difference to costs to have a real impact. The superfunds approach will require fundamental changes to legislation and take significant time to deliver.
The master trust can deliver the level of cost savings needed and really only needs confidence from employers (and trustees) to overcome the current inertia in the decision-making process. It still provides flexibility to take advantage of any simplification or harmonisation that may be available at a later date and may also accelerate the path towards a full settlement through an insurance buyout.