Defined Benefit (DB) pension schemes in which the employer bears the investment and longevity risk have been on a downward journey to eventual extinction in the U.K. and many other jurisdictions for years. Extending life spans and low investment returns have combined to make running these schemes far too operationally risky for most employers including many of the largest. To cap increasing liabilities, most have either closed to new members (the lowest level of intervention), through to also stopping new accrual of entitlements for existing workers, and on to eventual buy-out or other run off strategies. The market for these risk transfer or sharing arrangements has grown rapidly in the U.K.
New proposed U.K. regulations, the Occupational Pension Schemes (Funding and Investment Strategy and Amendment) Regulations 2023, have been launched in draft form in July and are now open for public consultation with the deadline for feedback set at 17 October 2022. This will then be considered in finalising the regulations with a view to bringing them into force next year.
As the title of the regulations suggests, the focus is primarily on future investment strategy, and in further de-risking. In the terminology of the document, regulators are seeking to achieve a state of “low dependency”. A scheme with low dependency is one where the employer no longer needs to make additional contributions or, in effect, the scheme is self-financing. Depending on the actuarial assumptions used for this assessment, it should mean that schemes are, more or less, ready for a final buy-out or equivalent when they are in low dependency. The trigger for a scheme to start these preparations is reaching a defined a level of “scheme maturity” based on the weighted outstanding duration of liabilities.
The intention is to try and improve member’s security of benefits and a gradual reduction in the number of inadequately funded schemes having to revert to the Pension Protection Fund (PPF) lifeboat. One of the most high-profile uses of the PPF, which involves a 10% haircut to members’ benefits, was British Steel, which is a classic example of a legacy pension fund covering an industry whose current workforce is considerably smaller than it was historically. This leaves behind a huge legacy benefit liability, with a much-diminished operation to make good any shortfalls.
From an investment perspective, the regulations will drive a rotation from risk-on to risk-off assets, but because future returns are potentially more limited, it will create an estimated £200bn of additional liability added to employers’ future commitments.
The view is that this legislation will hasten the runoff of remaining DB schemes but there is concern amongst actuaries as to whether existing capital resources – almost invariably reinsurers – will have sufficient capacity to deal with this. Buyout levels are estimated to accelerate towards annual capacity requirements of £200bn a year. In 2019, estimates of market size were £43bn, and in the Covid-19 years of 2020 and 2021 this fell to around £30bn each year. It is certainly an opportunity for capital markets to engage, especially if they can sharpen their offerings.
The biggest risk for markets looking to gear up ready to participate is the one of whether the legislation proceeds to statute. Undoubtedly, the additional expense of migrating to a low dependency investment strategy will be a drain on employers’ resources and around 5% of schemes are already in the same position as British Steel were: a large pension fund and a now much diminished sponsoring employer. Applying the regulations to all scheme/employer situations alike may well lead to employer insolvencies and job losses. At a time when the world looks like entering a period of slowdown with pockets of recession expected, not least in the U.K., this might be a difficult political move to pull off and the legislation could end up being deferred.
At the moment, there is little noise of dissent beyond the Pension Scheme Village, but as employers wake up to some of the implications this does have the potential to capture the mainstream media with its preference for emotive impacts (i.e., job losses) rather than obscure technicalities. However, most affected schemes and employers won’t be entering “scheme maturity” and therefore having to implement the low dependency rules for a few years hence so the political counterargument required to push these rules over the line will be that the current economic squeeze may well be short term, whilst this program to secure members’ benefits is a much longer project.
Roger Lawrence is Managing Director at WL Consulting