Having a DB scheme can be a major factor in any potential acquisition. Mike Ramsey looks at how the risks associated with DB can be minimised
- Any transaction with a DB scheme in the mix poses a challenge
- There are things that can be done to mitigate risks that companies should explore
- Schemes can do a lot to reduce running costs and liabilities
The combination of regulation, volatile investment markets and increased longevity has transformed the legacy of defined benefit (DB) pension schemes into an administrative nightmare and blackhole for resources.
Businesses with a DB scheme can feel inhibited in their corporate activity. Any transaction with a DB scheme in the mix poses a challenge, not only for the organisation trying to sell it, but the prospective purchaser in trying to justify the risk.
There are so many variables it is easy to see how having a DB scheme involved could be a deal breaker. There are, however, things that can be done to minimise and mitigate these risks and it is perhaps surprising that more schemes don't tackle them more systematically and also that purchasers assume that all the risk exercises have been explored.
The success of any scheme is reliant upon contributions and investment performance, but if you have had an unfavorable valuation, that immediately makes things much harder.
Should the market move against you over the next three years, running costs will increase and it will affect the value of the company either as a risk on the balance sheet or a drain on profitability.
However, many schemes don't have a great handle on the key risks facing pension schemes. Major risks include interest rates, inflation, longevity and market risk. Interest rates in particular are one of the largest factors affecting the calculations the scheme actuary makes.
As little as a 1% shift in interest rates can translate to a 20% increase in the value of liabilities. That's a small shift with a very big impact. Interest rates have fallen sharply in recent years, leading to a big increase in liabilities and negative impact on funding levels. The resultant large liabilities and deficits can have a significant impact on future corporate activity that the organisation can potentially engage in.
The employer should take their own advice during the valuation process, to review the assumptions put forward by the scheme actuary.
Take the money and run
Even if the valuation is on the money, there are things a scheme can do to reduce running costs and liabilities.
First of all, there is offering wider options to members at point of retirement, in addition to the traditional option of a pension, or a pension with a tax-free cash sum, possibly with some form of advice where appropriate.
The introduction of freedom and choice in DC schemes from April 2015, whereby members no longer have to buy an annuity, has led to a number of schemes now offering members the alternative of a transfer value at retirement.
Some members don't value the traditional format of DB benefits (i.e. escalating pension with spouse's pensions) and may feel that the flexibility offered by a DC fund provides a better alternative for them.
Regulated advice has to be obtained where a transfer value is in excess of £30k, which may provide comfort to scheme trustees concerned that offering a transfer value at the point of retirement will lead to members making inappropriate choices. The cost of any advice may be provided by the corporate if they wish to do so.
An alternative option for DB members may be to offer a rights exchange – a pension increase exchange – where they give up an escalating pension, for a higher flat rate pension.
From the member perspective, the option of a higher pension in the early stages of retirement may be attractive, but any member communication needs to be simple, clear and transparent so that members fully understand the implications of their decision.
These member liability management exercises can also be offered to members as a one-off exercise, as well as at the point of retirement and can include enhanced transfer values, where a top-up is added to the standard transfer value, but this is less common now given that transfer values are near historic highs.
Member liability management exercises do cost money, but risk is reduced as liabilities fall. Ongoing costs may also fall. Those who opt for a transfer value are off your hands, while those choosing a PIE will have the same reduced benefits, which takes the edge of the future unknowns.
Consolidation, consolidation, consolidation
Companies that have survived some time may have a number of different schemes from which it is very difficult to develop economies of scale.
Where there is a valid reason for consolidation, schemes could transfer a number of their schemes into another one. Alternatively, they could find a master trust provider to transfer into that could offer markedly lower costs, improve governance and provide access to cutting edge investment funds and solutions due to the scale of assets under management.
This can include access to liability driven investment solutions, which aim to hedge out part of interest rate and inflation rate, using instruments that many would struggle to access affordably.
A transfer to a master trust can provide an opportunity to carry out member liability management exercises as part of the process. This could potentially save significant sums of money over the longer term.
As part of the wind-up of an existing scheme, winding up lump sums can be offered to members with small pots valued at less than £18,000, regardless of age or benefits held elsewhere. An existing scheme can't be wound up just to facilitate this type of exercise.
Making the numbers work
Where M&A work is already under way, the options above may demonstrate to a prospective owner that running the DB scheme may not be as bad as they had feared and illustrate potential savings in the future.
Another important benefit is an excellent opportunity to improve your data. This may be something that has probably been deferred on a number of occasions, because it's too difficult, too expensive or a combination of both.
A data cleansing exercise isn't only beneficial from an operational point of view, but can reduce the cost of buy-in or buyout by as much as 20%, because insurance companies who doubt the quality of your data will put an extra premium on the price.
I can see clearly now
Once you go through one or more of these exercises, you may even find you have reached a point where you are much closer to self-sufficiency, buy-in or even buyout than you may have thought possible before.
By better defining the costs of the scheme – and reducing these, along with a reduction in future risks – a sponsor or interested party may find they are better able and more willing to support the scheme in the future. A scheme that is smaller in size, has hedged out a significant portion of key risks and is cheaper to run in terms of ongoing costs, may improve the value of the sponsoring employer's business.
This requires negotiation with trustees and perhaps unions, but by working in partnership these parties can be satisfied that securing the risk of the scheme in the medium-term will have a profound effect upon the organisation in the long term.
Mike Ramsey is chief executive of The Pensions Trust
Defined benefit (DB) schemes that provide GMPs must revisit and, where necessary, top-up historic cash equivalent transfer values (CETVs) that have been calculated on an unequal basis, a landmark court judgment said last week.
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Opportunities for defined benefit (DB) schemes to pursue investment approaches that help repair the UK’s economy cannot stand in the way of improving member outcomes, Aegon says.
More members transferred out of defined benefit (DB) pension schemes in October after September's record lows while values were surprisingly stable, according to XPS Pensions Group's Transfer Watch.
Joanna Smith says trustees will need to accurately identify if covenant issues are short-term affordability concerns, or the start of more material deterioration.