Across the UK pension industry, assets and liabilities have been subject to huge volatility over the last year and a half. Funding levels for many have soared, some deficits have increased, almost all strategies have needed review. Against that backdrop, companies and trustees alike report that endgame planning is one of their most important priorities. But are schemes really considering all the options available to them? In this article, we take a deeper look to what an active run-on is and the benefits that this strategy can deliver to members and sponsors.
What is active run-on?
Active run-on is the strategy of operating a well-funded pension scheme with the explicit intent of building up surplus assets, then using that surplus to benefit the key stakeholders of the scheme; the members and sponsor. This type of strategy is not new but was highlighted in the recent Mansion House consultations as something the Government might want to further encourage in order to facilitate long-term pension scheme investment in productive finance.
Active run-on strategies are being deployed both for short periods (say, 3-5 years with the expectation to buyout with an insurer after that period has elapsed) or as the long-term endgame strategy for schemes. Active run-on is generally a best fit for mid-to-large schemes with a strong or tending-to-strong sponsoring employer. These schemes can target material levels of surplus over time whilst maintaining exceptionally high levels of security for members.
How does active run-on generate value?
In simplistic terms, a scheme that is well funded on a low-risk basis only needs to target an investment return above the discount rate used to value liabilities and it should expect to build up surplus over time. The more conservative the discount rate, the easier that is to achieve. Schemes should also expect to make a modest demographic profit over time as members retire and the prudence in demographic assumptions unwinds.
This sounds fine in theory but is it possible to take a pension scheme and generate steady stable outperformance without taking too much risk? For a good example of how this balance can be achieved we don't have to look further than the bulk annuity insurance industry. The bulk annuity business model relies on taking a well-funded pension scheme generating a long-term profit by steady, stable outperformance and the unwinding of demographic prudence.
Putting it into numbers, our modelling shows that a mature £1 billion scheme that has sufficient money to buyout, could instead invest in the same way as an insurer for the next 20 years and generate around £300 million of surplus. The central premise of active run-on is that this surplus is used to benefit the members and sponsor of the scheme.
Using active run-on to benefit the members and the sponsor
There are many ways that members can benefit from active run-on. In some cases, simply running on (and not buying out) will allow members to continue to have access to valuable benefits and options that can otherwise be challenging and/or expensive to insure. For example, our data suggests around 30 percent of schemes currently offer options or support at retirement that is typically not insured at buyout. In addition, building up surplus allows enhanced member benefits to be funded over time, such as discretionary pension increases.
Sponsors can also benefit in multiple ways. Surplus may be recognised on the balance sheet. For a US-owned sponsor, targeting appropriate levels of asset return may also have a P&L benefit. However, for many sponsors, surplus only has tangible value if there is a clear way to access it. That is why a good active run-on strategy needs to come with an agreed surplus-release mechanism, that allows surplus assets to contribute to a company's free cashflow. No change to existing law is needed to enable this.
This alignment of stakeholder interests is of critical importance in making active run-on work. Trustees need to be comfortable they are acting in members interests with any strategy they adopt. Equally sponsors provide very valuable contingent security against tail risk for schemes who operate any run-on strategy. It is appropriate that they receive financial compensation for the ongoing exposure and for any discretionary benefits they agree to award.
Doing it right
At Aon, we believe that any solution to run-on should have a well-designed framework that allows schemes the ability to run-on in a way that maximises value for minimal level of risk. However, it also needs to be flexible enough to be adapted for each scheme-specific situation.
Our active strategy to run on (ASTRO) has four key pillars to its framework, combining to offer a very secure and value-generative strategy that schemes can adopt with confidence.
These four pillars are:
· Investing like an insurer
· Triple layer security
· Benefits for members
· Payback for the sponsor
Our modelling shows that, for a scheme choosing to run on for 20 years under the ASTRO framework rather than buyout can do so with:
1. A very high level of benefit security (greater than 99.5 percent of promised benefits being paid out for the average modelled scheme)*
2. Significant value creation, equal to broadly 30 percent of the current fund on average.
If one third of surplus goes to members benefits, these figures evolve to 110 percent of promised benefits being paid on average and 10-15 percent after-tax payment to the employer).
More detail about the ASTRO framework can be found here.
Well-funded pension schemes can generate substantial surplus value over time. The bulk annuity insurance model gives a ready example of how material value can be generated in a low-risk way. Using structures such as ASTRO, can replicate these insurance models with similar results for pension schemes. The key premise of active run-on is that surplus so-generated then goes to the benefit of members and the scheme sponsor. Case studies exist that prove this can work and the changing environment for funding levels and regulation mean that it is growing interest in active run-on across the UK pensions industry.
If you would like to discuss the opportunities for your scheme to run-on in greater detail, then please do get in touch.
* Average proportion of benefits paid/insured, based on a £1Bn scheme 100% solvency funded with a 20-year core ASTRO run on with 100% of solvency surplus released to a BBB-rated employer. Stochastic analysis based on the Aon Asset Model, with buy-out pricing variability and dynamic downgrade/insolvency modelling.