Partner Insight: Are defined benefit schemes insecure?

clock • 5 min read
Alex Beecraft, Partner, Aon
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Alex Beecraft, Partner, Aon

Most weeks see an announcement that a defined benefit (DB) pension scheme has secured members’ benefits. While the UK has a strong insurance regime, these statements might imply that benefits are at risk where schemes are yet to transact with an insurer - but is that really the case?

In this article, we look from covenant, control and capital perspectives at why many schemes can continue to provide secure benefits without insurance, should they wish to do so.

Recognising the strength of most sponsors

Most sponsors provide a secure covenant, and failures are generally quite rare. Pension Protection Fund (PPF) figures show that the insolvency rate was only c.0.3 percent p.a. in 2022/23 across the employer population (about one-third of that for UK companies as a whole). Over a five-year time horizon, over which trustees might decide whether to run-on, for the strongest half of employers the PPF's insolvency modelling implies the cumulative default risk is less than one percent.

If the sponsor does not fail, benefits will remain secure within the scheme, which still can draw on the sponsor's capital in the unlikely event that further funding is required.

Once schemes can afford insurance they should be able to pay benefits without further funding

Analysis from the Government Actuary's Department on behalf of The Pensions Regulator (TPR) shows that schemes that are fully funded on a Gilts+25bps basis and which follow a credit-focused investment strategy over 25 years, should be able to meet over 99.5 percent of benefits (on average across modelled scenarios), without any further need for employer contributions.

While this analysis does not include demographic risks, this percentage is on a par with the proportion of future events that the insurance regime is designed to withstand - which is a good benchmark for high security. Schemes that can afford to insure may well be more than fully funded on this basis and so have enough capital to deliver full benefits without further contributions.

In fact, within just five years of this point, a scheme with the right investment strategy could be able to meet the capital requirements of the UK's insurance regime - and, as above, insolvency is unlikely within this timeframe for most sponsors.

Protecting against covenant weakening will still be important to consider, and Aon's own modelling which also allows for demographic risks shows that scheme benefits can be even more secure if schemes actively run on with the right package of support from the employer.

Optionality and the benefits of control

So, at the point of deciding whether to insure, many schemes will have a secure sponsor and enough capital to pay benefits securely for the long term. However, there can be an understandable nervousness about whether these two conditions will continue.

Crucially running-on is not a one-time decision. By keeping control of their scheme, if the scheme stays well-funded then trustees retain the flexibility to pursue insurance to keep benefits secure if their covenant weakens. A robust framework of covenant monitoring and contingency planning is key to making sure this optionality is used effectively.

Protecting against twin tail risks

The only remaining concern is the twin-tail scenario where rapid insolvency of the sponsor coincides with a material deficit arising in the scheme. The likelihood of such a scenario is very low, but schemes can still protect against it.

Under the ASTRO framework (Aon's Active Solution To Run-On) we start on the basis that many schemes can do this by investing like an insurer to minimise volatility in the buy-out deficit and, if needed, use a surety bond to provide third-party capital for any buyout deficit if the sponsor becomes insolvent.

So, in summary:

  • The majority of sponsors will not fail and at the point schemes can afford insurance, they also have enough capital to provide ‘secure' benefits on an ongoing basis
  • If the sponsor covenant does weaken or fail and the scheme can still afford a buyout, then benefits can still be insured
  • Trustees can protect against the very low probability scenario in which there is a simultaneous insolvency and a material deficit through the right investment strategy and use of additional security

Recognising regret risk

Insurance remains the prudent option where there is a material near-term covenant risk (making it an important safety valve for run-on strategies) and may be attractive to many schemes for other reasons. For example, there will be schemes and sponsors that wish for governance, accounting, corporate risk management or other reasons to move their scheme into a consolidation arrangement in return for a premium - and insurers are the most secure consolidators available.

But as with all insurance, only in time will it become clear whether the cover was worth the premium. Where the sponsor does not become insolvent, some may look at the profits generated by the insurers and question what else could have been done with this excess capital - for example, by using DB surplus to meet DC employer contributions. Some Aon clients have already implemented this.

Some schemes may already be in this camp. Of the more than 80 known schemes that have transacted insurance deals greater than £500m* and where the sponsor was not already distressed, none of the sponsors have since become insolvent.

Had those schemes instead decided to run-on securely using a similar investment strategy adopted by their insurers, they would be likely to have generated surplus. This could have been used to the benefit of members or sponsors or both. This does not necessarily mean that the wrong decision was made, but the potential for regret risk is there.  

How does the industry address this regret risk?

First, there should be better distinction in the industry between ‘insuring' and ‘securing'. This is not because insurance is not secure but because - done correctly - run-on can be too. This will reduce misconceptions and encourage parties to consider fairly all credible options for the future of their pension schemes.

Secondly, more focus is needed on understanding the latent value in schemes that is expected to emerge as actuarial prudence unwinds over time. While this will just be an estimate, forgoing this value represents the true 'cost' of insurance and recognising this will aid decision making.

Finally, more focus should be given to how this value could otherwise be used both to support members and return to sponsors some of the funding provided in recent years. Further innovation should be expected even if proposed legislative reforms do not proceed.

 

Aon's response to this challenge is ASTRO, a best practice framework designed to enable schemes to run on with confidence to deliver value to members and sponsors. You can find more detail about the ASTRO framework here.

 

 

*Source: Professional Pensions, December 2023

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