Partner Insight: Is it possible for a Defined Benefit scheme to actively run on and adopt a prudent funding strategy?

clock • 5 min read
Steven Keller, Partner, Aon
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Steven Keller, Partner, Aon

The events of the past 18 months have resulted in significantly improved funding positions for many UK defined benefit (DB) pension schemes. As a result, pension scheme trustees and their corporate sponsors are suddenly faced with an ‘endgame’ decision that would previously have seemed years away. That is, should they look to secure the scheme’s liabilities with an insurer, or should they continue to run-on for the foreseeable future?

Clearly this is a nice problem to have, but it can be all too easy to fall back on plans made many years ago and in very different circumstances. After all, for years, buyout has been seen as the ultimate aspiration. Indeed, most pension schemes will eventually move to buyout – surely no DB pension scheme will keep going until the final beneficiary passes away?

The Government hopes that one strategy that schemes will consider is running-on in order to target a surplus, or ‘active run-on'. How would trustees become comfortable with such a strategy and what would it mean for pension scheme funding? 

The question trustees should be asking themselves is not IF they should buyout, but WHEN?

For the right scheme, it is a perfectly reasonable strategy for trustees to actively decide to run-on in the short or even medium term, with the expectation that additional surplus will be generated (relative to the price of insurance).

If trustees are comfortable that:

·       Their sponsor is strong (more details about those considerations are here).

·       Their funding is strong (perhaps with a funding buffer in excess of insurance pricing and with additional non-cash security held as a contingency to protect against downside risk).

·       There are good reasons to run-on from a member's perspective – it could be that their scheme offers valued options to members at retirement, has complex benefits that cannot currently be replicated with an insurer, or a history of granting ad hoc benefit improvements that might prove unaffordable to codify in a contract of insurance (see more here).

Then running on may be the best solution in the short or medium term.

 Expected additional surplus relative to insurer pricing should come as a result of asset outperformance and ageing of a scheme's membership. Trustees will want to consider their fiduciary duties – their responsibility to pay members' benefits as they fall due, with a focus on protecting the security of those benefits. They will also need to demonstrate to their own satisfaction that if they are running on actively, this does not lead to unacceptable risk to members.

Aon's Active Solution To Run On (ASTRO) framework, is expected to be able to build up surplus at a rate of 2 percent p.a. Our modelling also finds:

·       Even if the additional surplus generated through running on is used solely for the benefit of the sponsor, we expect more than 99.5 percent of promised benefits will be paid out over a 20-year time horizon using the ASTRO framework.

·       Alternatively, if a third of any surplus generated is used to enhance member benefits, that figure rises to 110 percent of promised benefits.

A common question that we hear is "what happens if a scheme's funding position deteriorates so that any funding buffer is fully exhausted, and the scheme finds itself with insufficient assets to meet insurer pricing at some point in the future?"

The ASTRO framework requires any deficits be made good over a three-year period, as expected by the draft funding code, once significant maturity is reached. Under an intentionally low-volatility strategy, we would expect most deficits to be small enough to be repaired through investment returns and, if necessary, ceasing any surplus release mechanism. That may be through a temporary stop on discretionary increases on the member side, or ceasing contributions being paid to a defined contribution section within the same trust (if this is the route the sponsor has chosen).

The regulatory framework

Finally, trustees (and their sponsors) will want to know about the wider regulatory framework.

Helpfully, the Pensions Regulator's 2023 Annual Funding Statement was hugely supportive of running on, giving comfort to trustees that it is both acceptable and that it can be an attractive option within the current regulatory framework.

The draft funding code, which will be effective for actuarial valuations from September 2024, requires trustees to determine their Long Term Objective (LTO) and recognises ‘running off' as being one of three alternative objectives, alongside those of buyout and the use of a consolidator. When determining their LTO, trustees need to consider their investment strategy, which the code expects should ensure asset cashflows broadly match benefit outgoings, and the impact on their approach to funding. If trustees choose to adopt a cashflow matching investment strategy, then the funding code supports the use of a ‘dynamic discount rate', where the discount rate used is based on the expected return of the cashflow matching assets with a suitable, prudent, allowance for default of the underlying assets.

At first glance though, a cashflow matching investment strategy and associated funding approach may appear to conflict with the code's low risk / low return expectations. When expressed in the traditional ‘gilts +' manner, some Dynamic Discount Rates look ‘high' for a low-risk target. The draft code is clear – if the underlying risk of the strategy is such that the low-dependency tests are met, then this is a perfectly valid target. However, this approach clearly will not satisfy the fast-track compliance route, so trustees will need to pursue the alternative bespoke compliance route.

Time to consider

In light of recent market volatility and the impact this has had on schemes, all trustees should actively consider their endgame position. It will be the case that for some schemes, pursuing a buyout as soon as possible remains the correct course of action. But for others, the opportunity to continue running their scheme on in an active, but risk-controlled way, does not conflict with a trustee's duty, is well supported by the current regulatory framework, and can lead to improved member outcomes. This is why a pension scheme trustee should give running-on beyond full buyout funding an appropriate amount of consideration.

If you would like to discuss the opportunities for your scheme to run-on in greater detail, then please do get in touch. More detail about Aon's ASTRO framework can be found here.

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