Larger, well-funded, defined benefit pension schemes are increasingly debating run-on vs buy-out. There are schemes for which buy-out is currently affordable, in theory, based on their funding level, but for whom there may be near-term road blocks in terms of illiquid assets, data quality, market capacity, or sponsor willingness to pay an insurer's profit margin. There may also be a desire to generate upside over an extended period in order to be able to ‘share profits', e.g. enhance member benefits, fund defined contribution schemes etc.
Although there has been much discussion about why defined benefit schemes shouldn't buy-out, we have seen very little debate on whether run-on actually makes commercial sense. By the time regulatory concerns and constraints are addressed, is the scheme going to be able to do much more than cover its costs? This is a key question for schemes and sponsors, and we need to cut through the noise created by the obviously conflicted advisors and address the actual underlying question. The key focus should be whether or not ‘run-on' will actually benefit members.
Avoiding ‘regret risk'
A key concern for trustees choosing to run-on is the ‘regret risk' of missing the opportunity to buy-out when they could, but why is that the case? Firstly, since pension schemes will be paying benefits to members for a long time (50 years+), there is a material probability of any scheme sponsor – unless you are a Local Government Pension Scheme (LGPS), for example – defaulting during the scheme's remaining life.
Secondly, times of sponsor distress or default are highly correlated with general market downturns. Let's assume that a scheme currently operates with a small surplus on a proxy buy-out basis, that the sponsor is reasonably strong, and trustees decide to run-on with a view to generating and distributing surplus to sponsor and members. But then in 10 years the sponsor finds itself in financial distress due to market conditions that mean the scheme is in deficit. This is wrong way risk for the scheme and its members – the weak sponsor can't afford any additional contributions, and trustees wish they had bought out when they had the chance.
The above risk is not to be taken lightly. Trustees have a fiduciary duty to scheme members, and failure to act in their best interests has serious consequences. We think that most trustees will only really get comfortable with the potential regret risk if they feel that the investment strategy pursued in run-off has a high probability of maintaining (and of course growing) the buyout surplus position and therefore benefitting the members.
We will come back to this idea of investing in order to maintain (hedge) the buyout position later. However, there is another problem – the difference between an actuary's estimate of buyout price vs a transactable price of the liabilities. Unless a scheme has directly approached the buyout market or done detailed preparatory work with a broker, in run-off it will need to allow a margin for error in its estimation of the buyout price. There are plenty of examples of significant data and retrospective benefit rectification issues arising within schemes as they approach the buy-out market. Occasionally, the longevity assumptions adopted by the scheme actuary are simply not in line with those of reinsurers. This additional prudence needs to be funded, and can't be distributed to members or the sponsor.
Not only does a scheme need to be able to generate and retain an initial ‘prudent surplus' to cover the above risks/uncertainties, it needs to be able to maintain this surplus on an ongoing basis to be able to achieve the key aim of run-on – sharing upside between members and sponsor.
Three considerations on surplus extraction
These above considerations were mirrored in the DWP consultation on surplus extraction, where the three core requirements were:
- Surplus should only be extracted when member benefits are deemed safe.
- Trustees are ultimately responsible for managing the scheme funding levels.
- Surplus extraction should not be contingent on a specific use of the surplus.
In order for a pension scheme to maintain a healthy buy-out surplus in run-off – so trustees can feel comfortable in their decision to run-on – the value of its assets needs to move broadly in line with buy-out pricing. This means investing in the types of long-dated cash-flow matching assets that insurers use to back their liabilities and to price their deals. However, not all these assets are insurer-friendly, so corporate bonds and gilts may be the best choice as these are assets that most insurers will accept in-specie.
Since most insurers have very small allocations to gilts, having a larger allocation to corporate credit should provide a better buyout hedge for pension schemes. Having a higher allocation to credit also generates more upside for pension schemes, which is the whole point of run-on.
