Analysis by Aon Hewitt has found that funding targets for UK defined benefit (DB) schemes to reach ‘self-sufficiency’ may not deliver the stability and certainty that trustees and sponsors expect, and that new strategies may be required.
In Aon Hewitt’s Global Pension Risk survey last year, the majority of UK pension schemes said that ‘self-sufficiency’ was their main long-term objective. Over 70% of the 600 trustees and sponsors polled by Aon Hewitt, felt 'self-sufficient' funding positions should provide at least a 95% chance of meeting the members' benefits in full. Almost 80% said that once fully funded, there should be less than a 10% chance of the sponsor needing to pay further contributions.
However, Aon Hewitt’s, ‘Pensions Stability White Paper – turning theory into reality’, finds that in most cases, typical self-sufficiency strategies do not provide the required degree of stability and certainty.
Paul McGlone, partner at Aon Hewitt, said:
“Our findings suggest that true ‘self-sufficiency’ is expensive and hard to achieve. Even modest risk accumulates over time, assets are volatile and the only way that a sponsor can be sure of not needing to pay more contributions, is to over-fund the scheme substantially.”
A clear disadvantage of over-funding for sponsors is that it means devoting more money in the initial outlay. Another is if the extra money means a higher chance of overpaying. For a scheme to have a 10% chance of future deficit means that there is a 90% chance it will end up having a future surplus.
The challenge for trustees and sponsors is to balance the need for certainty with the desire not to pay more than required. Aon Hewitt’s white paper suggests it is realistic for schemes to do this, but they need to look more broadly than conventional funding arrangements.
Paul McGlone added:
"Sponsors and trustees should look at options outside of the pension scheme, such as contingent assets, to provide the stability required. While contingent assets are not new, as schemes approach full funding we see them having a role to play in long-term funding, rather than just being a specialist tool for specific situations.
“Importantly, creating stability is not just about a decision taking place in the future. For many schemes it should affect their short term decisions. Specifically this will be important for when contributions should be redirected from the scheme itself and into a contingent vehicle outside of the scheme.”
Balancing the competing demands of the parties in this way can lead schemes to identify a stability ‘sweet spot’ which sensibly addresses risk, does not excessively tie up corporate assets and gives a reasonable chance of getting to a buyout target in the long term. For example, Aon Hewitt's modelling for a typical scheme has found a ‘sweet spot’ centred on an overall funding target (scheme plus buffer) in the order of 105% to 108% of a ‘gilts + 0.5% p.a.’, with a corresponding investment policy.
Paul McGlone commented:
“We urge trustees and sponsors to review their funding targets and strategies and to take action to reach a position of stability – meaning fewer surprises, less intervention and a reduced chance of eventual surplus or deficit.”
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