Pensions - Articles - Why trapped surplus is more of an issue than TPR implies

 Jamie Harding, Senior Consultant at LCP

 Under these proposals, even where a scheme is not planning to adhere to the explicit requirements of the Fast Track approach, they will be expected to justify clearly any departure from the Fast Track parameters.

  

 We considered the possible unintended negative consequences of the proposals more generally at a high level in our July 2020 “LCP on point” paper, A Fast Track to problems? Why TPR's new DB funding code needs to be flexible.

  

 Looking ahead to the second consultation on the details of the new code, a key question that TPR will wish to consider as part of its impact assessment is: does the likely acceleration of contributions under the new regime represent value in achieving schemes’ overall objectives, or is there a risk that for many schemes it could represent an inefficient cost providing limited additional security to DB scheme members?

  

 In order to answer this question we need to think about the long-term objective of schemes, and in particular whether they are aiming to pass across their liabilities to a third-party insurer or superfund, or are targeting self-sufficiency and run-off. It is this latter type of scheme where a short-term increase in contributions is less likely to provide additional value over the longer term, as our analysis shows it is simply going to lead to an increased likelihood of a problem which is already a concern for many sponsors: that of trapped surplus.

  

 The scale of the issue

 Let’s turn first to the potential scale of the contributions required under TPR’s proposed framework. We concentrate our analysis on larger schemes, those with £1bn+ in assets. This is because these schemes are more likely to be targeting self-sufficiency, as they have the economies of scale to make this a more cost-effective solution than buyout in many cases.

  

 If these larger DB schemes were required to achieve full funding on a low risk, gilts+0.5% basis within the next decade, our analysis shows this could require at least £100bn in contributions over that period.

  

 Of course, a proportion of these £100bn contributions is already expected to be paid under the current regulatory regime, but under the new regime there is expected to be less flexibility and a requirement to pay more over a shorter timeframe. For example currently schemes have a number of levers available to them when setting their funding target and contributions in order to reduce the risk of long term overpayments, including:

  

 Ensuring technical provisions are not set overly prudently

  

 Allowance for additional investment return in their recovery plans

  

 Flexibility around recovery plan length and the date at which they target their long-term objective

  

 The consultation proposes less flexibility in each of these areas, and each has an economic cost that contributes to the £100bn figure above.

  

 These contributions represent £100bn which is then not available for investment elsewhere in the UK economy, noting that for some sponsors, the next few months and years will be critical for the solvency of their business. There are also likely to be Brexit headwinds.

  

 At an individual level, this is also £100bn which is not available for DC contributions or for the ongoing employment of active members.

  

 It is therefore key that this £100bn provides significant value in achieving the longer-term objectives of these schemes and materially improves the security of member’s benefits. However, I would argue this may not be the case.

  

 Money well spent?

 In practice, given their size most, if not all, of these schemes would be able to adopt a low-risk investment strategy expected to return well in excess of that assumed within their funding basis – for example we understand insurers typically target returns of around gilts + 1% to gilts + 1.5% (net of defaults, downgrades and expenses) on their annuity-backing portfolios, albeit this is dependent on credit spreads.

 
 If these larger schemes targeted something similar, then over the longer term they would expect to develop a significant surplus on a low-risk basis as their investment returns outstripped the prudent low-risk discount rate they are required to use to assess their liabilities. In fact we project that if these large schemes were all to adopt run-off as their strategy, having achieved full funding on their gilts+0.5% basis by 2030 as might be broadly expected under the new regime, they would then be expected to go on to build up around £90bn in surplus relative to a gilts +0.5% benchmark by 2050!

 
 And once a surplus is created, current legislation means there are very few circumstances where this excess funding can be accessed in future by the sponsors. This projected £90bn can therefore be viewed from the sponsor perspective as expected future trapped surplus in that it would provide no additional economic value (at least until the scheme is wound up, and even then there are large tax penalties). Contingent funding approaches such as escrow arrangements and asset-backed securities can certainly help, by making it easier to get that money back over the longer term if it ultimately proves to have not been needed. But they cannot eliminate this problem entirely.

  

 All schemes heading for the insurance world?

 In practice, well before such surplus levels started to build up, schemes are likely to look to secure liabilities via an insured buy-out. But, in order to reach this position, is it necessary for UK businesses to commit £100bn of capital over the next 10 years?

 
 If, instead of targeting gilts + 0.5% pa by 2030 (the top end of where TPR’s first consultation indicated a Fast Track compliant basis might be), large schemes adopting a Bespoke approach were able to fund to a slightly less prudent target of gilts + 0.8% pa we estimate that the additional contributions due over the next decade would reduce by around £40bn.

 
 And, by targeting gilts +1% pa returns in a low-risk strategy, these schemes would still be projected to reach a buy-out level of funding – just a bit later than if they funded to gilts + 0.5% pa by 2030. In the meantime, as long as the low risk returns emerge, they could be confident of paying members’ benefits in full with little need of sponsor support. And sponsors might argue that £40bn spent on bringing forward buy outs – or adding to future trapped surpluses for schemes running off – could instead be put to better use in the current economic climate.

  

 Flexibility is key to avoid inefficiency

 In my view it is therefore key that there is flexibility in the new funding regime for trustees and sponsors to be able to find and implement the balance that is right for them, which of course comes back to the potential negative consequences of benchmarking Bespoke valuations against a “one size fits all” Fast Track.

  

 Ultimately all of what is written above comes down to a political question about the best use of capital in the current economic climate, and is not one we can answer. We just hope this is considered carefully by TPR when carrying out its impact assessment, and perhaps more importantly by DWP when the new Regulations are being drafted off the back of the Pension Schemes Bill, as it is these regulations that will give TPR powers to impose the new funding regime.