UK Chancellor of the Exchequer Rachel Reeves’ announcement at the end of January that she wants to unshackle billions of pounds locked in defined benefit (DB) pension fund surpluses has raised questions about how such a move might impact the country’s bulk purchase annuity market.
Reeves told a meeting of City chiefs that by releasing the money “trapped” in DB pensions, employers could allocate it to potentially more lucrative strategies outside of their scheme investment remits.
Surpluses are tied into schemes by rules agreed between sponsors and trustees. If the Chancellor loosens those rules, employers may be encouraged to run their schemes on, slowing growth in the bulk annuity market from which insurers are benefiting.
“These [new] rules might make it easier for a sponsor to access surpluses whilst the scheme is still running on or use it in a different way, such as for DC contributions,” said Lara Desay, Hymans Roberston’s recently appointed Head of Risk Transfer.
Reeves’ proposal has the backing of The Pensions Regulator whose Chief Executive, Nausicaa Delfas, said it “supports efforts to help trustees and employers consider how to safely release surplus if it can improve member benefits or unlock investment in the wider economy”.
The motivation for changing the rules around surpluses is clear. About 75% of DB schemes are fully funded with around $226bn of surpluses at the end of January, according to the PPF 7800 Index. That money could provide plenty of ammunition for the Chancellor’s hopes of stimulating the UK’s economy.
The implications can be positive for sponsors and trustees alike. Employers will have new funds to support growth and investment initiatives, while scheme members could see some of the released capital ploughed back into the scheme benefit schedules or put into defined contribution (DC) schemes.
Just how beneficial any move might be would depend on the detailed wording of any proposal. A draft is expected after a consultation that’s slated for the spring. For many schemes, however, this isn’t even an option: only those that struck agreements before 2016 are entitled to begin the process of early access to surpluses.
Already, at least two major companies have announced run-ons since the Chancellor’s announcement. In March, global investor Aberdeen agreed a plan with trustees to access £800m of DB scheme surpluses. That followed a decision by Schroders to run-on its scheme in January.
A change that could benefit the risk-offset industry is a redrawing of the tax code associated with wound-down schemes. Full buy-outs carry a tax implication that can outweigh the cost benefits of winding down. Although previous chancellor Jeremy Hunt lowered the tax rate to 25% from 35%, it’s still regarded as penal, especially for smaller schemes. If Reeves introduces a lower tax rate, the cost of wind down relative to that of running-on a scheme would be reduced and potentially drive more business to bulk annuity providers.
The likelihood of a shift either way, however, hinges on a variety of factors as well as the peculiarities of each scheme. While sponsors may be encouraged to run-on if the Chancellor creates a climate more favourable to doing so, they will still need the support of trustees. That could be forthcoming with incentives such as pledging to use substantial proportions of those funds to top-up DB contributions, enhance benefits or fund DC schemes. Both the Aberdeen and Schroders deals, for example, were focussed on releasing surpluses, in part, to fund DC contributions.
Covenants written into schemes differ, too, and where they place less emphasis on sharing returned surpluses to members, trustee appetite for a run-on is likely to be minimal. As well, a run-on under better terms may still be more expensive to administer for smaller schemes, which don’t have the economies of scale to maximise returns from, or balance the risks to, their members’ contributions.
“For the most part, unless there is a particularly strong sponsor covenant in place, trustees are generally targeting the insurance market – it’s the sponsor that is driving the run-on discussion,” Desay said.
“If you can afford to buy-in/buy-out that is likely to remain the option of choice at the smaller end of the market.”
Desay also doubts whether other pension developments introduced recently, including the CDC scheme, is likely alter the trend towards buy-outs and wind-downs.
The promise of reinvesting in the company is likely to be a greater incentive to sponsors than the opportunity to invest elsewhere. With restrictions on schemes’ investment strategies already limited, industry figures have questioned how much more capital sponsors would allocate to other assets.
“It’s been somewhat lost in the debate so far that bulk annuity providers already invest tens of billions in productive assets in the UK,” said Frankie Borrell, Head of BPA Origination at Royal London.
Offset deals represent a small part of insurers’ business but it is a market that has been growing for a decade. Willis Towers Watson forecasts that £50bn of bulk annuity transactions will be completed in 2025, which will be supplemented by £20bn of longevity risk deals, a market that it said is likely to benefit from any loosening of surplus return rules.
Insurers hope any measures Reeves introduces will do little to halt growth in a market that Royal London’s Borrell said had seen thousands of buy-ins by bulk annuity providers give millions of members of DB pension schemes financial security.
“Whilst it is often the multi-billion-pound transactions that attract the headlines, beneath the surface there is a highly functioning and competitive marketplace with all segments being well serviced by the ten active bulk annuity providers,” Borrell said.
“Buy-out and wind-up of a DB pension scheme also crucially removes funding risk and delivers improved operational freedom for the companies that sponsor them.”
He stressed the need for to ensure protections to scheme funding levels under any new rules, a sentiment that pension and insurance industry advocates alike support. The Aberdeen deal struck in March came with stringent guardrails to ensure that the security and funding position of the DB scheme was not affected, for example.
Borrell warned, however, that unless carefully implemented, change could come unintended consequences.
“Many trustees and corporate sponsors of pension schemes remember all too well the surpluses and contribution holidays that were enjoyed in the 1990s, only for the situation to reverse into a ‘deficit migraine’ for over 20 years,” he said.
“The government would better meet their objectives through supporting the thriving bulk annuity market whilst providing the right investment opportunities to insurers, that they can naturally invest in at scale and more efficiently than most pension schemes.”
