The PPF’s latest Purple Book reported that the funding ratio of defined benefit schemes on a full buy-out basis increased from 73.7% as at 31 March 2021 to 79.2% as at 31 March 2022. Since then, market movements and associated changes to insurer pricing has meant that many DB schemes are even closer to the funding levels required to de-risk or fully buy-out their pension obligations. LCP’s October 2022 Pensions De-risking report estimates that the recent increase in funding levels will translate into a potential demand of over £200bn for transactions over the next 3 years.

Despite this significant increase in demand, insurer capacity (from both an asset and personnel availability perspective) has not increased at the same rate. With TPR launching its second consultation on the draft DB Funding Code last Friday, we consider the arguments for and against running on your scheme on a fully funded low dependency basis.

Arguments for running on

Control over decision-making

At buy-out, insurers demand certainty over which benefits are being insured. As such, trustees need to decide how to codify any discretions that exist under scheme rules. A common area where issues may arise in practice is in relation to the trustee discretion to pay dependant’s and child’s pensions – in particular a priority order for payment in future cases will need to be agreed. Another challenging area, particularly in the current high inflationary environment, is how to deal with any discretionary increases provided for by scheme rules.

Running on a scheme means trustees can continue to exercise those discretions as and when the relevant factors relating to a particular case are known. This can be a tangible issue for some members, especially in smaller schemes where trustees are likely to have had a greater personal connection to and understanding of a member’s personal circumstances and the sponsoring employer’s business.

Control over investments

The Single Code of Practice will require trustees to establish and operate an effective system of governance which should include consideration of environmental, social and governance matters relating to scheme investments. As the largest institutional investors in the UK, bulk annuity insurers have also been making progress in this area. However, some are further ahead than others with only 4 out of the 8 main insurers having signed up to the UK Stewardship Code as at 31 March 2022, for example.

Trustees have fiduciary responsibilities to consider how their members’ pensions are managed and can use their influence throughout the investment chain.  Post buy-out, however, trustees and members will lose input and insight into how scheme assets are invested which may be particularly important to those members with a strong shared ethical or ideological identity, such as schemes in the religious or charitable sector.

Member administration experience 

Research commissioned by digital customer experience firm Eptica in 2019 found that just 3% of respondents rated insurers as the most-trusted companies, leaving them joint last with airlines, telecoms and automotive firms. The study showed that the majority of insurers were failing to cope, being unable to deliver adequate customer service on consumer's channels of choice.

Having been paid the buy-out premium up front, there is no commercial incentive on insurers to perform their administrative duties promptly and effectively (outside of the bulk annuity policy terms). Administration pressures will only increase in light of increased demand. By contrast, trustees regularly monitor the performance of third party administrators against agreed benchmarks and become aware of any issues through quarterly reports, member feedback and the internal dispute resolution procedure. The Single Code of Practice will require trustees to periodically review the market of service providers and consider if the scheme continues to receive quality of service and value for money.

Increased duty of care 

Trustees have a fiduciary duty to promote the purpose of the scheme, act in the best financial interests of beneficiaries and consider the interests of all beneficiaries. Failure to do so may result in liability for breach of trust. Whilst insurers must treat customers fairly, unlike under a pensions trust, a failure to do so will not result in the potential for personal liability.  

Financial 

The final, and perhaps most significant argument for continuing to run your scheme is a financial one. With insurers expected to make a 30-40% return on a buy-out premium, employers with strong covenants may question whether this additional fee is worth paying. 

Arguments for buying-out

Risk reduction

Historically, the main argument for buying-out is that it removes long term financial risk as the insurer becomes liable to pay the insured benefits, irrespective of increase in inflation, movements in gilt yields or improvements in mortality. However, with DB trustees potentially from next October having to set out when the scheme will reach ‘significant maturity’ and how it will get there, a big question arises as to whether schemes will, in future, target remaining at low dependency over buying-out. This is the point at which the scheme is funded and invested so that, under reasonably foreseeable circumstances, no further employer contributions will be required to fund the benefits accrued by members.

However, unless residual risk insurance is purchased (which comes at a cost), buying out does not remove all legal risk. Trustees who completed buy-in contracts before the October 2018 High Court decision in Lloyds Banking Group Pensions Trustees Ltd v Lloyds Bank plc will be aware that insurers only cover those liabilities that the trustees are aware of and have disclosed at the date of entering into the contract. Therefore, if a future change in law means that members are entitled to additional benefits, such as equalised overall pension benefits to account for the fact that GMPs are unequal between the sexes, these will not be covered. Members may still, therefore, bring claims after a scheme has been wound-up and no longer has any assets, which may mean further liability for the sponsoring employer. Whilst run-off insurance will cover the cost of defending any claim, it will not cover the cost of the liability itself.

Removes ongoing governance obligations 

Whilst a scheme is ongoing, trustees retain ultimate responsibility for compliance with their legal obligations, even where they have chosen to delegate the task of meeting these to a third party or sub-committee. Frequent changes in pensions legislation and increased regulation has led to many sponsoring employers appointing professional trustees, who are expected to show a greater level of knowledge and meet higher standards than other trustees. Buying-out ensures that trustees and sponsoring employers no longer need to incur the time and cost of compliance.

2023 sees one of the most significant developments for the pensions industry in years – the introduction of the Pensions Dashboard. The first DB schemes (those with 20,000 or more relevant members at the reference date) will be required to register and connect their scheme with the Money and Pensions Service by 30 November 2023.   

Schemes in wind-up must still connect according to their staging deadline, which is determined by how many ‘relevant members’ it had as at the scheme year end date falling between 1 April 2020 and 31 March 2021. This means that schemes that have recently bought out and commenced wind-up may still be required to connect but they can take comfort from the fact that they must only provide value data "if the trustee or manager of the scheme considers it appropriate to do so". Buying-out and completing your scheme’s wind up before your staging date will avoid having to comply with the new dashboard obligations. 

Covenant and protection on insolvency

On buy-out, members will be swapping the covenant of the sponsoring employer and the protection of the Pension Protection Fund for the covenant of the insurer and the protection of the Financial Services Compensation Scheme (“FSCS”). If post buy-out, the insurer fails and is unable to pay the benefits, members should be protected by the FSCS (which currently provides compensation worth 100% of the claim with no upper limit). However, there are a number of conditions which would need to be satisfied at the moment in time a claim arose, so FSCS protection cannot be guaranteed in all circumstances.

In contrast, whilst the scheme continues, members will have recourse against the employer (to fund the benefits) and, in the event of the employer’s insolvency, to the PPF. In broad terms, the PPF currently provides 100% of benefits by way of compensation for those over the normal retirement date at the date of the insolvency of the sponsor (with limited future increases) and 90% of benefits for those under normal retirement age at that time (again with limited future increases).

Something to ponder over Christmas

The decision whether to buy-out or run-on a DB scheme is one that will need to be made following collaborative discussions between the trustees and the sponsoring employer, not least because a scheme’s funding and investment strategy under the Occupational Pension Schemes (Funding and Investment Strategy and Amendment) Regulations may be subject to employer agreement (if agreement is currently required under Part 3 of the Pensions Act 2004 and the accompanying 2005 Scheme Funding Regulations). 

It will be interesting to see whether the introduction of the Regulations and the new DB Funding Code of Practice, which will require schemes to focus on targeting and ultimately maintaining a low dependency funding basis, will result in more schemes deciding to retain control and save the cost of the profit element of a buy-out premium by continuing to run on their scheme until the death of its last beneficiary.

This blog was written by Callum Duckmanton and Catrin Young.