What’s been happening and what’s on the horizon in the world of pensions
With the inexorable rise of Defined Contribution (DC) schemes and the continued closure of Defined Benefit (DB) schemes to new members and future accrual, suggestions that DB is dead are ever present. However, with funded DB schemes accounting for around 80% of UK pension assets, most of which are not going to buyout just yet, DB is very much alive and kicking. DB also provides the foundation for many millions of retirement outcomes. Given this, here we examine the current DB landscape and what it might look like three to five years from now.
The UK’s Defined Benefit landscape
As the world’s fourth largest funded pension system by assets, the UK is still very much defined by the relative size of its Defined Benefit (DB) assets. Despite the average split of pension assets for the world’s top seven pension systems being 55% Defined Contribution (DC)/45% DB, for the UK the split has long been around 80/20 in favour of DB. Indeed, only Japan and the Netherlands have a greater concentration of DB assets.1 Despite this, the number of private sector (corporate) and funded public sector DB schemes,2 and the number of active members, are overshadowed by the UK’s 26,990 DC schemes and their 16 million active members.3 Additionally, the size distribution of funded DB schemes is much less skewed than DC: UK DB being characterised by a high concentration of mega schemes, a cluster of large schemes and a long tail of small schemes.4
The most recent data suggests that there are 5,131 corporate DB schemes, with assets of £1.67 trillion, of which 89% are closed to new members and 51% closed to the future accrual of benefits. Of these schemes’ 9.65 million members, pensioners account for around 43%, deferred members 47%, and only 10% comprising active members.5 Funded public sector DB schemes, numbering around 200, are dominated in terms of size of assets and membership numbers by the eight Local Government Pension Scheme (LGPS) pools – comprising 86 administering authorities – with collective assets of £342 billion,6 and the mighty Universities Superannuation Scheme (USS), the UK’s largest funded DB scheme at £88.9 billion.7 Of the LGPS’ 6.2 million members, there are around 2 million actives, 2.3 million who are deferred and 1.8 million pensioners,8 while of the USS’s 500,000 or so members, 212,000 are actives with 207,000 deferred and 81,000 pensioners.
Is UK DB in rude health?
The health of funded DB, whether in general or at a scheme-specific level, has traditionally been measured by funding levels (or ratios) on a range of liability bases, some more prudent than others. In 2022, scheme funding ratios were principally determined by individual schemes’ sensitivity to rising yields and inflation expectations – a theme magnified by the gilt market turmoil of last autumn, which ensued in the aftermath of the government’s disastrous mini-budget of 23 September. Sparking the most violent mean reversion of yields ever seen and culminating in the most volatile period that both sides of DB scheme balance sheets have had to contend with since the global financial crisis (GFC) of 2008/09, the resulting diffusion of scheme funding ratios came into sharp focus.9
This sensitivity to violent moves in nominal yields, in particular, and to rising inflation expectations, hence also real yields, was determined by the level of each scheme’s liability driven investment (LDI) hedge ratios. That is, the extent to which each had hedged its liabilities’ exposure to long-run unrewarded interest rate and inflation risk.10 This, in turn, determined whether a scheme’s funding ratio materially improved or markedly deteriorated both in the run up to and, more notably, in the aftermath of this turbulent period. Typically, a scheme with a low hedge ratio, say one that hedged 50% or less of its liabilities against rates and inflation risk throughout the year, would have ended the year with a considerably higher funding level than it started with. That is, as gilt yields rose, the scheme’s liabilities would have fallen by more than its assets. This would have been typical of a funded public sector DB scheme.11 By contrast, a scheme targeting something close to a 100% of assets, or funding level, hedge – one that typifies many corporate DB schemes – would have, asset allocation notwithstanding, seen its assets fall at the same rate as its liabilities. After all, the majority of its liabilities would have been hedged. Moreover, the absolute value of the scheme deficit would have fallen.12
Interestingly, despite this dichotomy in outcomes, higher gilt yields and wider credit spreads meant the buyout deficit, the premium charged by an insurer to take on a scheme’s assets and liabilities, of both these illustrative schemes, now with smaller asset portfolios and diminished liabilities, would have fallen quite considerably from the start of the year – albeit by a greater amount for the 50% hedged scheme. Moreover, continued market stability throughout January, has meant that both schemes would have exhibited small improvements in funding levels and buyout deficits.13
So, despite cries that DB is dead, funded DB remains in comparatively rude health. Not only that, with well over 16 million pensions to pay – some potentially stretching into 22nd century – for now at least it remains the cornerstone of a great many retirement outcomes.14
Where is the DB landscape prospectively heading?
There is also likely to be a considerable amount of corporate DB risk transfer activity, comprising buy-ins, longevity swaps and buyouts – the latter further denting scheme numbers and assets.
Indeed, the Broadstone Sirius buyout index has continued to show that on average corporate DB schemes have sufficient assets to buyout their pension promises with insurance companies, with a collective surplus on a buyout basis of £165 million.16 Of course, at an individual scheme level the picture is much more diverse. Additionally, there are limits to the number and size of deals that can be accommodated. In fact, professional services firm PwC notes that, based on recent annual deal flow, it would take over 25 years to buyout the entirety of corporate DB.17
While all corporate DB schemes will eventually go to buyout,18 on a three-to-five-year timeline the chances are that it will principally be those well-funded (larger, if not the very biggest) schemes with well sorted member data, clear benefit specification and appropriate asset allocations who, in targeting settlement as their long-term objective (LTO), will progress to buyout. Assuming, of course, sufficient market capacity exists.19
Not that buyout is the default for all of corporate DB. There will be those schemes who, in targeting selfsufficiency as their LTO, will transition from return seeking to low/no covenant dependency, low risk, life company-type portfolios, perhaps adopting, collateral-lite, longevity hedging in the interim.22
Moreover, those not yet going to buyout for a while and those for whom buyout isn’t their LTO, may be well positioned (liquidity requirements notwithstanding) to keep hold of some or all of their illiquid assets, depending, of course, on what each contributes to the portfolio. Some may even add to their illiquids allocation. More on this shortly.
So, is this the beginning of the end for DB?
Despite its increasing maturity, with prospectively reducing numbers and assets, funded DB will continue to play a central role in underpinning a considerable number of pension outcomes for some time yet. However, as a complex exercise in multi-faceted risk management, with an ever-expanding list of quantifiable and less quantifiable risk factors to address,25 maintaining DB’s rude health will continue to necessitate not only exceptional risk management, but also bigger operational and investment governance budgets.
Moreover, this process will coincide with, and become complicated by, almost all corporate DB schemes becoming cash flow negative as sponsors switch off deficit repair contributions (DRCs) for those schemes with much improved funding ratios and pensioners become a rapidly increasing percentage of scheme memberships.31 This could also affect some funded public sector DB schemes as well.32 Consequently, cash generative strategies, with secure long-term implicit or explicit index-linked cash flows, and formalised cashflow driven investment (CDI) strategies, each with ever stronger ESG credentials, will become increasingly popular.
There will also continue to be ever more data cleansing and remediation exercises to contend with. This will be the case even once guaranteed minimum pension equalisation has been consigned to the history books and the pensions dashboard is up and running as schemes prepare for and variously conduct liability management, longevity hedging and bulk annuity exercises. And, of course, there will be plenty of new legislation and regulation to become familiar and compliant with, not least The Pensions Regulator’s (TRP) forthcoming new DB funding code of practice and single code of practice.
Plugging the governance gap
Additionally, with the increased policy focus on value of money, there is every possibility that something akin to the annual DC value for money/members (VFM) assessment and the recently announced VFM framework are applied to DB, likewise with a focus on enhancing levels of scheme governance.
Why does this matter?
As we approach the point of peak pension income, especially with potentially higher structural price inflation, and with DC very much in the ascendency and reliance on inadequate DC pots in retirement ever increasing, index-linked DB benefits will become ever more valuable. While considerably more prevalent in the public sector, DB benefits are still accruing within select pockets of the private sector, with deferred benefits significantly more widespread.
Of course, the DB pensions promise, or member security, is only as good as the sponsor covenant that underpins it and the integrated risk management applied to the covenant, funding and investment strategy and those myriad risks that impact each of these three pillars. Central to the efficacy of this risk management is employing an advanced level of operational and investment governance which, given the extraordinary demands on pension fiduciaries finite governance budgets, may see even more schemes delegating their day-to-day investment, risk and cashflow management to a FM or OCIO. Indeed, this potential trend is reinforced by the fact that most corporate DB schemes won’t be going to buyout yet, while others will continue to target self-sufficiency.
In short, all of this illustrates that if DB is to continue to form the foundation of a comfortable, rather than just a modest, retirement for many millions of people for some time yet, it must evolve and adapt and be effectively managed to meet the challenges of the ever-changing ecosystem in which it operates. In all likelihood, it will.
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