DB consolidation – newly emerging end-game solutions
28 Sep 2018 - Estimated reading time: 4 minutes
DB consolidation encompasses a wide range of potential solutions, including DB master trusts, mergers, buy-ins/outs, aligning service providers, and investment platforms. However, one area that has caught the eye recently is the emergence of new commercial consolidators like Clara Pensions and The Pension SuperFund, with the first transactions into these vehicles expected this year.
What are commercial consolidators and how do they work?
Transferring a DB scheme to a consolidator gives a clean break for employers at a lower cost than insurance buy-out. The consolidators run a DB scheme under the existing occupational pension scheme framework, so the management of the scheme runs just like your own DB scheme. However, the crucial difference is that the covenant of the employer is replaced by covenant support from a risk capital buffer, expected to be around 15% of the DB liabilities. The capital in the buffer is provided by external investors and a contribution from the employer.
What is the difference between Clara Pensions and The Pension SuperFund?
Both of these consolidators work as described above at a high level. However, at a more detailed level there are two fundamental differences in approach:
- Sectionalisation – each scheme transferring into Clara Pensions has its own section backed by its own capital buffers, whereas schemes transferring into the Pension SuperFund go into one large scheme backed by one large capital buffer.
- Long Term Objective – Clara transfers each section to the insurance market as the liabilities mature, meaning the Long Term Objective is unchanged from the existing target for many schemes. The Pension SuperFund runs off the assets and liabilities within the fund.
Clara Pensions can therefore be thought of as a packaging of an existing strategy to reach insurance buy-out. However, The Pension SuperFund is a self-sufficiency end game backed by a capital buffer.
What are the benefits of transferring to a consolidator?
Consolidator pricing is expected to be around 10% cheaper than insurance buy-out, so the key benefit for an employer is a clean break from their DB scheme at a lower cost than buy-out. This translates into a far more significant reduction in the required corporate cash injection to achieve this clean break. For example, if 70% funded on buy-out, the value of the required cash top-up falls by 33%.
One clear benefit for scheme trustees is that a transfer to one of these consolidators is typically dependent on a significant cash injection from the sponsor. It therefore leads to a significant improvement in the scheme’s funding level, enabling a lower risk investment strategy and more certainty that the assets will be sufficient to meet the liabilities once in these consolidators.
The key concern for the Trustees will be the loss of covenant support from the employer. The improved funding and additional capital buffer means that member security should not be adversely affected in many circumstances. However, it would likely be difficult for trustees that have very strong covenant support to agree to a transfer to a consolidator, perhaps unless a legal obligation back to the employer is retained.
When will consolidators be used?
We expect early transactions will be driven by corporate activity, where there is a driver for paying cash in return for a clean break from DB liabilities, for example M&A transactions. As the process becomes more established and regulatory guidance is published, transactions could become more widespread.
There are some more nuanced areas which could drive some activity. Two examples include:
- Pension Protection Fund (PPF) + transactions – in corporate distress situations where a scheme is better funded than PPF funded but not fully buy-out funded, consolidation could be a way to secure a higher level of PPF+ member benefits than would be possible to provide with insurance.
- Exiting non-sectionalised multi-employer schemes – employers participating in non-sectionalised schemes with ‘last man standing risk’ may see the value in transferring their share of assets and liabilities to a consolidator, as this secures full member benefits at a lower cost than the Section 75 debt otherwise needed to achieve a clean break from these schemes.
How are insurers responding?
Insurers are innovating in a range of ways. As has already been widely reported, insurer pricing in itself is now far more competitive than it was a year ago. However, another solution coming to market is ‘insured self-sufficiency.’ Conceptually this is very similar to the Clara Pensions solution, but without the clean break for the employer. Scheme assets, with any employer contribution required to reach the initial funding requirement, are passed to the insurer and invested to reach buy-out over time. An insurance wrapper is then also included, whereby the insurer covers a fall in funding level in all but the worst 1-in-200 year event. This insurance is funded from a basis points charge on the asset out-performance, triggered when the assets out-perform the liabilities.
I expect there will be an initial trickle of transactions driven by a particular corporate need in the first instance. However, as the market builds, as regulatory guidance is issued, and as scheme funding improves, it is likely to become increasingly common to adopt these solutions.
Our analysis shows that 17% of the FTSE350 could already transfer at least one of their schemes into a consolidator with less than 1 month’s earnings, so a significant minority of corporates could already use these solutions at an affordable cost.