With many UK defined benefit (DB) pension schemes now on track or ahead of their funding targets, the Institute and Faculty of Actuaries (IFoA) said capital backed funding arrangements (CBFA) can offer “distinct benefits” when compared with superfunds, master trusts and conventional insurance risk transfer policies.
According to the latest Annual Funding Statement from the Pensions Regulator (TPR), a quarter of all UK DB schemes may now have sufficient assets to buy out their liabilities with insurance companies.
However, according to IFoA, despite strong funding, schemes may find that insurance buyout is not feasible or desirable in the near term due to schemes for multiple reasons including not being ready to buy out liabilities in full with an insurer, or concerns around corporate accounting implications or the potential loss of future surplus that might support discretionary increases, fund a defined contribution (DC) section or be refunded to the company.
In its report looking into benefits of CBFA, the Institute said that in contrast to a DB master trust, superfund or pension buyout where there is a “step-change in a governance arrangement” the CBFAs are primarily an investment decision, time-limited and within the remit of the existing trustee board.
It added that CBFAs can improve member outcomes in a number of ways, including reducing downside investment risk by underwriting the risk of poor investment returns, pay benefit cashflows with added security while retaining some investment upside and flexibility and supplement the sponsoring employer’s covenant, to provide assurance where sponsor covenant has more limited visibility or greater uncertainty.
While a CBFA is principally an investment decision that sits with the trustees, IFoA highlighted that for the sponsoring company, the arrangement has the potential to change its relationship with a scheme.
It said that the company will want to work closely with the trustee to consider scheme objectives and circumstances; features, benefits and risks, including whether they are better than available alternatives; legal and regulatory considerations, including whether trustees have the skill and power to transact and what signoffs are required; and company considerations including borrowing capacity potential surplus and accounting impact.
Lead author of the IFoA report, Derek Steeden, said: “CBFA can offer tangible benefits for defined benefit pension schemes to secure member benefits in full: downside investment protection, covenant improvement, access to investment expertise, governance arrangements and potentially assistance to prepare for an insurance buyout or a low dependency strategy.”
He added that arrangements “offer distinct benefits when compared with DIY approaches, superfunds, DB master trusts and conventional insurance risk transfer policies”.
He continued: “However, there are new risks to consider and this remains a relatively new area with limited standardisation or information in the public domain.”
Steeden pointed out that it is “important” to understand how an arrangement works both in the normal course of events, in periods of stress and if the arrangement is terminated.
He concluded: “In this paper we set out a framework to enable an effective initial comparison, assessment and discussion of these arrangements, and to give sufficient introduction to enable the reader to identify appropriate next steps.”
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