However, just because a transaction is possible, it doesn't mean it is necessarily the right move today. Buyout is an irreversible decision and meticulous deliberation is required before proceeding.
Future legislative changes could potentially relax rules around surplus extraction
Future legislative changes could potentially relax rules around surplus extraction from schemes, providing opportunities for those that opt to continue running on. Buyout remains the optimal choice for many schemes because it removes reliance on the sponsor and enhances the security of member benefits.
Why might you want to defer buyout?
There are a number of reasons to consider deferring buyout:
- Increasing member benefits: Continuing to run your DB scheme may allow for the generation of significant surplus. This surplus can be used to uplift members' benefits and potentially provide a return of money to the sponsoring employer. High inflation in recent years has eroded DB members' benefits in real terms due to caps on pension increases. Running the scheme on could help counteract this erosion, increasing benefits to offset the real terms decline experienced over the past few years.
- Value for employers: DB schemes could become a source of value for employers. Over several decades, sponsors have contributed substantial sums to these schemes, intended as a prudent reserve for member benefits. There may now be an opportunity for sponsors to recoup some of that money, potentially providing significant additional revenue to support company growth and stability.
- Alleviating capacity bottleneck: In the current environment, there is immense demand from schemes for insurance. Deferring buyout can help mitigate the current capacity bottleneck, allowing for a smoother, more manageable transition to buyout for all parties involved.
What type of scheme may consider deferring buyout?
Deferring buyout is not suitable for every scheme. The following characteristics may indicate a scheme could benefit from deferral:
- Strong corporate sponsor: The sponsoring employer should be financially robust, with a low risk of insolvency. This financial strength is crucial to ensure the continued viability of the scheme.
- Low ongoing running costs and good governance: Schemes with low ongoing costs and strong governance are better positioned to manage the complexities of deferring buyout. Typically, these will be larger schemes, although smaller schemes might explore efficiency improvements and cost reductions through solutions like DB master trusts.
- Immature schemes: Schemes with a high proportion of deferred members could see significant benefits from deferring buyout. Deferred members represent long-dated (more uncertain) liabilities, making them more expensive to insure. Deferring buyout could allow these schemes to mature naturally, resulting in a higher pensioner proportion at the point of transaction.
Size of the prize – case study
Consider a hypothetical £1 billion scheme. Using stochastic modelling, we estimate that by deferring buyout for five years, the scheme could generate approximately £88 million in surplus on a buyout basis. This surplus could be divided between members and the sponsor, providing members with a one-off bonus equivalent to 20% of their annual pension, and delivering a £60 million return of surplus (after tax) to the sponsor.
This case study illustrates the potential financial benefits of deferring buyout, highlighting the significant value that can be created for both members and sponsors. We have a full case study document available upon request and are happy to use our modelling capabilities to carry out similar analysis for any UK DB scheme considering their options.
How to manage risk
Managing the risks associated with deferring buyout (running-on) is crucial. The investment strategy should be low risk, with an approach aligned with how insurers invest. This alignment can help reduce the volatility of the scheme's funding level on a buyout basis.
Hedging buyout pricing and determining the appropriate type of credit to hold are complex topics that we’ll address in detail in future articles. However, the fundamental principle is to adopt an investment strategy that minimizes risk while aiming to achieve the desired surplus generation.
Conclusion
In the short term, many schemes will proceed with buyout, enhancing the security of millions of DB members. However, for some schemes, there may be substantial benefits to deferring buyout and generating surplus in the interim, to maximize value for both members and companies. While careful consideration of the associated risks is paramount, the potential rewards of deferring buyout may outweigh these risks. Each scheme must evaluate its unique circumstances to determine the best course of action, balancing immediate security against the prospect of future gains.
Important notes
Case study figures are for illustration only based on abrdn house views on expected future investment returns and investment risk. They are based on 5-year stochastic projections from 31 March 2024, with an investment strategy with expected return of gilts + 1.5% p.a.
Surplus is calculated on a proxy buyout basis, with the assumption that 8% of the surplus is paid to members as a one-off bonus and the remainder is extracted from the scheme and returned to the sponsor. For simplicity, the member benefit is expressed as a one-off bonus payment as a percentage of current pension. This is for illustration only and the implementation of any member uplift will require detailed consideration.
The return of surplus to the sponsor is assumed to be taxable at the authorised payment rate of 25%, which is aligned with the reduction in the tax rate from 35% to 25% from 6 April 2024.
Next steps
If you would like to find out more, or request our full case study document, please contact us at ukinstitutionalall@abrdn.com.
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