For some time it has felt like the shift towards consolidation of Defined Benefit (DB) pension schemes has been a question of “when”, not “if”.

Whilst this might not be the answer for all schemes, the case for consolidation among many is increasingly compelling. Last year saw a flurry of developments that point to us reaching a tipping point.

In this article we take a look back at developments in 2021, recap on the DB consolidation options available in the marketplace and ask how DB consolidation could evolve this year.

Market backdrop

It's easy to see why insurance buyout is the dream for DB schemes. It represents the ultimate discharge of risk for both trustees and sponsors, enabling a scheme to be wound up completely and for the sponsor to focus on managing its business rather than its pension scheme. However, this prize comes with a high price, and for all but the most well-funded schemes it either takes a lot of time or a lot of money to reach this target.

For some schemes, even if their funding position is strong enough to make insurance buyout a realistic goal in the short term, the demand for insurance at the larger end of the market means there's a danger of smaller schemes being crowded out.

From a sponsor’s perspective, as businesses emerge from the Covid-19 pandemic and are faced with shifting consumer trends (some in their favour, others not), it will be essential for them to assess their cost base and how their pension obligations fit into that, especially given that for many employers their DB pension scheme is now a legacy funding matter rather than a live workforce matter.

From a trustee’s perspective, the shift towards professional independent trustees continues to gain momentum as it becomes harder for trustee boards to find willing member-nominated trustees and the burden on employer-nominated trustees grows.

Add in a number of new regulatory requirements focused on raising the governance bar to improve member outcomes, plus a potential new code of practice in relation to how DB pension schemes are funded, and it's easy to see why now more than ever small schemes may be contemplating alternative means of reducing risk and achieving cost efficiencies outside of the traditional insurance market.

What happened in 2021?

Whilst it's fair to say that the DB consolidation market has not taken off in earnest yet, there were some key developments in 2021 that could be seen as sowing the seeds for a growth in DB consolidation in the near future.

The Pensions Schemes Act 2021 came into law in February last year. Although this did not cover DB consolidation directly, it introduced a number of items that are likely to focus the mind of trustees and sponsors on the end-game for their scheme. For example, the introduction of a long-term funding target, a formal Chair’s statement of strategy, and a consultation on a new code of practice for funding DB schemes all point towards an upping of the bar when it comes to setting a plan for the scheme’s end-game and delivering against that plan. Ultimately this should be applauded, as the developments are all aimed at improving outcomes for schemes and their members. But this could create challenges for trustees and sponsors along the way.

In October 2021, the Pension and Lifetime Savings Association (PLSA) launched a new self-certification regime for DB master trusts. This regime was designed to enable DB master trusts to provide trustees and employers with more information, clarity and comfort on how they operate. The fact that several DB master trusts have already completed their self-certification against this standard shows that the supply is there. It's just a case of the demand catching up to meet it.

In November 2021, Clara Pensions became the first vehicle to pass the Pension Regulator’s assessment process for DB superfund consolidators. This marked a major step forward for a new form of commercial consolidator, which uses third-party capital to help sponsors achieve a quasi-insurance solution with a lower up-front cost.

What DB consolidation options are available in the marketplace?

DB consolidation is a broad term. In its widest sense it's based around the principle of pooling pension scheme operations together to benefit from economies of scale. In the chart below we provide a brief overview of the main DB consolidation options in the marketplace. 

What are the key considerations in deciding whether DB consolidation is right for you?

There are lots of criteria that can be used to consider whether DB consolidation is right for a particular scheme and, if so, which particular options might be best suited to that scheme. But in reality, there's no perfect solution. Those consolidators which measure well against one criterion may not measure so well against others. Therefore it's vital for trustees and sponsors to work together and be clear in setting criteria most important for them. That way the DB consolidation options can be assessed against those criteria.

The key considerations in assessing each DB consolidation option are likely to come from the following:

Upfront cost and cost of transition: this can be an obvious barrier for some forms of consolidation, so the benefits of making a move to a DB consolidation vehicle need to be worth the costs. The key points to understand are: are there any transition costs associated with transfers of investments or service? Is there an immediate funding requirement? What professional advice is needed to facilitate any transition?

Ongoing cost: as a general rule one can expect a move to a DB consolidation vehicle to achieve continuing cost savings, whether through reduced investment management costs, reduced administration costs or removing the obligation for ongoing costs entirely. Understanding the specifics of these cost savings is important so they can be compared to any upfront costs – for example using a “payback period” analysis.

Risk management: as a general rule, the further down the consolidation spectrum one goes, the better the levels of risk management. For example, insurance buyout is the ultimate form of risk management as all pension obligations are transferred to the insurer. Other forms of consolidation can still achieve significant reductions in risk (often retaining the link to an existing employer covenant), but it's important for trustees and sponsors to understand the specifics of each option so that any residual risks are understood and mitigated against, where possible. Investment, funding and covenant risks will be key.

Governance structure and control: an important differentiator between some of the consolidation vehicles is the governance model they use, and hence the balance of power between various stakeholders. Some stakeholders may be concerned about loss of control, whereas others will see the passing of a governance burden as positive. It all depends on the circumstances, so understanding the dynamics of each consolidation option is essential.

Where might DB consolidation go in the next 12 months?

It seems that the case for DB consolidation is growing. If we look at it from a “supply and demand” point of view, it feels as though a lot of pieces are falling into place. The question is: will 2022 be the year that DB consolidation truly takes off?

On the supply side, there has never been a more widespread group of viable DB consolidation options in the marketplace. The October 2021 PLSA self-certification regime for DB master trusts, and the November 2021 regulatory approval of Clara, feel like landmark moments in terms of providing trustees and sponsors with greater information and comfort about relatively new consolidation options that provide genuinely viable alternatives to the traditional insurance buyout model.

On the demand side, there's still a gap to bridge. Doubtless there are many sponsors and trustees who are having feasibility discussions with DB master trusts and superfunds. But as yet there are only a small number of DB consolidation vehicles that can say they have achieved scale. That said, given the market backdrop described above, it's easy to see why sponsors and trustees may be assessing their DB consolidation options now more than ever and filling the pipeline of DB consolidators.

Final thought

The UK pensions industry is often accused of moving at a glacial pace. That's true in some areas, but we have seen momentum gather quickly in others once inertia is overcome. The pace with which a focus on environmental, social and governance (ESG) factors and DB consolidation gathered momentum after a slow start are recent examples. There are good arguments, too, that some developments in 2021 could give the DB consolidation market the momentum it needs to take off. As to whether 2022 is the year, only time will tell.