What does the future hold for DB schemes?

The event, held in association with Russell Investments and chaired by PP editor Jonathan Stapleton, looked at the changing environment for DB schemes – assessing how scheme governance is likely to evolve and looking at the impact the new DB funding framework will have.

It also looked at DB consolidation – assessing the options currently on offer and asking whether run-on and run-off will become mainstream options for trustees going forward.

It additionally discussed the Mansion House Reforms and private market investment, considering how DB scheme usage of private market and illiquid investments is likely to change.

Given the changes we have had to the funding and regulatory backdrop over the past 18 months or so, how has your approach to DB schemes evolved?

Duncan Willsher: A lot of what is coming down the road is just more of the same. There has been a push for improved governance for some time and there is always an enhancement to what people can do, but well-governed schemes won't have to make major changes to their current processes.

For smaller schemes, many of whom may well have been doing a good job in practise, there is a lot more paperwork coming down the line.

Colin Richardson: This trend towards thinking about different consolidation options or endgames has been going on for some time but has been accelerated by improvements in funding levels.

There are other trends of increasing governance from the General Code, increasing pushes on diversity, diverse teams and diverse trustee boards, and a general need for all schemes to have more detail about their journey plan and where they are going. These are not new things.

David Morton: Trustees are, in my experience, steadfast in reducing risk, and the priority is securing members' benefits. There is still this move towards securing members' benefits through de-risking, liability-driven investment and other strategies.

Judith Codling: We have had some schemes that have, with their funding improvements, shifted from looking at run-on to focusing on insurance. A recent industry survey found there was a 10% increase in insurance investment in 2023 compared to 2022. We have had quite a few partial or full buy-ins over the last 12 months.

From the governance side, the big issue is data and looking at that data holistically. 

Graham Jung: There is a lot more public interest and regulatory and government interest now compared to a few years ago, with far more regulators and regulatory bodies involved with their own agendas. I am not sure that is overly helpful to us as an industry because it isn't necessarily solving a clear problem.

I do not think more regulation is on the way, just more discussion, more consultations and more interest.

Simon Partridge: The landscape has changed as funding positions overall are better, with more options available to DB schemes, whether that is a run-on and run-off, whether that is a refundable surplus. What we are finding when we talk with our clients is that they are grappling with all these things as well as regulation, the impact of increased reporting, more visibility and regulatory requirements.

Are you finding increasing numbers of spotlights targeted at smaller schemes?

Nick Atkin: There is clearly a focus from the regulator both in its statements and actions to target smaller schemes to drive them towards its preferred model of large consolidated schemes. We saw this in the proposals to apply a small scheme premium to the administration levy. While some effort has been made to consider proportionality in the new funding regime and single code, until we see how the regulator intends to police the arrangements it is difficult to know what this means. A heavy-handed approach to smaller schemes could quickly lead to disproportionate costs.

We do challenge the premise that smaller schemes produce worse outcomes for members. We believe they can be run differently to larger schemes and judging them on the same metrics is not necessarily helpful. We believe that if The Pensions Regulator wants to effect change, it should be by encouraging what they consider good behaviours and allowing schemes to decide what options best suit their circumstances. Based on their proposals and statements, they appear to believe there to be one correct way of running smaller schemes and aim to encourage schemes to adopt that approach. I think, in doing so, there is a danger that a lot of what is good about the current system with its diversity of different approaches, advisors and schemes might be lost. 

To what extent do you think that DB schemes are reassessing their options in the wake of the past 18 months on the endgame front? Do you think run-on will become mainstream going forward?

Stuart Travers: For the last 18 months, the words ‘endgame strategy' have featured on most trustee board agendas. Most, if not all, are looking at a longer-term strategy, if not explicitly endgame planning, it's a moving target – there are many moving parts that are considered in any endgame, and trustees and sponsors owe it to themselves and their members to ensure the right strategy is applied after ensuring all options are considered.

This is not just something for the big schemes, but for all schemes!

The question should be, are endgame and its associated options not already options that trustees are discussing and considering today? They are now very commonly spoken terms and ideas. We do recognise that those not in the pensions industry may not be fully aware of all the options – this goes back to the point around engagement of all the strategic partners.

Colin Richardson: It will become mainstream to consider the other options, and there will be a certain proportion of schemes deciding that run-on is feasible and desirable, and can be agreed between the sponsor and trustees. However, it will never be the majority of schemes because it is size and circumstance specific.

You must have a sufficient body of assets to generate sufficient additional investment return over insurance pricing to generate a meaningful future surplus with an acceptable small level of risk, because the chance that you might not be able to buy full benefits later would be very difficult for the trustees.

Duncan Willsher: I see greater take-up of the options and certainly greater consideration. It was mentioned earlier about there being no momentum in these new approaches. The people around this table are responsible for driving that momentum, because if we cannot, what lay trustees are going to? If professionals cannot engage with these solutions, products, approaches and everything else, then how do we expect anyone else to?

Graham Jung: The message that we need to buy out now because stocks will not last was going around two or three years or so ago, but I have not been hearing it recently. It has predominantly been the other way around, with people considering their options because the major risks are well understood and well hedged, so there is less pressure. 

The message to the wider industry outside the trustee table is, ‘be patient'. Many questions are being asked and worked through, but they are not seeing much in the way of outcome yet. However, I am not hearing any worries about the risk of a backwards step.

Are there quite as many options out there for those smaller schemes that you are working with? 

Nick Atkin: For many of our clients and their sponsors, a long history of deficit contributions and expensive project work, such as GMP equalisation, for a scheme which bears no relevance to the ongoing business means that there is a clear preference to buy out as soon as possible. I suspect the new funding regime, with its increased focus on a more detailed demonstration of covenant strength, will be an additional disincentive to continue schemes. 

On the other hand, there are only a small number of buyout providers that are prepared to quote for smaller schemes, and pricing is looking expensive. While this might change as markets react to demand and, potentially, the public consolidator fund offers an alternative option, many schemes may end up in an extended run-off period anyway.

If smaller schemes are to be encouraged to consider taking some more investment risk over this run-off period, as envisaged by the Mansion House reforms, I suspect that reducing the tax on refunded surplus to 25% will not be sufficient. The costs and downside risk are likely to make it unworkable and additional incentives might be required. For instance, the tax could be removed completely on the first £100,000 of refunded surplus paid each year.

Judith Codling: We are starting to see trustees putting the discussion of surplus on the agenda, because they recognise that is a conversation they need to have without the employer in the room, and the employer separately has their discussion. 

The issues that they have around buyout is whether they have sufficient liquid assets and how they are going to be able to get rid of any illiquid assets, which have a long run-off. Trustees are having discussions around getting the specialist firms that deal with disposing of those types of illiquid assets on the secondary market. 

There is a heightened awareness of surpluses among sponsors, to the extent where I have one of the employers talking about whether they can set up some sort of escrow arrangement so that they can take money out of the plan, because it is already in surplus.

Stuart Travers: It is interesting that even in the small scheme space, which still represents the vast majority of the remaining DB schemes, those schemes with overseas parents, notably in our experience from the US and Europe, have seen a resurgence in discussions around endgame and use of surplus following the latest budget from the Chancellor, where it was announced that there would be a reduction in the surplus tax paid on a refund to a sponsor. 

While this is not the only driver, for small schemes, as already highlighted, options are more limited where the decision is to buy in and wind up the trust, but we are seeing some small schemes re-open their DB schemes for key appointments and strategise a DC proposal for the future.

David Morton: There has not necessarily been a change in long-term objective, but action that we have seen has included all my trustee boards recognising the benefit of higher gilt yields. There has been a massive increase in hedging, right up to the value of the liabilities, which is a positive. There has also been a focus on minimising the deficit volatility, or perhaps stability of surplus, at least from a gilt yield perspective. 

The framework of the investment strategy for a client running on surplus is essentially the same as it always was. The level of freedom you have in terms of taking risks is totally dependent on the strength of the covenant. If the strength of covenant is not absolute, there is only limited freedom in terms of seeking to grow that surplus.

It is also important to consider risks outside of financial risk. When you keep shrinking the risk of a pension scheme's investment strategy versus the liabilities, your longevity risk makes up a bigger share of a smaller pie. Tricky for smaller scheme to hedge longevity in a way other than buy in of course.

Colin Richardson: The strategy will also depend on your time horizon and how long-term your run-off decision is. If it is more marginal based on size, the scheme will gradually reduce in numbers over time.

If a surplus is shared 50/50 between the scheme and the employer, there will be a tax on the employer share. In the draft consultation there are quite a few constraints on the surplus extraction. 

A good portfolio can be created if you have sufficiency of assets that give a good equation between some return and good security in these positions.

Do you think there is there any appetite on the DB side for the broader point of view pushed by the Mansion House reforms?

Stuart Travers: With smaller schemes, when you are looking at endgame strategy, it comes back to whether re-risking makes good investment sense for your scheme and its journey. It comes back to the point where people understand the rationale as to why the Mansion House reforms could become part of a diverse portfolio, but the question remains whether it is appropriate. The application of Mansion House seems very much aimed at those schemes that have a longer life strategy.

At the moment, Mansion House is a subject where both trustees and sponsors are still understanding what it would mean for their scheme but until they are mandated to do so, it remains a watching brief.

Graham Jung: In terms of re-risking, some schemes will re-risk once they understand the requirements and pause on the derisking path. Equity risk will have a part to play in that. Schemes outside of LGPS [Local Government Pension Scheme] and USS [Universities Superannuation Scheme] will not be moving back to illiquid assets quickly, as the Mansion House reforms are pushing for. With a whole world to choose from, what is the attraction of the UK as an investment destination?

Colin Richardson: Our duty is to the members, not to the UK economy. Our members have their lives, employment and other things dependent on the UK economy, so there is a diversification argument to invest away from the UK because most of our members' lives are UK-based already. We are investing on a global basis for the best global opportunities, and let's be clear: the UK is not an engine of global growth. 

Nick Atkin: I suspect that there has always been an appetite to invest in UK markets partly based on these markets being more familiar, with a wider range of investment options and lower charges. Therefore, if the return argument can be made for the UK, this could be pushing against an open door. However, I believe this could be made more attractive if investments were able to offer other, less tangible, benefits. For instance, local development funds which, alongside targeting returns, are able to support local businesses or to finance infrastructure projects and other capital investments. These could be expected to improve, indirectly, the strength of the sponsor and be popular with the membership.

David Morton: From a fiduciary management perspective, we have spent our entire career trying to avoid unconscious or conscious bias and have a purely risk-adjusted return perspective for building portfolios. Mansion House may turn out to just be the first phase. At some stage, the government must provide a way to incentivise, from a risk-adjusted returns perspective, UK productive assets if they want to change behaviour in the industry. 

Simon Partridge: When we come to private market discussions, we are seeing more focus on liquidity rather than a venture capital type strategy or locking up your assets for 15 years and seeing what happens at the end of it. Liquid private markets is somewhat of an oxymoron, but there are ways of investing in more evergreen, open-ended funds that do allow a certain amount of flexibility after the investment period.

How do you think the new DB funding code may change DB investment strategy more than it already has?

Colin Richardson: Many years ago, when the funding code was first conceived, most schemes were a long way from self-sufficiency funding. Now that it's about to be enacted, most schemes are on average closer to, or already at self-sufficiency. Part of what the funding code is trying to address has, therefore, happened already by circumstance for many schemes, and so its impact will therefore be much less than if it had come in five years ago. 

How do you see governance evolving going forward? Are we going to see more of the same in terms of looking for that additional independent sole trustee fiduciary resource?

Duncan Willsher: It is often represented that traditional boards and sole trustees are almost competing, which they are not. Sole trusteeship is just another tool in the toolbox. The theme is this increasing governance requirement. It is sometimes called a burden, but that is not what it is, because many of the requirements are just good, sensible, things to do.

Portfolio risk coming down will make longevity risk larger proportionately, but it also increases operational risk and cyber risk proportionately. When people look at it through that risk lens, they may start to think that these topics fall outside their knowledge and it does not make sense for this lay trustee board to be doing everything.

Can I ask for your final thoughts following our discussion?

Graham Jung: We have touched on this point already, but there much discussion going on around a lot of trustee and sponsor tables. The wider industry probably thinks not much is happening, but it is. It will come and it is a big inflection point. There are decisions to be made that will be taken and revisited. To the wider industry I would say, be patient. Trustees of all forms are on this. It is a very active discussion, but there is no pressure to make a decision that has not been carefully thought out.

Judith Codling: From my perspective as a scheme secretary, I guess it is slightly different. It is more about the governance, the new general code coming in, and documenting that to show evidence to the regulator, if they ever came knocking, that you are doing everything that you need to. My big thing for trustees is to think about data holistically. Do not look at each project as a discrete project, make sure you look at it holistically because that will be more efficient and cost effective.

Duncan Willsher: We have spoken about lots of different things that are available to us. The challenge that we should all give ourselves is to make sure we are fully embracing them. Rather than just sitting around a trustee table and talking about them, actually make that decision. Follow the path – if that is the right thing to do for that scheme, then just do it. Do not wait for everybody else. Embrace it. I think that is what I want people to do.

Simon Partridge: There are lots of options. There is also a lot more regulation and work with the government's requirements. I always go back to focusing on getting the governance structure right. Delegate to specialists as appropriate – it is delegating responsibility, but not accountability, for various aspects. The trustee role is still to be accountable. It is still their neck on the block, but can they delegate parts of running a pension scheme to make life easier?

Colin Richardson: The managing out of private sector DB schemes will be a long-term winding down. There is a lot to do and a lot of interesting things to do, and all the options that we discussed should be looked at.

On another note, however, as we are now in long-term wind-down, DB schemes have probably bought all the UK government bonds they are going to buy. There are now a lot of headwinds against the gilt market, especially given the issuance of new gilts the government needs to make. As such, gilt yields could rise relative to inflation, which could put a few interesting scenarios into play.

David Morton: I guess the main theme of our discussion has been about the plethora of options that you have. Do not close any doors to the options by making a snap decision and going down a particular route. At the same, do not lose access to the options open to you – try to reduce risk and lock-in the current advantageous position as much as possible. Finally, do not be blinded by lots of different options, because sometimes that is scary and it can lead you to inaction. Keep focused and make a considered decision on whatever option makes sense for you.

Stuart Travers: DB pensions are some way away from disappearing – today's question remains to run or not to run on!

There are now more opportunities for schemes of all sizes and all funding positions, from consolidation, superfund or looking into capital-backed journeys as well as buy-in.

The new regulatory frameworks from the general code, and indeed from the new funding code, provide for more rigorous and defined pathways for schemes to assist with funding while providing even greater protection for members.

Nick Atkin: The future does seem very exciting, with a lot of change happening. However, I think there is a lot to like about what we have now and that there is danger of losing much of what is good in the rush to accommodate change. It is now time to step back and allow schemes, and the industry, to respond to the changes and evolve new approaches that reflect the diverse range of schemes and sponsors. The Pensions Regulator needs to give space for this to happen and be flexible to accommodate different approaches, supporting schemes to adapt and not be too heavy-handed during the initial bedding down period. They need to be wary of becoming agents of change pushing for a preferred outcome rather than allowing schemes to make their own rational choices based on their own circumstances.

The current ecosystem, with a wide range of different approaches, schemes sponsors and advisors, has evolved over many years and proved itself to excel at practical innovation. It now needs time to digest and percolate change. 

This roundtable was held on 16 April 2024 in association with Russell Investments