A closed defined benefit pension scheme is a financial burden for most sponsor companies – but there are solutions
It’s hardly surprising there are only 11 defined benefit schemes still open among the FTSE 250 companies, given the doubling of pension deficits over the past decade. For most private sector companies in the UK, final salary schemes are now a tricky legacy issue that requires careful financial management.
While they were still open, DB schemes were viewed as a cornerstone of a company’s benefits package and were usually managed by human resources. But that’s no longer the case.
Adrian Hartshorn, senior partner at Mercer, says: “Now that the majority of schemes are closed to future accrual and there are no active members, they are viewed as a financial issue.”
Most finance directors and treasurers increasingly view the legacy liabilities as a form of debt, he adds.
This shapes the way DB legacy schemes are treated. Hartshorn says: “Finance directors apply the same principles to management of the DB legacy as they would to other forms of debt.”
They look at how the series of debt payments contained in a DB scheme should be financed. As part of that process, the finance department will try to ensure those debt payments can be made as efficiently as possible. They apply similar ideas used in other forms of debt management.
They are viewed as a financial issue”
“For example, they will consider if it should be re-structured or made more cash efficient,” says Hartshorn.
However, managing a legacy DB scheme is much less straightforward than other debt instruments. A closed DB scheme is the epitome of chief financial officer’s worst nightmare. Unlike a bond, which has a clearly defined cost to the company and a precise duration, the value of the DB scheme constantly fluctuates and has a long and not easily predicted shelf life.
The complexity of managing a DB legacy scheme is due to difficulties associated with managing the four key risks: interest rates, inflation, longevity and financial market risk. Alex Waite, partner at LCP, says: “As well as these four risks, companies and trustees also have to consider administration and regulatory risks.”
Faced with such complex risk management, most finance directors would rather transfer the legacy DB scheme to an insurance company, which is used to managing these risks.
However, there is a growing awareness this is an impossible dream for many schemes. Waite says: “The value of many pension schemes is close to the valuation of the sponsoring company and sometimes even larger, which makes a buyout unattainable in anything less than a decade.”
While a buyout might not be possible, closed DB schemes can still be outsourced – to a DB mastertrust. Typically, mastertrusts tend to be a feature of the defined contribution market: providing a service to smaller employers not equipped to set up their own scheme.
Trustees have to consider administration and regulatory risks”
But a number of pension providers are now either considering or rolling out the mastertrust to the DB market. The Pensions Trust already has such a scheme, while Deloitte and KPMG have just launched similar schemes and there are others coming to this market.
Just as the DC mastertrust solution allows smaller companies access to low-cost pension providers so, too, can a DB mastertrust offer a similar solution to smaller schemes.
Billy Wheeler, product and technical manager of The Pensions Trust, says: “Transferring a DB legacy scheme to a mastertrust can solve many of the headaches.” Under such an arrangement, trustees know their scheme will be well governed and managed, he adds.
The Pensions Trust has assets of £7bn in its DB mastertrust. Wheeler says: “Our scale allows schemes to access a wide range of funds, including LDI solutions, at very competitive prices.”
But not everyone is convinced about the benefits. One of the major concerns is that it is much more difficult to pool DB assets than it is to group DC assets.
Peter Askins, director at Independent Trustee Services, says: “There is a lot of disquiet in the industry about ‘last man standing’ schemes.” If the assets are not separated, if other businesses fail, then the remaining businesses will have to shoulder not only their liabilities but also those of the defunct enterprises.
Transferring a DB legacy scheme to a mastertrust can solve many of the headaches”
These problems can be avoided, however, if both the assets and liabilities of the schemes of individual companies are segregated. But many of these benefits can be achieved by allowing segregated schemes access to the same administrator. Askins says: “This still allows the companies to benefit from economies of scale but without having to establish a mastertrust.”
This issue about ‘last man standing’ risk underlines an important consideration about any solution a company considers for a legacy DB scheme – how does it ensure that it is still well governed?
Even when considering outsourcing options, a company still has to ensure it does not focus on efficiency at the expense of effective governance.
When DB schemes were still open and providing retirement benefits to the majority of staff this was less of a concern. Lay trustees, who had a vested interest in ensuring the scheme was well run, could be appointed from the workforce.
But today that’s no longer the case. Askins says: “For many schemes, and especially for smaller schemes, the majority of the liabilities relate to deferred members who no longer work for the company.”
Ian Pittaway, senior partner at Sackers, adds: “Often very few of the current senior employees have any benefits in the DB scheme, which can make employers reluctant to nominate them to be a trustee.” Increasingly the employer-appointed trustees can be a combination of retired senior executives or professionals.
There has to be healthy and continuing dialogue between the employer and trustees”
This can make it more challenging to ensure the scheme is well governed. Pittaway says: “There has to be healthy and continuing dialogue between the employer and trustees.” If these two groups become too detached, it becomes much harder to find solutions, he adds.
From a company’s perspective, the advantage of using a sole professional trustee is that it’s no longer necessary to appoint anyone else – one company can perform all the trustee duties.
But sole trustees can also create problems. Pittaway says: “There are not the usual checks and balances found on a normal trustee board where trustees can question and challenge one another.”
In addition, this can create potential conflicts of interest. Pittaway says: “The professional trustee is being paid by the organisation with which they will be negotiating with over funding, so this needs to be approached with care.”
But a good professional trustee will remain independent and can provide some vital backbone to a trustee board. Richard Butcher, managing director at PTL (which has a large number of sole trusteeships), says: “Sometimes the finance director can view the trustees as a soft touch who can be pushed around.” A good independent trustee will prevent this from happening, he adds.
Butcher says: “The best way to avoid all potential problems is for the trustees to be very frank about their inherent conflicts of interest and make sure these are taken into consideration before making a decision.”