The Budget focused on defined contribution savers but defined benefit managers should be wary of unintended consequences, warns Sam Brodbeck
“Beware the ides of March,” a soothsayer warns Julius Caesar in William Shakespeare’s tragedy. But for defined benefit pension scheme managers, it should perhaps be Chancellor George Osborne’s ideas of March they should be worried about.
The Budget’s focus was pensions and savings and the future is undoubtedly defined contribution. However, as is always the case with grand reforms, there will be unintended consequences.
And as if there wasn’t enough big news, in the same month as the Budget came the completion of two huge de-risking exercises. The £3.6bn buy-in of the ICI pension scheme and a £5bn longevity swap covering 19,000 members of the Aviva Staff pension scheme reset the limits of what is possible.
So the question is: will the Budget’s proposals put a dampener on de-risking activity, or will the momentum of the past few months continue to push pension schemes over the line?
The chancellor was not thinking about DB schemes when he gave pension savers new freedoms in the Budget.
There are growing fears Osborne’s reforms could cause headaches for DB schemes
Most of the industry was agreed something had to be done to address DC members’ increasingly inadequate incomes, but there are growing fears Osborne’s reforms could cause headaches for those responsible for DB schemes.
The source of pension managers’ headaches is the gleam the Budget has added to DC. While DB have been the gold standard of pension provision, the public has suddenly been made aware of the flexibility of DC pots. Given this, it seems likely more DB members will explore converting their benefits into a DC pot and seize the chance for more control over their savings.
Charles Marandu, director of European institutional advice at SEI, says the Budget has “potentially huge consequences for DB”. He notes that sponsoring employers might also explore an opportunity to swap some expensive and risky DB liabilities for a lump sum.
Members of DB schemes have the right to a Cash Equivalent Transfer Value (CETV), where their entitlements are turned into a fixed amount that will not increase over time and is not tied to length of service. Sponsors who convince members to take a transfer are likely to make a saving compared to retaining DB liabilities, “certainly compared to the cost of insuring members”, says Marandu.
Likewise, if there were a run on DB, Marandu and Aon Hewitt’s head of liability management Ben Roe predict that the funding position of schemes would probably improve.
Unburdened sponsors and healthier schemes – so what’s the downside?
If members do leave DB schemes in significant numbers, managers would face several challenges, says Helen Forrest, the National Association of Pension Funds’ head of policy and advocacy.
The most immediate impact would be cash flow
“The most immediate impact would be cash flow,” she says, explaining that schemes don’t necessarily have enough liquid investments to meet a sudden demand for cash.
Anita Higgins, head of prime and core UK institutional businesses at BlackRock, notes that schemes with liability-driven investment (LDI) strategies in place would need a rethink. “Schemes would need to review the profile of DB liabilities much more often,” she says, “and putting hedging in place would have to be more nimble… increased governance and a greater requirement for liability review and activity would all increase costs.”
About half of UK schemes have an LDI strategy in place, according to a recent poll conducted by SEI.
While these issues are primarily the concern of DB professionals and trustees, there is also a potential macro-economic fallout. A consultation, which closes on June 11, reveals the government is “concerned that a large-scale transfer (or anticipated transfer) of members of private sector DB schemes to DC schemes could have a detrimental impact on the wider economy”.
BlackRock’s Higgins agrees mass transfers could deter schemes from holding illiquid assets and it would be “detrimental to investments like infrastructure”.
The government has been keen to secure pension fund money for infrastructure and so is unlikely to do anything to scupper those plans. Even closer to home, the government could finds its own rate of borrowing increases if schemes no longer need to hold significant quantities of gilts and the expected decline in insurer demands comes true.
It would be difficult for the government to legislate against it
Despite these risks, a recent Aon Hewitt survey of more than 200 pension managers, trustees and finance directors found just 10% thought transfers should be banned, with 70% calling for transfers to remain a right as long as some restrictions were introduced. Those would be based on the existing code of good practice for enhanced transfer values (ETV) exercises.
SEI’s Marandu thinks it will be difficult to block transfers. “If members and sponsors want to transfer, and there is a precedent, then it would be difficult for the government to legislate against it,” he says.
Others highlight the inconsistency if DC members are given freedoms at retirement but DB members are not.
Aon’s Roe says he is seeing interest in member transfer but he doesn’t “expect much activity, because the schemes would have to act very quickly”.
There is too much to lose – imagine if the government back-dated a ban?
Ian Gutteridge, a director at Premier Benefit Solutions, says for any schemes going through ETV exercises it is a “nightmare scenario”.
He adds: “I’d advise extreme caution. There is too much to lose – imagine if the government back-dated a ban?”
Helen Ball, a partner at law firm Sackers, says some of her employer clients are wondering about how best to communicate the transfer situation. “They can’t win,” she says. On the one hand explaining the options might inadvertently spark members’ interest in a transfer, but if they do not, “members could complain that they weren’t told about the option”.
The impact of bulk annuities
And what about the bulk annuity and longevity swap markets? Those two giant deals (see Aviva case study) seem to suggest the market won’t be held back by the Budget. Dominic Grimley, risk settlement advisers at Aon Hewitt, finds it “hard to believe it’s not going to be a record year”.
He says the traditional multi-line insurers used to have a set budget for the year, but the ICI deal proves that the brake on activity has been eased. Likewise, some firms – such as PwC – are predicting a more competitive market as insurance firms move resources previously earmarked for their individual annuities.
Completion rates are at about 35% up from just 13% five years ago
Aviva, for instance, are said to be targeting £200m deals again after publicly exiting £50m-plus deals in 2012.
Tom Ground is head of bulk annuities and longevity insurance at L&G, the major insurer in the £3.6bn ICI buy-in. He says the market is quickly growing in expertise, with completion rates at about 35% up from just 13% five years ago. He adds that insurers are confident enough not to let “the short-term impact on their profit margins affect long-term business”.
So while schemes may lose one release valve in ETVs, the insurer-driven de-risking market is not slowing down.
You have until June to make your opinions on transfers known to the government. Webb and co have a difficult decision to make.