taking control of your pension scheme’s future · taking control of your pension scheme’s...
TRANSCRIPT
Part 1 | SponsorWe look at what you need to know about your sponsor’s business, financial health, prospects, and the strength of support available to the scheme.
Part 3 | AssetsWe explore how you determine the right Long Term Funding Target and the right level of risk to get there.
Part 2 | LiabilitiesEvery pension scheme is unique: your members and your cashflows are unlike any other. Therefore any strategic decision-making needs to build from an understanding of your scheme’s liabilities and how they will evolve over time.
Part 4 | MembersMembers sit at the centre of your scheme. We highlight how making the most of your membership can materially improve the prospects for your scheme and improve their experience at the same time.
Taking control of your pension scheme’s futureAn XPS guide to funding and journey planning
In brief
Our four-part guide will give you insight into how you can form a coherent strategic plan tailored to your unique circumstances.
The Pensions Regulator (TPR) has raised the bar and now expects all pension schemes to set a Long Term Funding Target and document their journey plan to get there. But what does this mean exactly and how can a scheme go about fulfilling these requirements?At XPS we believe a successful journey plan is more than a de-risking flightpath. It should capture all strategic decisions and culminate in a clear action plan to get your scheme from where it is today to its end-game.
In this four-part series we have grouped the various considerations into four key areas of strategic decision-making, highlighting the main issues that need to be considered and acted upon by all DB pension schemes.
Together this represents an Integrated Risk Management approach.
XPS Pensions Group xpsgroup.com
Whyunderstanding your sponsor is crucial:
− Every DB scheme is reliant on the support from its sponsor to some extent
− The sponsor has to fund any shortfall and it underwrites all the risks the scheme is exposed to
− The Pensions Regulator expects trustees to understand the strength of the covenant and categorise their scheme accordingly
− Decisions made based on the covenant now will influence the scheme’s future financial position
Whataction you can take:
− Take steps to understand your current risk tolerance
− Build this assessment into investment and funding strategies
− Set a plan to preserve and improve security either immediately or over time
− Monitor the covenant regularly and act promptly if needed
− Be vigilant for any covenant leakage and be ready to protect the scheme
The Pensions Regulator (TPR) now expects trustees and employers to develop a Long Term Funding Target (LTFT) for their schemes (beyond becoming fully funded on the technical provisions basis) and to put in place a journey plan to achieve that target reflecting the strength of the employer covenant. The wider framework mapped out by TPR for balancing key risks faced by pension schemes is built on a new categorisation of schemes determined by several key characteristics.
Which Regulator category applies to your scheme?
Step 1: Determine your letter
Strong or tending or strong
Weaker with limited affordability
Weak and unable to provide support
Strong funding basis and short recovery plan
Weak funding basis and/or long recovery plan
A CE
B D
Fund
ing
Covenant
Step 2: Determine your number
1. Immature scheme (fewer pensioners).2. Mature scheme (more pensioners).
Trustees will need to have a solid understanding of the employer covenant characteristics of their scheme. This will be important to determine in which category their scheme fits in TPR’s new framework and more importantly what expected actions follow from that.
Taking control of your pension scheme’s future
An XPS Guide to funding and journey planning
Part 1 Understanding your Sponsor
Lorant Porkolab Head of Covenant Advisory Services
The Pensions Regulator has been clear that having an overall strategic plan that takes direct account of the strength of the employer covenant is now a fundamental expectation of all schemes.
XPS Pensions Group
5 key covenant questions that trustees should be able to answer
1How much can the company “comfortably afford” to pay in ongoing annual cash contributions?
− This is the amount that the company could, if required, pay out in cash on an annual basis without undermining day to day operations, capital expenditure, future business growth opportunities and a reasonable dividend policy.
− This is a key input when it comes to cash funding negotiations and understanding the desired long-term risk tolerance of the scheme. It is an essential input in the process of setting the Long Term Funding Target – which will be covered in detail in Parts 2 and 3.
2What is the “upper threshold” in terms of annual cash affordability?
− This is the upper limit that the company could pay out in cash on an annual basis without pushing the company into insolvency, it is likely to compromise future growth opportunities and have material implications for other stakeholders including the dividend policy.
− This will inform the maximum level of risk that can be taken in the journey to get to the Long Term Funding Target, which will be covered in part 3.
3How might affordability change in the future?
− This includes understanding the company’s prospects and the uncertainties surrounding this, which will be a combined picture of factors specific to the business, the wider industry, sector, geographic and political environment.
− This ultimately affects both the comfortable level and upper threshold of cash affordability in the future. It therefore affects the choice of long-term target and the amount of risk that can be taken on the journey to get there.
4What is the existing level of security?
− This includes understanding the strict legal recourse of the scheme in an insolvency event based on the corporate structure, borrowing arrangements and security provisions as well as the balance sheet of the sponsor.
− Understanding this element highlights the key factors that are of greatest relevance to the scheme’s security and how this security can be positively and negatively impacted by corporate actions.
5What options are available to improve the security of members’ benefits?
− There are often ways that a scheme’s security can be improved either immediately or over time.
− By having a clear understanding of the current position and available options, the scheme can set on a path to preserve or indeed improve security over time.
XPS Pensions Group
Assessing covenant strength in practice The covenant strength will be determined by a host of factors, including:
Developing a good robust understanding of all these areas and bringing them together to form an objective view about the covenant strength can be challenging. The following case studies illustrate how conclusions can hinge on small but significant details:
“Profitable business with strong prospects”
The business was profitable with a strong pipeline of new business. However on investigation two issues affected how this translated to strength of covenant.
Firstly the new opportunities involved considerable capital expenditure meaning that little cash was available to the scheme in the near term. Further, as a result of historic business disposals where liabilities had been retained, the scheme had become large relative to the organisation. Despite the relatively moderate deficit the level of ongoing risk was therefore substantial.
“Large strong business, well known to trustees”
The business was large relative to the pension scheme and the trustees all previously worked there and knew the business.
However, assessing group structure and intra-group arrangements was a key initial step in the trustees’ covenant assessment which uncovered a few key details. The perceived strength of covenant was based on the overall group but in fact it was one of the smaller subsidiaries within the group that had formal legal obligation to support the scheme. This wholly undermined the perceived security as the wider group had no obligation to fund the scheme.
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Action taken
The trustees pursued a more moderate investment return target, such that the downside risk was controlled, whilst agreeing a recovery plan with lower initial cash contributions rising over time with increases linked to strong business performance.
The long-term target was focused on getting the scheme to a high level of funding so the scheme would ultimately not represent an ongoing risk to the company.
Action taken
The trustees were in a better position to negotiate a parent company guarantee as part of the forthcoming actuarial valuation in exchange for pursuing the company’s desired level of investment return.
The Long Term Funding Target was set taking into account the ongoing parent company guarantee which could support a higher risk investment strategy. Higher expected returns were anticipated to get to the target within a reasonable timeframe.
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security provisions and guarantees provided by the employer and its wider group
company’s industry position and the longer term prospects of that industry
wider group context and borrowing arrangements
balance sheet strength of the employer
profitability and cash generation of the underlying business
Trustees often have more scope than they realise to manage the risks to which their scheme is exposed. Specifically they can:
Maintain a collaborative relationship with the sponsor
Be an active stakeholder, not afraid of asking difficult questions
Understand the level of risk the sponsor can underwrite and manage the scheme within this
Seek contingent assets and non-cash support
Be alert to covenant leakage and ensure fair treatment of the scheme
Monitor the covenant regularly and consider the impact of one-off events
Review the journey plan in light of the changing covenant and realign it if needed
Balancing needs of different stakeholdersSponsor free cash flow can be directed to a number of places:
Free Cash Flow
Reinvest in business Payment to lenders Payment to scheme Payment to shareholders
TPR has reiterated its concerns regarding the relatively high level of dividend payments compared to pension contributions and the recent divergence between these. Trustees need to ensure an equitable treatment of the scheme relative to other stakeholders and restore the balance if needed. Similarly, any material leakage of value from the covenant net should not go unnoticed and these may need rectification in the form of mitigation. In relation to these issues trustees are expected to become more active stakeholders.
How to manage the employer covenant
Whyunderstanding your liabilities is crucial:
− All schemes are unique. A single liability figure hides a wealth of information. Two schemes which have a similar liability figure can be very different in practice.
− Your liabilities will be subject to unforeseen factors in the future but we can already tell a lot about where a scheme is heading if we look closely enough.
− You need to understand whether you are heading for the right target and how that target will evolve over time.
Whataction you can take:
− Take action to manage the factors that are within your control.
− Make adequate provision for the factors beyond your control.
− Map the current and future expected buy-out cost, as this is likely to represent your eventual end-game, even if you have another long-term target in the interim.
− Consider setting a medium term Low Dependency target until buyout pricing comes into view.
Taking control of your pension scheme’s future
An XPS guide to funding and journey planning
Part 2 Understanding liabilities
Robert Wallace Partner
Your liabilities are not a single number, rather a complex moving target. It is crucial to understand the assumptions you are setting and the factors that could drive changes over time.
Pension scheme liabilities are often viewed as a single number at a snapshot in time, such as an actuarial valuation. Today’s liability figure, however, does not determine the actual cost of your pension scheme, rather it is part of an ongoing budgeting exercise.
Understanding not only what your liabilities look like today, but also how they could change over time is key to building a robust journey plan and strategic decision-making framework.
Liability measuresThere is a wide range of liability measures which might be relevant to your scheme, including the accounting basis and the Pension Protection Fund basis. However, in this note we focus on three bases which form part of the long-term planning for many schemes:
Funding – a prudent basis used in scheme funding valuations and termed ‘technical provisions’. Where the scheme is fully funded you expect existing assets with investment returns to be sufficient to meet liability cashflows, however you are exposed to ongoing risk and rely on the sponsor continuing to support the scheme if needed.
Low dependency – a low-risk basis, where there is a low probability of needing to call on the sponsor for further cash, and if there are any cash calls they would be expected to be comfortably affordable. Often interchanged with ‘self sufficiency’ which unhelpfully implies no further need for additional support which is not achievable in practice without buy-out or some form of consolidation vehicle.
Buy-out – the target level of assets needed to be able to transfer the liabilities to an insurance company, hence removing any future obligation on the sponsor.
XPS Pensions Group
Factors affecting the liabilitiesYour liabilities are unique – the single liability figure quoted at a valuation date can conceal a wealth of important information. We set out a summary of considerations below:
MaturityThe maturity of your scheme helps determine your time horizon and is an important aspect for consideration flagged by TPR in its 2019 annual funding statement. It will inform whether your scheme is getting bigger or smaller and how much risk is appropriate to take, given the amount of time you have left to recover from any losses.
AssumptionsAssumptions that determine your cash flows:
Mortality – generally the most significant assumption in determining the projected future cash flows from a scheme.
Inflation – often impacting on revaluation of benefits before retirement and increases in payment.
Retirement age – the age that members draw their benefits.
Dependants – proportion of members who have a spouse or dependant eligible for a benefit and the age of a spouse or dependant.
Salary increases – how active members’ salaries will increase and how likely members are to remain in service up to retirement.
Cash lump sum – level of cash lump sum taken at retirement.
Demographic experienceMost low-dependency or buy-out bases have prudent demographic assumptions but, in projecting forward liabilities, you might expect actual experience to be favourable relative to this conservative estimate. This means that the buy-out pricing should typically become cheaper as your scheme matures.
Significant individuals For smaller schemes, or schemes where a small number of members make up a significant portion of the liabilities, the actual experience of individual members can alter the course of your journey significantly. Insurance can be useful to hedge this kind of idiosyncratic risk.
Member choices Understanding how members’ choices can alter the expected progression of your liabilities can help to shape your journey. For example a greater take-up of transfer values can change the shape of your future cash flows and hence the evolution of your liabilities.
Once you understand your scheme’s cash flows you can consider what an appropriate liability target looks like for your long-term strategy.
Buy-out: the ultimate end game?Even if your scheme has no intention of buying out at the moment, there will ultimately come a point when the scheme is not practical to continue to run due to diminishing economies of scale (i.e. with fewer members) and buy-out becomes the most cost-effective option.
Therefore, buy-out is the likely ultimate end game for most schemes. However, this does not lead to a natural conclusion that all schemes should target buy-out as their Long Term Funding Target, nor that all schemes should necessarily seek to insure members in tranches (generally known as a partial buy-in) as a stepping stone to this eventual destination.
For many schemes buy-out will take place many years from now when the scheme is unrecognisable from today’s arrangements, and the current pensioner population will represent a small portion of the residual scheme. Therefore insuring current pensioners now does not necessarily aid the pursuit of reaching buy-out in 20 or 30 years’ time where those members may have died by that point.
A low-dependency strategy can therefore have a substantial role in getting schemes from where they are today to the ultimate destination of buy-out.
XPS Pensions Group
Case study: A tale of two schemesIn the example below, the Mature Scheme is based on a genuine XPS client. The Immature Scheme is a fictional scheme with the same liability value as the Mature Scheme, but a very different profile. Below we look beyond the single liability figure and see that these apparently subtle differences can significantly influence the strategic decision-making.
Mature Scheme Immature Scheme
Assets £90m £90m
Funding liabilities £105m £105m
Deficit £15m £15m
Funding level 86% 86%
Duration 15 years 25 years
% of funding liability in respect of pensioners
60% (mature in TPR’s classification)
30% (immature in TPR’s classification)
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2019 2024 2029 2034 2039 2044 2049 2054 2059 2064 2069 2074 20790
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Mature Scheme Immature Scheme
Buy-out Low dependency Funding
2019 2024 2029 2034 2039 2044 2049 2054 2059
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(£m
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Mature Schemein 20 years
Immature Schemein 20 years
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Mature Scheme Immature Scheme
Mature Scheme Immature Scheme
Buy-out Low dependency Funding
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Mature Schemein 20 years
Immature Schemein 20 years
The chart shows the cash flow profile of the two schemes.
The Mature Scheme has already broadly reached its peak expected cash flow. The Immature Scheme on the other hand is not expected to reach its peak cash flow for around 20 years.
This chart shows the expected future progression of liabilities for the two schemes, with very different expectations for the future sizes of the schemes.
The Mature Scheme is expected to reduce in size more quickly than the Immature Scheme, which has implications for the extent of the future reliance on the sponsor.
Initial trustee perspectiveThe trustees of the Mature Scheme had previously ruled out consideration of a longer-term low-risk target, and in particular buyout, as being too far away. They were sceptical about buy-out due to the £55m gap between the funding and buy-out liabilities at the current date.
How to manage your liabilities
To build your journey plan you need to understand your target and how that target will evolve over time.
Seek to understand your scheme liabilities not just defining their current value.
Hone your demographic assumptions to understand the factors that could significantly affect your cash flows.
Consider steps you can take to reduce the uncertainty around your liabilities such as liability management, interest rate and inflation hedging, and use of partial buy-in.
Work with your sponsor to establish sufficient cash support and security to meet the scheme’s current needs, and how this will evolve.
Understand the buy-out cost and how this will change over time. This is likely to be your ultimate end-game even if you don’t currently have aspirations to get there.
Consider the role of a low-dependency target as a medium-term safe haven until buy-out pricing comes into view.
How close is buy-out?
The chart below shows the liabilities of the two schemes both today and in 20 years’ time building up from the funding liability to the low-dependency and buy-out liabilities.
Why does buy-out get relatively cheaper over time?
There are two key reasons:
Pensioner members are priced relatively more cheaply than deferreds within the insurance market. Therefore, as more members retire, a scheme becomes relatively cheaper to insure.
The buy-out cost today will incorporate conservative demographic assumptions in relation to the life expectancy of existing pensioners etc. As time passes you would expect the actual experience to be in favour of the scheme which will then reduce future buy-out pricing.
Buy-out is currently much more expensive for the Immature Scheme highlighting a key difference between the schemes.
In addition, for the Mature Scheme the buy-out cost converges with the low- dependency basis much more quickly than the Immature Scheme.
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Mature Scheme Immature Scheme
Mature Scheme Immature Scheme
Buy-out
Now in 20 years
Low dependency Funding
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Mature Schemein 20 years
Immature Schemein 20 years
Case study outcome: Action takenFollowing initial scepticism, on seeing the speed at which the gap was expected to close, the trustees constructed a journey plan to get to a low-dependency target of gilts +0.5% over the medium term, with the intention to jump to buy-out if and when conditions where favourable.
The trustees have also started to put in place a programme of member options exercises, such as enhanced transfer values and pension increase exchange. These exercises give members additional flexibility and when taken up they accelerate the closing of the gap to buy-out.
12
Taking control of your pension scheme’s future
An XPS guide to funding and journey planning
Part 3 Understanding assets
Simeon Willis Partner, Chief Investment Officer
Performance of your assets is the difference between confident success and catastrophic failure.
To have any chance of success the strategy has to be right, but it’s not as hard as it sounds.
The asset strategy represents one of the key ways that a scheme can control its future financial position.
Managing assets spans several distinct areas of pension scheme strategy including journey planning, portfolio construction, implementation and monitoring.
In this paper we will focus on the journey plan flight path. If the journey plan isn’t right then the scope for meeting your requirements is severely compromised, irrespective of the quality of your portfolio construction, implementation and monitoring.
What is a journey plan flight path?A journey plan flight path has three key elements:
Target: The Long Term Funding Target permits a low-risk strategy resulting in a low probability that additional funding will be required. In the event contributions are required, the cost will be immaterial to the sponsor.
Timeframe: A realistic timeframe to achieve your Long Term Funding Target within your risk tolerance.
Trajectory: The route to reach your target and how you can adapt in response to positive or negative events or market opportunities that may arise.
We describe our approach to setting each of these three key elements in the next pages.
Whyunderstanding your assets is crucial:
− The investment strategy is your single most significant means to control the future financial position of your scheme.
− Your near-term and long-term risk tolerances will directly influence the strategy that is right for you, and this is directly related to the sponsor and your current level of funding.
− There will be more than one correct strategy. But it’s essential to avoid choosing the wrong strategies.
− A higher long-term target isn’t necessarily a better target, and in some cases can cause you to take too much risk.
Whataction you can take:
− Focus on defining a clear long-term target with a timeframe and trajectory to get there safely.
− Set your target such that the ultimate risk level is expected to be very comfortable for the sponsor to run indefinitely.
− Set your strategy to get there so the current risk is within the upper threshold of your sponsor’s risk tolerance.
− Consider what, if any, actions you will take in response to surprises both good and bad.
XPS Pensions Group
Step 1: Setting the Long-Term Funding TargetWe start with defining the destination.
The sponsor’s comfortable cash affordability can be used to inform the maximum level of risk you will wish to take once you have achieved the long-term target.
This can be demonstrated using a worked example:
Whilst a company would clearly prefer to pay zero contributions, if the sponsor of the scheme can comfortably afford £20m pa once it has achieved the long-term target, you will only want to risk incurring a fresh deficit that can be repaired with these £20m contributions.
If we apply this to a 3-year valuation cycle, you’ll want to be confident that you can comfortably recover from any likely deficit by the time of the next triennial valuation (£20m pa for 3 years).
This would imply a target level of downside risk of no more than £60m over 3 years.
We can then model the scheme as if it were fully funded today on different target funding bases, with an appropriately low-risk investment strategy, and assess how its risk compares to this £60m downside risk tolerance.
Possible LTFTAssets
requiredTarget asset
return3 year
1 in 20 risk (VAR)Possible LTFT?
100% funded on buy-out 1,300 – £0m Yes
100% funded on Gilts + 0.25% 1,150 Gilts + 0.5% £60m Yes (just)
100% funded on gilts + 0.5% 1,100 Gilts + 1% £100m No
For schemes that have weaker sponsor support, some targets will involve too much risk. For schemes with stronger sponsor support there will be a wider range of possible answers which could work.
A quick reminder
In Part 1 of this series we highlighted the importance of determining the sponsor’s annual affordability, specifically:
1. Comfortable cash affordability: level of cash the company can comfortably afford on an annual basis without compromising its prospects; and
2. Upper threshold cash affordability: the upper threshold of cash the company can pay the scheme on an annual basis whilst not risking insolvency.
XPS Pensions Group
Step 2: Setting the timeframeFor most schemes it is advantageous to take more risk in the short term than they wish to take in the future.
To determine this near-term risk tolerance we can use the sponsor’s upper threshold cash contributions. This can be combined with the maximum desired length of recovery plan to determine the maximum deficit that can be supported. We then subtract the current deficit from this maximum to determine how much downside risk can be taken.
Worked example
Take a scheme whose sponsor has upper threshold cash affordability of £50m pa and assume the trustees would wish to recover any deficit within a 7 year period. This would equate to a £350m deficit that can be supported.
If the scheme currently has a £100m deficit then this means that the downside risk tolerance is £250m from the current deficit position.
It will also be important to consider wider factors such as the scope for a change in the covenant to affect the funding basis assumptions, potentially increasing the deficit further, and which risk metrics to use.
Step 3: TrajectoryThere are a range of trajectory approaches that can be considered in terms of how a scheme’s investment strategy evolves through time. We do this by projecting a ‘central best estimate’ scenario.
Approaches include time-based de-risking, funding-level-based de-risking or a constant risk approach. Further, as pension scheme funding levels don’t move in predictable straight lines, there is also a need to consider how you might respond to being ahead or behind your target.
There is no single correct approach to managing your trajectory and it is important that all approaches are considered as part of a comprehensive exercise to assess which is of greatest benefit to a scheme. Funding-level de-risking is a common approach but isn’t optimal for all situations. For example schemes needing to reduce risk as far as possible are often best served by a constant risk approach that de-risks immediately and then maintains this through time, rather than starting with a higher level of risk with a hope to reduce risk when good performance materialises.
Taking unnecessary risk
Existing strategyThe trustees had previously considered that the safest strategy was to get to buy-out as soon as possible by maintaining the current investment strategy, to reduce long-term reliance on the sponsor. However, analysis revealed the following:
An immature scheme
Small technical provisions funding deficit with 2 year recovery plan
Portfolio: well diversified and hedged, featuring 75% growth assets
Sponsor: ‘tending to strong’C
ASE
STU
DY
The current investment strategy was at the top end of the sponsor’s risk tolerance based on the upper threshold cash affordability assuming a 10 year recovery plan. Running this level of risk continually once fully funded was not desirable to the sponsor or trustees.
Action takenThe trustees decided that once the scheme had achieved fully funded status on the technical provisions basis, they would reduce risk materially to a lower returning Cashflow Driven Investment (CDI) strategy and target getting to low dependency within 10 years.
This would lead to an expected risk reduction of 50% in 3 years time, and a further substantial risk reduction in 10 years once low dependency was reached. They did not wish to reduce risk immediately so as to support the current recovery plan.
Once low dependency was reached the trustees would look for opportunities to buy out tactically as the pricing became more attractive.
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2019 2021 2023 2025 2027 2029 2031 2033 2035 2037 2039
Ass
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Year
Journey plan projection
Technical ProvisionsLow Dependency TargetOld Target: Buyout
Assets (Current)
Assets (Alternative)
Deficit contributions stop
Further risk reduced by 30%
Scope to reduce risk by 50%
Buy-out is currently considerably more expensive than a low-dependency basis as a result of the large proportion of deferred members who are more expensive to insure. As time passes and members retire the insurance cost is expected to get noticeably cheaper.
A low-dependency target of gilts + 0.25% would permit a low-risk strategy that was well within the sponsor’s long-term comfortable affordability, once it was achieved.
How to manage your assetsThe asset strategy is a core means to drive your scheme in the right direction.
Getting the journey plan right is fundamental as it informs your choice of asset classes and hedging strategy, which has far more influence on your outcome than the choice of investment manager.
Define your short-term and long-term risk tolerances. This should link directly to your sponsor covenant.
Set a Target, Timeframe and Trajectory that reflects your scheme’s specific circumstances and objectives – every scheme is different.
Avoid the temptation to run too much risk now in the hope of getting to a safer place. Patience is usually rewarded.
Don’t plan for all eventualities but consider broad positive and negative surprises and how they may impact your approach. This way you can pre-empt the key actions you may wish to make should these surprises play out.
Revisit your journey plan at least annually and refer to it as a working document that can be modified and adjusted as the scheme evolves.
Source: XPS Radar
Taking control of your pension scheme’s future
An XPS guide to funding and journey planning
Part 4 Understanding members
Helen Ross Head of Member Options
It will cost more money, take more time to get to your target and could be detrimental for your members if you ignore member options as part of your strategy. It isn’t an optional thing to do when it makes strategic sense.
There are over 6 million members of defined benefit schemes in the UK yet to retire. How will these members navigate their pension options, what choices will they make and what impact will it have on pension schemes?
Members are making choices every day that have an impact on their scheme’s funding progression and risk profile. This impact, whether positive or negative, is usually incidental to the scheme’s long-term strategy.
A well thought-out strategy around member options should form an integral part of any scheme’s journey plan and allows trustees and sponsors to take control of the likely impact. Without such a strategy, your objectives will either cost you more or take longer to achieve.
Setting a member options strategyIn our view the following elements should be considered as part of any member options strategy:
What options to offer: There is a wide range of options available and it is important to select options that are appropriate, compatible and straightforward to understand.
The terms: These need to be fair to members but will also have a significant impact on the journey plan flightpath. Where possible there should be consistency between different options.
Communication, education and support: This is key to whether members engage with their options, understand the choices available and ultimately to whether they make appropriate decisions regarding their benefits.
Whyunderstanding your members is crucial:
− Trustees need to tailor engagement and communication strategies to suit their members.
− A member options strategy is not one size fits all.
− Financial attitudes vary and not all options will resonate with your members.
Whataction you can take:
− Profile your members to better understand their characteristics and attitudes.
− Consider which projects will have the greatest beneficial impact on your scheme.
− Support your strategy with clear communications and the selection of independent financial advisors.
XPS Pensions Group
Those that discharge some or all of a members’ benefits in exchange for a cash payment that:a. Reduces scheme liabilities and will generally accelerate progress to the Long Term
Funding Target.b. Requires cash outflows, which may have an impact on investment strategy.c. May improve the funding position where terms are set appropriately.
Those that reshape members’ benefits that:a. Have only modest impact on scheme liabilities and progress towards the Long Term
Funding Target.b. Does not require cash payments but will increase the level of pensions payroll.c. Can reduce exposure to inflation or mortality risks.
Cash commutation
• Exchanging part of a member’s pension for a lump sum. • Paid at the point of retirement and tax-free under current legislation.• A well established and communicated option for most schemes.
Trivial commutation
• Exchanging a small pension for a one-off lump sum.• Usually at least partly taxable.• Can apply at retirement or for existing pensioners.
Transfer value
• A cash payment representing the value of the member’s benefits. • Extinguishes all benefits but must be paid to another registered pension scheme.• Allows access to flexibilities available to Defined Contribution members.• IFA advice is required if over £30,000.
Partial transfer
• A transfer that only represents part of the member’s benefits.
Pension increase exchange
• Exchanging an increasing pension for a higher, non-increasing pension.• Only applies to non-statutory increases.• Can apply at retirement or for existing pensioners.
Bridging pension • Brings forward income from later years to pay a higher pension upfront.• Intention is to pay the same overall income, after allowing for the member’s
State pension
Which member option is right for youA member options strategy may involve the introduction of a new option or it may focus on communicating an existing option to members.
There are broadly two types of option.
Crucial to the success of any strategy will be choosing the right options:
• Some options will be more applicable on certain schemes, for example based on pension size or type.
• Offering too much choice can be counterproductive, particularly if members are not financially sophisticated.
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2
XPS Pensions Group
We look at how 2 schemes identified the right options strategy for them.
Immature scheme with large deferred population
Mature scheme targeting buyout
CA
SE S
TUD
Y A
CA
SE S
TUD
Y B
Step 1: What options to offer? Immature scheme with liabilities of around £250m and 1,500 members. Large proportion of deferred members with no relationship with the employer.
Which options?• Transfer value • Partial transfer
Step 2: The termsThe Scheme has set a low-dependency long term funding target of gilts + 0.25% pa.
What terms?• The investment strategy has a best estimate
expected return of gilts + 1.5% pa. This can be allowed for when calculating transfer values.
• Transfer values are 15-25% cheaper than the reserve on the low dependency basis.Step 3: Communication, education
and supportFew members considering the option to transfer. Finding and paying for a financial advisor seen as a barrier. Profiling of the membership revealed that members were likely to engage online and be financially mobile.
What communication, education and support?• Tracing addresses and issuing ‘warm up’
communications in run up to retirement.
• Online member access with retirement and transfer quotes.
• Sponsor meets the cost of independent financial advice (advisor selected by the trustees).
The outcomeImproved communications, along with the provision of paid for financial advice results in more members transferring.
Over the period to reach the Long Term Funding Target around £40m in transfer values is now expected to be paid out. This reduces the time taken to get there by 2 years, as well as reducing liability risk in the meantime.
The Trustees also have the comfort of knowing that members can transfer only part of their benefits to access pension freedoms, are receiving proper advice and are protected against pension scams.
Step 1: What options to offer? Mature scheme with liabilities of around £500m and 4,000 members. Mostly pensioners with some older deferred members.
Some very small pensions in payment. Some pension increases are non-statutory and inflation-linked.
Which options?• Pension increase exchange • Trivial commutation
Step 2: The termsThis is a mature scheme that has already identified their objective to buyout within 10 years.
What terms?• Pension increases can be exchanged at 30%
less than the cost of buyout.
• Trivial commutation terms are 30% less than the cost of buyout.
Step 3: Communication, education and supportConcern that options may be too complicated for older members so careful consideration given to how best to engage to make the process reassuring and easy to follow.
What communication, education and support?• Paper based correspondence using scheme or
company branding, in clear plain English with simple to follow processes.
• Dedicated telephone helpline including tax support.
• Excluded oldest members that were considered vulnerable.
The outcomeThe trivial commutation exercise is run first. 400 pensioner members chose to take their benefits as a one-off lump sum. This reduced the cost of the subsequent pension increase exercise – as well as reducing the ongoing administration costs of the scheme.
25% of the remaining pensioner members choose to take up the pension increase exchange option, which is expected to be mirrored by 25% of future retirees.
The two exercises reduce the expected ultimate cost of buyout by around £25m, as well as reducing inflation and mortality risk in the meantime.
XPS Pensions Group
How to manage our member optionsTo devise an effective member options strategy you need to prioritise actions which have the greatest beneficial impact to the members and to the scheme.
Understand what options are available to members in the scheme and what other options could be additionally implemented.
Gain a better understanding of your membership. By using member profiling you can better appreciate the attitudes of your members to financial risk, level of understanding and preferences for communications.
Consider how the take-up of each option impacts the overall journey towards your long term funding target to consider which strategy is likely to have the largest influence.
Members need appropriate communication and education in order to make informed choices. Traditional methods of communication and engagement are not always suited to the membership.
The risks associated with pension scams and transfers that are not in the interests of members should be mitigated with best practice scam-checks and ensuring members have access to good quality independent financial advice.
Accessing their pension flexibly may be better suited to the financial interests of certain members in their particular circumstances.The Pensions Regulator
We are supportive of trustees putting mechanisms in place to help savers make good decisions about their retirement planning, including the provision of IFA services where resources allow.The Pensions Regulator
XPS Pensions Consulting Limited, Registered No. 2459442. XPS Investment Limited, Registered No. 6242672. XPS Pensions Limited, Registered No. 3842603. XPS Administration Limited, Registered No. 9428346. XPS Pensions (RL) Limited, Registered No. 5817049. Trigon Professional Services Limited, Registered No. 12085392. All registered at: Phoenix House, 1 Station Hill, Reading, RG1 1NB. XPS Investment Limited is authorised and regulated by the Financial Conduct Authority for investment and general insurance business (FCA Register No. 528774).
This communication is based on our understanding of the position as at the date shown. It should not be relied upon for detailed advice or taken as an authoritative statement of the law.
For further informationPlease get in touch with Lorant Porkolab, Robert Wallace, Simeon Willis, Helen Ross, or speak to your usual XPS contact.
Simeon Willis Chief Investment Officer
t 020 3967 3895 @xpsgroup xpspensionsgroup Watch our latest updates
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XPS Pensions Group is the largest pure pensions consultancy in the UK, specialising in actuarial, covenant, investment consulting and administration. The XPS Pensions Group business combines expertise, insight and technology to address the needs of over 1,000 pension schemes and their sponsoring employers on an ongoing and project basis. We undertake pensions administration for over 870,000 members and provide advisory services to schemes of all sizes including 25 with over £1bn of assets.
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Robert Wallace Head of Governance, Partner
Lorant Porkolab Head of Covenant Advisory Services
Helen Ross Head of Member Options