DB consolidation - where next?

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DB consolidation - where next?

At a glance

• Consolidation can bring major benefits to smaller schemes

• There are several ways consolidation can be brought about

• Master trusts could prove most popular as a tried and tested solution

Mike Ramsey, Chief Executive reflects on the government's Green Paper.

The debate about the future direction of defined benefit (DB) schemes has heated up with the government's recent Green Paper (Security and Sustainability in Defined Benefit Pension Schemes).

The section on consolidation of schemes has generated most interest and attention and draws our attention to some interesting facts. Of the 5,800 DB schemes in the UK, the vast majority have less than £1bn in assets. Three quarters have fewer than 1,000 members and one third have fewer than 100 members.

Why is this an issue? One only needs to turn to a recent study from The Pensions Regulator (TPR) to see the reason why.

Smaller schemes face significantly increased costs per member and tend to have less effective governance. Money spent on running schemes is money that could be used to pay down deficits and secure member benefits. Similarly, poor governance can lead to poor decision making across the whole gambit of funding, benefits and investment, which could significantly increase the cost of financing a scheme.

If possible both are to be avoided and this is where the consolidation debate gets traction. Schemes that are sub scale cannot afford to access investment instruments that optimise the management of risks and returns or find it difficult to install appropriate governance structures that are run by trustees with the necessary skill and experience to discharge their duties properly.

Not all small schemes are poorly run but clearly it is more difficult to operate in an ever-more challenging regulatory regime and increasingly complex investment/funding environment.

Need for consolidation

The Green Paper suggests that some form of consolidation is desirable. Key potential benefits of consolidation are economies of scale leading to reduced costs, access to more sophisticated funding and investment strategies, and improved governance.

All of these factors combine to improve the likelihood that the member will receive their benefits in full.

DB consolidation is also favoured by TPR, but it won't be easy and could give rise to a number of challenges. What are the options? What then are the options for consolidation of existing schemes?

Money could be saved by pooling - e.g. administration, actuarial, legal, and covenant costs - but this only goes so far. Greater benefits come from bringing the management of schemes together under one set of trustees, allowing for a more professional approach to be adopted and further cost and time savings.

The possible routes to achieving this goal are:

• Superfunds

• Discontinuance funds

• Master trusts.

The main attraction of superfunds is the opportunity to consolidate liabilities as well as assets, which would potentially lead to greater cost savings.

The liabilities would not be segregated in any way. This leads to significant questions over cross-subsidies and how liabilities would be shared across participating schemes and employers.

If the funding risk is not locked down then there is not a clean break for the employer - a key perceived benefit of the superfund concept. The question then becomes who takes responsibility for the liabilities of sponsors who fail and become insolvent.

These so-called orphan liabilities could grow and become a strain on the remaining stronger employers.

An extension of the superfund idea is a central discontinuance fund. This would prevent the taxpayer having to step in to address the problem of orphan debts.

So a superfund designed to discharge liabilities as part of an endgame in pension funding would require the PPF to underwrite it, or if not the risk needs to be passed back to scheme members so that benefits might in future be cut back in the same way as happens with Dutch schemes.

The master trust has significant advantages over other models in that it already exists and builds on consolidating back office functions by having a single set of trustees and a common investment fund.

A stronger governance framework and more available resources, typically result in a higher standard of trusteeship. In our experience, by pooling all services under one trust with common advisers and building a large asset portfolio, not only can cost savings be made over single schemes but each scheme can ‘punch above their weight' by accessing leading edge technology, the full range of investment opportunities and high quality advice.

But unlike alternative forms of consolidation it enables each separate scheme section to retain its own benefit structure, scheme-specific asset allocation and agree its own funding strategy commensurate with its covenant. These are important considerations when it comes to the consolidation debate.

At TPT we agree with the point in the Green Paper that there is not an affordability crisis across all UK pension sponsors, and that the struggles most face are a result of the current very difficult economic conditions. More importantly, most issues can be overcome without significant changes to benefit design.

In summary we would argue there is already a good consolidation vehicle in existence without the need to create new models.

For more information about our DB Complete package, visit our page here.

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