Superfunds are looking to muscle in on the pensions de-risking market. What should trustees consider?
Being responsible for funding peoples’ retirement is rarely easy, but it must have been less stressful when 10-year gilts returned around 8% and most members paid into their pension pot each month. Trustees of defined benefit (DB) funds today face a different reality.
Of the almost 5,500 schemes in the Pension Protection Fund’s (PPF) universe, only 11% accept new members, while 44% do not and the same percentage are closed to further accrual. Rising deficits resulting from low gilt yields are also increasing the pressure on sponsors.
At the start of the year, deficit reduction contributions accounted for 60% of all employer payments into DB schemes, the Office for National Statistics (ONS) says. Add to that the economic impact of the Covid crisis, which is still unfolding, and it becomes clear why more and more trustees and sponsors want to pass the responsibility of paying their members’ pensions to someone else.
So far, buyouts have been the preferred option for those looking to de-risk. The size of this market has the potential to grow significantly. Indeed, in the next 10 years, 72% of final salary schemes will have enough capital to secure a full buyout, up from 6% today, the Pensions Policy Institute predicts.
For schemes that cannot currently afford an outright buyout, a new option is approaching on the horizon. Consolidation through a trust-based, commercial pension provider which manages the assets of several defined benefit schemes. The potential market for these trusts, known as superfunds, could be significant.
Despite defined contribution (DC) scheme members outnumbering those saving into a DB scheme, the latter owns most of the assets. Indeed, by the end of 2019, £1.8trn of the £2.2trn of UK pension assets were managed by final salary schemes, according to ONS.
The managing director of one of these consolidators predicts that funds such as his could radically alter the pensions landscape. “If the UK follows the experience of the Dutch and the Australian market, the 5,500 schemes we have today could fall to 1,500 by the end of the decade,” says Antony Barker of The Pension Superfund.
“A percentage of those, maybe as of today, will go into insurance buyouts and 50 to a 100 schemes, maybe 1% or 2%, will unfortunately end up in PPF assessment due to the failure of the sponsor, and that no doubt may accelerate over the next couple of months. But if you do the maths, that leaves potentially 2,000 or more schemes that could end up with a superfund. That’s probably £800bn or more at today’s valuations.”
It’s no wonder then, that competition for the biggest chunk of the consolidation cake is growing. And this is also where the debate on the merits of DB consolidation becomes not only contested, but fiercely political.
At the heart of it is the fact that the financial burden or retirement provision is increasingly born by individuals, rather than their employer. As scheme sponsors are offloading such commitments to corporate entities such as insurers or consolidators, the question remains as to how much income risk will member be exposed to.
Then there are the issues of how should consolidated investment risks be managed and who polices these funds. Because superfunds target schemes in the PPF universe, if they default schemes would fall back into the protection of the pension lifeboat, for which members would potentially pay the price through lower retirement benefit.
The lack of regulation for superfunds has attracted fierce criticism from insurers. Hetty Hughes, senior policy adviser for long-term savings at the Association of British Insurers (ABI), warns: “By underwriting superfunds with the PPF, you are potentially privatising the gains and socialising the losses.”
A two-tier system
Superfunds are being created to fill a gap in the DB de-risking market. Despite most final salary schemes no longer admitting new members; an outright buyout, which would require high levels of funding, is only available to a fraction of schemes as in most cases it would be too expensive.
As covenants come further under pressure from the Covid crisis, many employers are looking for alternatives to offload their pension liabilities. A recent survey of trustees and their investment directors showed that one in five schemes have discussed superfunds as a potential exit route, according to Willis Towers Watson.
The government has also made clear in its March 2018 Whitepaper that it welcomes consolidation through superfunds. Emboldened by political support, two main providers – The Pension Superfund and Clara – attracted significant start-up capital while there are reported to be other players looking to enter the market.
The two main providers aim to tackle different parts of the market. Clara, which is on track to receive up to £500m in seed capital from TPG Sixth Street Partners, describes its services as a “bridge to buyout”, rather than a permanent transfer. By extension, the transferred assets will be managed on a segregated basis.
In contrast, The Pension Superfund, which is backed by an initial £500m from private equity firm Disruptive Capital, offers a permanent run-off model for DB schemes and the assets, as well as liabilities, will be pooled.
Both are pension providers, not insurers, and as such they are not subject to the stringent capital and investment requirements of Solvency II. Because superfunds operate as pension funds, there is no legislation which sets standards on their capital requirements or investment strategy.
The issue of superfunds has not been tackled in the current Pension Schemes Bill, which means it could take several years until legislation is approved. The Pensions Regulator (TPR) aimed to tackle this lack of regulation with an interim guidance in June. But is it working?
The industry is divided on this. The interim guidance spells out that trustees attempting to transfer their assets should, along with the superfund, approach the regulator first.
Superfunds must also hold a capital buffer, and, unlike insurers, they cannot distribute profits to investors for three years. The Pension Superfund and Clara have welcomed the new guidance, as it provides the certainty needed to convince trustees to hand over their assets.
Lincoln Jopp, a director at The Pension Superfund, believes that it could be a much needed kickstart. “We have not officially completed any transfers yet because we had to wait for the framework to be published. “We expect TPR to issue a statement saying that they have finished their assessment of The Pension Superfund and that we can do deals,” he adds.
“We could have done deals last year, but we knew realistically that it made sense for the regulator to finish their assessment because it would be more difficult to convince trustees.”
His colleague Barker addresses the criticism from the insurance industry by arguing that in some ways, rules for superfunds are stricter. “Insurers are right in that this isn’t a level playing field. “If you do the maths on their one-year test versus our five year test, they have to hold less capital than us,” Barker says. “For the schemes in PPF assessment, insurers can cut members’ benefits unilaterally in securing them, but superfunds cannot.”
Hughes believes that the interim guidance is insufficient. Her concern is that the policy is targeting well-funded schemes. “That is where the risk of regulatory arbitrage becomes more acute,” she adds.
“The regime doesn’t need to be Solvency II compliant as it is trying to serve a market that can’t afford a buyout, but that doesn’t mean the regime doesn’t need to have similar features to Solvency II.
“For example, the life insurance industry has undergone stress tests recently, where they have to measure the impact if half their assets’ credit rating were downgraded. This was found to be manageable, whereas TPR guidance simply says that superfunds can do their own homework and come up with their own stress tests,” she adds.
Similar concerns have allegedly also been raised by Bank of England governor Andrew Bailey, who in a letter to Work and Pensions Secretary Thérèse Coffey leaked to Sky News, warned that the lack of firmer rules in TPR’s interim guidance could pose a risk to financial stability.
The Bank of England was approached by portfolio institutional but chose not to issue a public comment. Critics of superfunds are also worried about consolidators being funded by private equity firms.
The regulator imposing a three-year ban on passing profits to investors, is still insufficient, argues Hughes. “We might not see legislation for another five years and the guidance also says that the three-year rule is under review. What it doesn’t say is that there are other ways of extracting value other than dividends. Performance fees and management fees are examples of the instructions private equity firms tend to put in place.”
Chris Clark, defined benefit policy lead at The Pensions Regulator, says that superfunds should not be compared to insurers. “We don’t see superfunds as a replacement for insurance, they are not targeting an insurance level of guarantee, but there are many schemes out there that can’t afford that level of guarantee.”
He also stresses that just because there is no formal regulation on superfunds, the regulator is not toothless. “All our usual statutory powers are available, just as they would be in relation to any other DB pension scheme within our remit.
This means that, where there could be unacceptable risks to members, we will have the powers to deal with those risks.”
The key factor which could help superfunds establish a competitive advantage is that they are more flexible than insurers when it comes to setting their investment strategy.
Because superfunds do not promise insurance-like cover, they can afford exposure to riskier segments of the market. However, TPR has spelled out in its interim guidance that a higher risk strategy requires more cash to be kept in reserve.
The Pension Superfund, for example, has a target allocation of 80% to its liability-driven investment (LDI) strategy, with the remainder in return-seeking assets. Barker highlights that unlike insurers, superfunds have more flexibility to adjust this target portfolio to the allocation that schemes already have in place.
“Our actual strategy will be driven to some extent by the schemes we inherit,” he says. “One of our unique features is that we novate the schemes’ existing portfolios. That ensures that our transaction costs are lower. So,if people already have private equity, we don’t need them to sell it to provide us with cash and government bonds.
“The return seeking assets are going to be drawn from public and private markets, but will probably allow us to focus more on private markets and illiquid assets because we expect that our peak cash-flows are going to be in the late 2030s to early 2040s so that gives us a lot of time to invest in illiquids. We can look at infrastructure, private equity, insurance-linked securities, land, property and other real assets,” Barker says.
Implications for trustees
For better or worse, superfunds have the potential to fundamentally transform the UK’s defined benefit landscape. The recent example of local government scheme pooling shows that where there is political will, billions of pension fund money could be shifted into a consolidating vehicle within less than five years, at which point there might still be no firm laws on superfunds.
The interim guidance has given trustees a lot to mull over, and early evidence suggests that the appetite for superfunds is there. David Weeks, co-chair of the Association for Member Nominated Trustees, predicts that given the deteriorating market environment, trustees will come under increased pressure from sponsors to consider the transfer to a superfund.
This could be the case particularly in industries which have been hit the hardest by the Covid crisis. Schemes with a weakened covenant could now show increased interest in transferring their assets, he predicts.
Weeks warns that superfunds in their current set up do not leave room for the presence of member nominated trustees, which could have an adverse effect on democracy and the ability of scheme members to have their say in the governance of the scheme.
Whichever way trustees end up seeing these new players, their main responsibility should be clear, argues Clark at TPR. “For trustees considering a transfer, it is vital that they are doing so because it is in the best interest of scheme members.”