The challenges at Arcadia’s pension scheme might be a taste of things to come for the industry. As the economic outlook for many DB schemes turns sour, many are keen to shift the burden of pension scheme liabilities.
Defined benefit (DB) scheme trustees had a challenging 2020. As markets plunged, the combined deficit of final salary schemes jumped to £229bn from £160bn in a year, according to the Pension Protection Fund (PPF). Meanwhile, funding ratios dipped to 94.9% from 99.2%.
At the same time, it was a year when many DB schemes edged closer to their endgame. Many of their sponsors were also struggling.
The economic damage caused by the pandemic is likely to leave a mark on the balance sheets of many DB scheme sponsors, two-thirds of whom issued a profit warning in 2020, according to Ernst & Young. The number of schemes in PPF assessment increased to 41 from 26 during the opening three months of the year. It’s safe to assume, therefore, that many sponsors would shift at least part of their pension scheme liabilities off their balance sheet in the year ahead, given the chance.
Outlook for bulk annuities
For the better funded schemes, this might mean a continued focus on buy-in or buyout insurance deals. Precisely because of market uncertainty, the bulk annuity market is on track to hit £30bn this year, Barnett Waddingham predicts. This is somewhat lower than the £40bn recorded in 2019, but nevertheless 2021 could be a close second.
A key driver for the rise in de-risking deals is pricing. As credit spreads widened at the beginning of 2020, schemes closing deals at the time managed to lock in a competitive deal. So, if volatility hits the bond markets when the UK’s transition period from the EU ends in the new year, could similar opportunities be on offer.
Life expectancy is, of course, a key factor in setting the terms for a de-risking deal, and the Covid pandemic has raised some unusual challenges in that respect. But the Continuous Mortality Investigation, the actuarial body measuring life expectancy for the insurance and pensions industry, announced at the end of 2020 that it was placing no weight on the data for this year, as they would have had a distortive effect on the figures.
For pension schemes, this could mean that they would not benefit from more competitive terms due to the decline in life expectancy seen this year. Another adverse factor could be the conclusion of the RPI reform, which is likely to lead to a reassessment of the pricing for inflation-linked liabilities among insurers.
Stephen Purves, a partner at Aon, sketches a cautiously optimistic picture for the risk transfer market. Speaking at a bulk annuity event organised by the Pensions Management Institute, he said that 2020 has seen a trend towards buy-ins rather than buyouts with many schemes who had previously closed de-risking deals coming back to the market to offload more of their liabilities. Schemes sponsored by National Grid and Maersk are examples, having each completed buy-in deals worth more than £1bn.
But Purves also warned that the number of schemes which are in the position to afford an insurance deal could fall. “For some schemes there has been a deterioration in funding levels as equities have been hit and leverage from liability-driven investing has been stretched, meaning that funding levels may no longer support insurance transactions. Across the industry, we’ve seen lots of transactions paused as a result,” he said. Cash management has also been an issue. “Lots of sponsoring employers became reluctant to deploy their cash reserves with uncertain trading conditions ahead, which again put transactions on hold,” he added.
Turning to superfunds?
This brings in superfunds as potential new consolidators for DB schemes which cannot afford an insurance deal. With The Pensions Regulator releasing guidance for trustees, the new consolidators might be in a good position to capitalise on sponsors’ problems.
That includes Arcadia’s scheme, which currently has a £350m deficit and is among those in PPF assessment. It has entered talks with The Pension Superfund (TPS). For members of the scheme, joining TPS could potentially provide a better outcome than the PPF, as in the latter scenario they stand to lose 10% of their benefits.
But politicians are keen to ensure that the move towards a consolidator should not be a get out of jail free card for scheme sponsors, particularly given the public controversy retail tycoon Phillip Green attracted over his handling of BHS’ pension scheme. In a letter to TPR chief executive Charles Counsell, Stephen Timms, chair of the Work and Pensions Committee, stressed that firm guarantees for deficit reduction contributions should be put in place as part of a transfer deal.
The fact that a growing number of trustees are considering turning to consolidators such as TPS or Clara could have investment implications by affecting the types of assets they hold in their portfolio. While an insurance deal would predispose an allocation to presumably risk-free assets in line with Solvency II requirements, superfunds are not required to comply with such liquidity rules and, therefore, have more flexibility to accept portfolios that have a higher proportion of return seeking assets.