Consolidators and superfunds offer an alternative endgame for DB scheme trustees, but, as Lynn Strongin Dodds explains, don’t expect to see too many transactions anytime soon.
As UK defined benefit (DB) pension funds move further along their de-risking journey, there has been a buzz around the consolidator and superfund model. Players and transactions are currently thin on the ground in these areas, although the field is expected to become more crowded over time. In the short term, however, the lack of a legislative roadmap and track record could hamper growth.
Consolidation is not a new theme in the pension world and has precedents in the Netherlands and Australia. They have appeared on the UK’s radar in the past two years as an alternative option for the declining and fragmented DB sector. Around two thirds of the roughly 5,600 UK schemes have a funding shortfall and the situation is likely to deteriorate in the current economic and political climate. Research from Mercer shows that in August alone the combined pension deficit of FTSE 350 companies grew by an estimated £16bn to £67bn as gilt yields were hit by fears of a global downturn and uncertainty surrounding Brexit.
To date, only two firms have thrown their hats into the consolidator ring, and each has their own particular spin. The Pension SuperFund is seen as a ‘destination’ vehicle which takes the reins from the corporate sponsor and looks to hold assets and liabilities over the longer term. The economies of scale generated can help drive down costs and improve investment returns to ensure that every pensioner is paid.
Clara Pensions, on the other hand, is often described as a bridge to an insurance buyout, albeit in a shorter timeframe, and pension schemes are kept in segregated sections.
The objective for both is similar – to reduce investment risk, strengthen governance and to wield greater influence over the fund management community. They are also seen as a cheaper route than the typical buy-out which insurance companies refer to as the “gold standard”. This is because consolidators are not subject to the capital and modelling requirements of Solvency II, which limits the types of asset classes insurers can invest in.
TEETHING PROBLEMS
The goal for the new breed, according to a report by KPMG, is to undercut insurance pricing by between 10% and 15%, depending on the profile of the pension plan. For example, for a scheme that is 70% funded against buy-out, the additional premium to move to a superfund could be half the cost. While price always captures the attention, the focus for many market participants is the regulatory discussions and wrangling between the UK government and regulators over the quantities of capital superfunds will need to hold to deliver on their pension promise. Last year, the Department for Work and Pensions (DWP) published a DB white paper which highlighted four options for defining capital adequacy for superfunds. These included three based on the current DB occupational pensions framework and one on an insurance-like structure.
We could see more interest and confidence being built after a few deals are done.
Alistair Russell-Smith, Hymans Robertson
Based on the DWP proposals, the government issued a consultation late last year canvassing opinion from market participants and watchdogs. It not only covered the capital buffers but also the wider regulatory agenda, minimum standards for authorisation and operation including governance, accountability and financial sustainability.
Criteria for transactions and supervisory processes were also in the mix. Feedback was expected in the autumn, but industry experts are unclear exactly when the results will be published given Brexit continues to overshadow almost every sector and the UK is likely to hold elections before the year end.
Opinions though have been aired. The Prudential Regulation Authority (PRA), which oversees insurance companies, but will not regulate superfunds, made it clear that it is in favour of stricter rules that mirror the industry’s Solvency II. In addition, it voiced concern over the risk of arbitrage between regulatory regimes and that “the insurance framework provides an appropriate model” for pensions consolidation.
The Pension Protection Fund (PPF), which would provide a safety net for superfunds if the vehicles collapsed, has also made its views known. While it recognises that superfunds have the potential to provide greater security for some schemes, it has said that unconstrained they “pose significant risks” to the PPF. It is calling for a detailed consideration of the inner workings of superfunds to guarantee that a robust regulatory charter is established.
In the meantime, The Pensions Regulator (TPR), which is expected to be tasked with the oversight and approval process, has launched its own guidelines. They not only aim to identify, assess and mitigate risk, but also assess whether the business model is financially sustainable, has strong governance and is able pay members’ benefits as they fall due. The Pension SuperFund and Clara are working closely with TPR as well as government officials to ensure they are aligned with any future rules. While the industry expected formal regulation to be finalised in this year’s Pension Bill, the jury is out as to whether it will see the light of day given the present political backdrop.
“I think we will see plenty of interest in consolidators, but regulatory uncertainty is holding activity back because of a lack of complete clarity on how exactly the TPR and PPF will view superfunds,” says Jos Vermeulen, head of solution design at Insight Investment. “As a result, I do not think we will see too many transactions being announced until there is more clarification.”
Alistair Russell-Smith, partner and head of corporate DB consulting at Hymans Robertson, adds that a lack of clarity over the authorisation process is partly to blame for transactions stalling.
“There are TPR guidelines and although they are recognised as a process, some trustees want to see a more formal regulatory regime,” he adds. “The other issue is that superfunds are new and there is no track record. We could see more interest and confidence being built after a few deals are done.”
THE 5% CLUB
While there has not been an onslaught of activity, interest has been sparked as evidenced in a study by Hymans Robertson called DB Consolidation: One year on. It shows that the two superfunds are sitting on a joint pipeline of £20bn worth of deals. The Pension SuperFund, which accounts for the bulk of this at £15bn, has already announced two transactions since its launch last year. The first is with an unnamed pension fund and the second is thought to be with a £300m UK pension scheme of a foreign-owned private company. Clara Pensions, which the report says has £5bn under its belt, has not made any public pronouncements.
In the near term though, the percentage of pension funds that are suitable for this type of arrangement is likely to be a fraction of the total universe – at perhaps just 5%. This could, of course change, and larger schemes may be attracted as the model develops and matures.
Initially, as outlined in the KPMG report, the first movers are expected to be pension plans where the sponsor is going through some form of transaction or restructuring, or those who are part of larger groups and their plans could impact the UK pension plan. This is reflected in The Pension SuperFund’s second deal.
Richard Williams, director of policy and communications at Clara Pensions, believes that size is definitely a factor when considering the consolidation model. He points to figures from the PPF’s Purple Book 2018 which show that of the 5,450 DB schemes listed, 35% have fewer than 100 members and another 44% have fewer than 1,000 members.
Williams notes that there are currently three options – to stay with the employer, although there may be a risk that if the sponsor is weak members will not get their full benefits even though they are covered by the PPF.
Then there is buy-out; a market which has doubled in the past year but is still nibbling away at the more than £2trn of liabilities on corporate balance sheets. “The consolidator or superfund model offers an alternative and Clara differentiates in that we offer an accelerated model to buy-out – achievable in perhaps seven to 10 years,” Williams says. “We are not the same as insurance. We are not subject to Solvency II and can invest in a broader range of assets.”
Antony Barker, managing director at The Pension SuperFund, also believes smaller schemes need an alternative. “A key problem is that around half of UK pension schemes are sub-scale and they have not had access to best advice. Maintaining high standards of governance has been a challenge too, as pointed out by the TPR consultation paper [issued in July on trusteeship and governance],” he says. “However, regardless of the size of their scheme, people getting the same benefit promise reasonably expect the same results and want their pensions paid in full.
We are not the same as insurance. We are not subject to Solvency II and can invest in a broader range of assets.
Richard Williams, Clara Pensions
“In many respects, consolidators and insurance companies are similar in that we both gain from economies of scale and superior management,” Barker adds. “However, a key difference is that if trustees want a full insurance buy-out, they have to get their portfolio into a nice matching transferable state and that costs several percentage points.
“That is not the case with us. We are a longterm run-off vehicle and the benefit we bring is our ability to invest in long-term illiquid and private market assets which can improve investment performance and generate surplus that we share with our members.”
IT’S GOOD TO TALK
Looking ahead, it is too early to determine the shape of the superfund industry and how many firms will join its ranks. Many though believe they will fill a gap and become a useful alternative to the other endgame choices available.
One of the challenges is making sure that communication channels are open, says Jo Holden, Mercer’s UK chief investment officer. “There will need to be enough transparency around their investments to make sure decisions around asset allocation can be aligned in advance,” she adds.
“Otherwise we could have a situation akin to trustees buying into a blind pool of private equity and debt. They are not subject to the same regulatory regime as insurers and while that may be reflected in pricing, there needs to be a good dialogue between trustees, members and the sponsor about the strategy.”
Sebastien Proffit, head of portfolio solutions at AXA Investment Managers, says that on paper, consolidation looks great, but in practice more time is needed to tell whether it is an ideal endgame. “At the end of the day, schemes need to look at the cost, governance and the ability of superfunds and all endgame solutions to pay pensioners.” He adds that to efficiently fulfil benefit payments many schemes are considering a cash-flow driven investment strategy. “The strategy may represent a scheme endgame in terms of self-sufficiency, or it could represent a suitable and beneficial step towards alternative longer-term approaches such as buy-out or consolidators.”
