For most defined benefit (DB) pension schemes, funding positions have never been better. This is a reason for action rather than complacency as the environment could change, certainly over the timeframes of DB schemes. Pension trustees should have a clear plan to take advantage of current positions.

Setting and delivering a strategic plan is in everybody’s interests – trustees, members and sponsoring employers. Removing volatility in what has traditionally been a key corporate liability involves working together constructively, elevating a non-urgent issue up the corporate agenda, to agree a positive way forward. In the case where a pension scheme sponsor could be weakened by debt restructurings or corporate transactions, improved funding levels give the trustee board the opportunity to address the impact on the scheme at a lower cost and in a way that is more sustainable.   

The opportunity

Overall, DB scheme funding has never been better. The Pensions Regulator (TPR) 2023 Annual Funding Statement estimated an aggregate surplus across DB schemes at the end of 2022 to be £79bn and that around 25% of DB schemes have enough money to buy-out.

Thanks to strong growth in return-seeking assets and high interest rates, funding positions of all but a minority of DB schemes should be ahead of plan. Neither of these factors is certain to continue for the long term and geopolitical risks remain high which, as shown by the impact of Russia’s invasion of Ukraine, bring risks to economies globally. Before things change, pension trustees have a real opportunity to ensure they capitalise on their current strong funding position in the long term interests of their members.  

The traditional solution

One option for many DB pension schemes is buy-out. At least in theory it is. As Hymans Roberston stated in their 2024 Risk Transfer Report, “If 2023 was about demand, 2024 is likely to be about supply.” Around 25% of the £1.4 trillion DB market is currently able to afford buy-out. The total buy-out capacity in the market last year was of just over £40bn.

As noted by Hymans Robertson’s report, new firms entering the market will increase capacity but insurer consolidation (such as Rothesay’s recently announced acquisition of the Scottish Widows bulk annuity portfolio) could decrease it. One thing we can be sure of is insurers can afford to be choosy about who they transact with. So, pension schemes looking to buy-out need to ensure they prepare well, including having excellent data quality. 

The other solutions

Superfunds provide an interesting alternative for DB schemes that cannot currently achieve buy-out, as demonstrated by the recent transaction with the Debenhams Retirement Scheme where Vidett acts as Chair of the Trustee. The problem is there is only one superfund listed by TPR so this option has only a fraction of the capacity of the buy-out insurance market.

This leaves pension trustees to consider how best to ensure they can have confidence the scheme will always be able to pay benefits, ideally without material reliance on the employer. They also face a new question of whether buy-out or run on would be better, with the forthcoming consultation on surplus withdrawal raising interesting issues.

The complicating factors

As ever, any trustee strategy will need to be grounded in what is best for members. However, as shown by the current complaints by BP pensioners around discretionary increases and the value of their pensions, this is not as clear cut as it was once assumed to be.

It can be a balancing act, further complicated by the ‘covenant horizon’ – a concept developed alongside TPR’s DB funding code – how long an employer’s ability to support their scheme can be relied on for.

Current insolvency levels are the highest they have been since 2009. That said, 80% have been creditors’ voluntary liquidations (referred to as CVLs) so triggered by the companies themselves and they are overwhelmingly small companies which generally do not sponsor DB pension schemes. 

Levels of merger and acquisition activity also remain subdued. However, with high interest rates, many companies are facing increased borrowing costs as fixed rate debts reach maturity. Reduced serviceability ratios (a measure of a borrower’s ability to meet debt repayments) could trigger harsher conditions, including the need for security provision and increased costs for debt. This will impact the security of the DB pension scheme’s position.

Whilst covenant threats are at muted levels, it is important for pension trustees to be vigilant, maintaining strong communications and positive relationships with employers. Better funding levels give greater options for both trustees and sponsors. Taking action to reduce scheme volatility or remove pension risk altogether (through buy-out) can both increase security for scheme members and stimulate corporate activity.

The £4.8bn Boots pension scheme buy-out in November 2023 is a good example of a transaction which was in members’ interests and an enabler for corporate activity by reducing potential balance sheet volatility. It is telling that Wallgreens announced they were reviving plans to sell the business a few weeks later.

All this underlines the need for a positive working relationship between a pension scheme’s trustees and corporate sponsor to agree a clear strategy to take advantage of current funding levels in a way that works for both the employer and scheme members.

To learn more about the above, please contact the author Mike Birch – who sits in our corporate transactions, M&A & refinancing and sponsor financial distress & restructuring teams.

Please note this piece originally featured in Professional Pensions.