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Article | Pensions Briefing

Pension funding – cash is king … or is it?

Could a non-standard funding solution help meet the needs of all stakeholders?

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By Tom Wood and Dev Gandhi | November 13, 2018

Traditionally cash contributions or banking on future investment returns have been seen as the main options to fill pension scheme deficits. Tom Wood and Dev Gandhi explore potential alternatives available to trustees and sponsors to fund their Defined Benefit (DB) pension scheme deficits where an acceptable traditional solution cannot be agreed.

Why now?

While many DB pension schemes in the UK have seen improvements in their funding positions over the last few years and some are close to their self-sufficiency or annuity purchase targets, a significant number of schemes still have sizeable deficits and a long time horizon over which the pension scheme needs support from its trustees and sponsor.

Neither trustees nor sponsors have a crystal ball to tell them how key macroeconomic factors or life expectancy of the population will develop and affect a particular pension scheme

Importantly, there is uncertainty around these deficits and neither trustees nor sponsors have a crystal ball to tell them how key macroeconomic factors or life expectancy of the population will develop and affect a particular pension scheme. Trustees are rightly concerned with how adverse scenarios might affect their schemes and sponsors are apprehensive that positive experience might lead to surplus being trapped within the scheme.

Given this potential divergence of views on the appropriate level of funding, and in the context of The Pensions Regulator’s increasing emphasis on working towards a long term target, it may be worth considering whether non-standard solutions could supplement the traditional levers of cash and investment return.

What options are available?

A range of options are available which provide contingent funding if a pre-determined event occurs. The appropriate solution will depend on the specific circumstances. Some of these are detailed below:

Figure 1. Types of alternative funding solutions

 

Why choose an alternative?

A cash only recovery plan may not provide the security or flexibility that both parties involved in funding agreements require

A cash only recovery plan may not provide the security or flexibility that both parties involved in funding agreements require. Alternative methods of funding the scheme can both protect members’ benefits and allow the sponsor to have greater flexibility. The benefits realised will depend on the solution implemented but may include:

Figure 2. Potential benefits of alternative funding solutions

Contrary to popular belief, not all of these solutions need to be complex or expensive and aren’t inaccessible to all but the largest schemes. In fact, they might allow a lot of schemes to find a compromise in the funding agreement more quickly and efficiently.

What should schemes consider before they consider alternative funding?

Schemes ultimately need to find a funding solution that works best for the specific parties involved. Before settling on a solution, trustees and sponsors should consider which option provides the best outcome for their members of the scheme, the sustainability of the sponsor and for the scheme’s long term goals. Sponsors and trustees alike should consider how any funding solution stacks up against other risks the scheme faces, such as the investment and covenant risks. Any funding agreement is multi-faceted and expanding the range of tools that can provide security and/or funding might just help trustees and sponsors more easily reach a mutual agreeable outcome.

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