With many defined benefit pension schemes looking to start their wind-up journey and transact a full scheme buy-in, understanding how the funding position affects the plan to wind-up has become more important than ever.
Test acceptable insurance terms and residual funding requirements for the full scheme buy-in
Take a realistic reserving approach for running costs through to wind-up
Consider pragmatic mechanisms for managing funding shortfalls
Understand rule provisions on 'use of surplus' and 'triggering wind-up'
Set investment objectives carefully, before and after the buy-in transaction
Identify uninsured liabilities and benefit complexities early, and assess their impact on post‑buy‑in funding and execution
Understand the accounting and commercial implications for the sponsoring employer
What could change, and when?
Buy-in terms: In most cases this is the single biggest influence on the ultimate funding position, but effective advance planning can be informed by strong market insight and detailed scheme-knowledge. Pricing and price-lock mechanisms will become clearer through the insurance tender process, allowing 'Plan A' to evolve
Investment outcomes: Short-term mismatches between asset values and buy-in pricing, option terms or the planned use of surplus can lead to plans having to change. Haircuts on the sale of illiquid assets and investment of residual scheme assets following buy-in should also be considered
Other factors: As the wind-up progresses there are many reasons why the cost of securing benefits or the cost/length of the process itself may not be as expected:
Terms for option exercises and take-up rates
Data cleaning
Changes to insured benefits and data true-up costs
Insurer/administration capacity
Implementation of GMP equalisation and other benefit rectifications
Compensation arrangements (eg for uninsurable benefits such as underpins or legacy with-profit policies)
Unexpected changes in legislation or past execution issues
Member disputes
Protections for residual risks at wind-up
What if we're expecting a funding shortfall?
Close collaboration between sponsor and trustee (eg through a joint working group) can lead to efficiencies if funding shortfalls are expected whilst still pursuing wind-up, potentially through:
Understanding mutually acceptable ways to manage buy-in costs (eg future insured terms for member options, or codifying discretions)
Recognising the impact of a schedule of contributions in place before wind-up is triggered, particularly if that includes deficit recovery funding, and agreeing pragmatic approaches for additional funding
Innovating with illiquid assets to avoid large haircuts on sale
Using an escrow account to manage contribution/expense requirements and avoid unexpected surplus or costly processes to recover an employer debt
What if we're expecting a funding surplus?
Rules provisions are key to the impact that surplus has on the wind-up process – for many schemes a material surplus is likely to mean a more complex project with greater reliance on good governance and potentially longer timescales to completion.
The more the pension scheme's rules direct on the use of surplus, the easier it is to plan ahead, even though the interests of sponsor and trustees could differ significantly.
Rules direct surplus to be refunded to the sponsor: The allocation of residual funds is clear, once the right benefits and residual risk protections have been secured and expenses paid. The sponsor's accounting position and desire/need for cash is likely to influence the plan if the surplus is material
Rules direct surplus to be spent on members (or not refunded to the sponsor): Again, the allocation of residual funds is clear, but if triggering wind-up requires sponsor agreement, then this may influence outcomes
Rules involve less clear-cut direction on surplus allocation: Even greater care is required when rule provisions require agreement between sponsor and trustee, or introduce trustee discretion, particularly if the surplus is expected to be material. Again, the power to trigger wind-up may be influential in discussions on use of surplus in wind-up. Member expectations can also play a significant role in determining a workable approach
Either way, wind-up plans involving surplus are generally longer and more complex. This could be because of additional communications to members required by law over sponsor refunds, designing member benefit improvements that are fair and practical, needing to accurately identify all member benefits (including equalising GMPs) and residual assets before insuring further benefits, or simply taking longer to design and agree the approach.
Final thought
The funding position plays a critical part in the formation and evolution of an efficient plan to wind-up any pension scheme. The earlier these issues are considered and preparations for risk transfer (such as cleaning data and analysing benefits) can start, the better risks can be managed in the post buy-in phase.
