The Pensions Regulator (TPR) has published a guidance framework for defined benefit (DB) superfunds and related DB consolidation vehicles.
What are the key points from TPR's guidance?
1. Superfunds must clear a high bar before they can transact
Most of TPR's guidance is aimed at superfunds themselves, setting standards of governance, funding and other matters which they must meet before they can take on assets and liabilities from existing pension schemes.
2. There are also requirements for employers and trustees to clear before trading with a superfund
Trustees should only contemplate a transfer to a superfund if they do not expect to be able to buy out benefits in the foreseeable future. Five years is given as an example of what TPR envisages the foreseeable future meaning (this is also the period set in the recent Government consultation on statutory superfund regulation). Employers are expected to apply to TPR for clearance in advance of a transaction.
3. The publication of the guidance removes a barrier to transactions
So far, no transactions with a superfund have completed. The publication of TPR's guidance fills a void in the regulatory structure relating to superfunds. We expect the publication of the guidance will enable some transactions to go ahead and this will serve the interests of certain (not all) pension schemes and the employers which sponsor them.
Background to superfunds
Superfunds, or consolidators, have emerged as a recent innovation in the occupational pensions market. They are consolidation vehicles, into which existing DB occupational pension schemes can transfer their assets in return for the superfund assuming the liabilities. An additional employer contribution may be needed to ensure that the assets are sufficient for the superfund to be willing to take on the liabilities.
They therefore provide the advantages of scale, in both administration and investment. However, they also involve the original pension scheme severing the link to its sponsoring employer. To replace the employer covenant, superfunds have a capital buffer, made up from the employer contribution and funds from external investors. Returns in excess of those needed to fund the pension liabilities to a defined level can be used to provide a return to investors. Click for more detail on how superfunds work.
Although two superfunds have been in the market for some time now, with more considering entering, at the time of publication of this Insight none have actually completed a transaction with an occupational pension scheme. In large part, this is due to the uncertainty over how superfunds are to be regulated.
The Department for Work and Pensions (DWP) has consulted on legislation to regulate superfunds, but this was not included in the current draft of the Bill.
We now have an important development in that regard, with TPR having issued interim guidance. It is interim guidance because more detailed legislation in the form of regulations is still expected. However, the interim guidance will enable transactions to take place.
Key aspects of the guidance
Click for the full guidance.
The following aspects listed below are of particular interest:
Standards for superfunds
Most of the guidance is taken up with operating requirements for the superfunds themselves, rather than guidance for trustees of pension schemes that are considering (or whose employers are considering) a transfer into one. The existence of these requirements will give greater confidence to trustees of transferring schemes.
The requirements for the superfunds can be divided into the following broad headings:
- Governance - in particular, there will be a 'fit and proper person' test for key individuals in the management of a superfund, and superfunds must demonstrate a "robust approach to governance".
- Operations - superfunds must have suitably robust information technology and administration systems.
- Member relations - superfunds must satisfy TPR on their approach to member communication and complaints handling.
- Solvency - superfunds must be sufficiently well-funded, and the Regulator has prescribed minimum actuarial assumptions that it must apply when determining its funding position. There are prescriptive restrictions on how superfunds may invest their assets. Additionally, it must have a plan for what will happen to secure member benefits if the superfund has to be wound up.
- Regulation - superfunds must be HMRC-registered and eligible for the Pension Protection Fund (PPF). As occupational pension schemes, they fall under TPR's jurisdiction. In addition to all the requirements that apply to any occupational scheme, TPR expects them to demonstrate how they meet its expectations in the superfund guidance before they transact, and on an ongoing basis thereafter.
In addition to the above, there are details on how the relationship between the constituent parts of the superfund (its pension scheme and its capital buffer) must operate, and on when profit can be withdrawn. We cover those separately below.
Access to capital buffer
Because the capital buffer replaces the employer covenant, it must be accessible to the superfund pension scheme when needed. There are two triggers which must be built into the superfund's legal structure.
- Low funding trigger - the assets in the superfund (i.e. its pension scheme plus the capital buffer) must cover its liabilities as calculated on the minimum actuarial basis set out in the guidance. If this trigger is met, all assets in the capital buffer must flow into the pension scheme.
- Wind-up trigger - if assets fall below 105% of the Pension Protection Fund funding level, the superfund must be wound up and members transferred to a different arrangement, unless a special dispensation is given to the superfund to continue in existence.
The first of these triggers will provide comfort to transferring trustees, by making it more likely that they will receive the benefit, if necessary, of the capital buffer on which they are relying in order to sever the link to the existing employer covenant.
The second trigger, on the other hand, is primarily designed to protect the Pension Protection Fund from having a superfund fall into it.
Profit for investors
During the initial period covered by the guidance, no funds may be extracted in profit, or to provide a return to investors, until the pensions benefits are fully bought out with an insurance company. This is intended to align the interests of the investors and pension scheme members, and thereby avoid creating an incentive for the superfund managers to put members' interests at risk in order to deliver a faster return to investors.
There are also anti-avoidance provisions to deter superfunds from disguising a distribution of profit as some other form of payment, or from finding loopholes.
TPR will review this position with a view to updating it within three years.
Guidance for transferring trustees
Although the greater part of the guidance concerns standards for the superfunds themselves, there is also detail on TPR's expectations for what should happen before the trustees of an occupational pension scheme agree to a transfer to a superfund.
Superfunds are not appropriate for schemes that are on course to be bought out with an insurance company in the foreseeable future. Five years is given as an example of what the "foreseeable future" might be. This is therefore slightly less prescriptive than the DWP consultation.
The employer in relation to the transferring pension scheme is expected to go through TPR's clearance procedure. In broad terms, the clearance procedure exists to provide comfort that TPR will not exercise its moral hazard powers in relation to a transaction, by having TPR scrutinise it in advance. As part of this scrutiny, TPR will expect to see the due diligence carried out by the ceding trustees on the superfund.
TPR has already published separate guidance for trustees which are considering a transfer to a superfund.
What does this mean for employers and trustees?
TPR has had to find a balance between ensuring that the standards it is setting for superfunds are tough enough to protect members, but not so tough as to block transactions that would have delivered a better member outcome than the status quo, or to stifle innovation.
It remains to be seen whether it has this balance right. It seems to us that TPR has tried to set a high bar for superfunds but not so high as to result in schemes which could have benefited from the superfund model being priced out. Tough standards are desirable in order to build confidence in the product, although the Association of British Insurers (which is, of course, familiar with the standards that apply to regulated insurers) has warned in strong terms that the guidance does not, in its view, go far enough.
The two main players in the market – which, incidentally, have very different business models and will be differently affected by the guidance – have both welcomed the guidance.
Whether or not the guidance is tough enough, the fact that it has now been published is likely to open the door to transactions with superfunds going ahead, as the existence of the standards will enable trustees of transferring schemes to have confidence in the arrangement.
There will still be costs involved, because trustees will need to carry out their own due diligence on the superfund, and the employer will need to go through the clearance process. However, those costs would be higher if it were not for TPR setting the basic standards.
We do not expect superfunds to be relevant to the majority of defined benefit pension schemes. For most, the ultimate end-goal will remain buy-out with an insurance company. This provides the greatest security for member benefits.
However, for a significant number of schemes, and their employers, which are not so fortunate as to be confident they will buy-out in the foreseeable future, superfunds are an attractive concept. They are particularly appropriate for schemes which:
- are relatively well-funded (making the superfunds' pricing affordable); and
- have relatively weak employer covenants (making the capital buffer look attractive by comparison).
The advantage for the employer is that they relieve it of the obligation to fund the defined benefit pension liability, at a considerably lower cost than an insurance buy-out.
With COVID-19 placing greater strain on employer covenants, and increasing the likelihood of an insolvent outcome for schemes, there is an additional category of schemes for which superfunds may be attractive, i.e. those which are likely as a result of employer insolvency to be forced to wind-up, and can afford to secure benefits that exceed PPF compensation but cannot afford to secure full scheme benefits with an insurer. A transfer to a superfund enables a greater proportion of scheme benefits to be secured (because of the lower pricing). Click for more detail on distress scenarios, and the various options available (of which superfunds are one).
We therefore expect the publication of the guidance to result in transactions with superfunds being completed. The challenge for the industry as a whole is to ensure that these transactions are well-handled, such that the effects are positive not only for the superfunds and their investors, but for pension scheme members and employers.