Companies offering a cheaper alternative to buyout have unions and others concerned about letting defined benefit employers off the hook via regulatory arbitrage, writes CMS’s Caroline Kurup, but consolidators remain attractive where insurance remains the end point for scheme liabilities.
The key advantage is access to scale. Consolidation results in lower running costs per member, improved access to investment strategies, lower investment costs and better quality governance.
Unions and others are concerned that employers may be permitted to jettison their schemes on the cheap
These improvements could make a real difference to member outcomes if the economic gains of consolidation are used to enhance member security, rather than just compensate capital.
On the other hand, ‘buyout-light’ solutions have raised concerns in some quarters. Are they a poor substitute for the promised land of insurer buyout?
Regulatory void presents risks
The key risk is that schemes are separated from their employer covenant and instead these long-term liabilities are transferred into a consolidator vehicle that escapes the regulation imposed on the insurance industry, in particular the capital requirements.
The charge levelled is regulatory arbitrage. Unions and others are concerned that employers may be permitted to jettison their schemes on the cheap.
They say members will not benefit from Financial Services Compensation Scheme protection or Prudential Regulation Authority regulation, but will be forced to rely in the long term on the already overworked Pensions Regulator for oversight and protection.
This is all (at least until a forthcoming regime is developed) without a dedicated regulatory framework in place for DB consolidation vehicles. But in the meantime the market is moving at pace and transactions are, apparently, imminent.
Weaker covenants make less attractive business
One angle to consider is the slice of the market that consolidators are targeting.
Schemes with a weak employer covenant are obvious candidates for consolidation since the transition is likely to be clearly in the interests of scheme members, but stronger schemes with solid employer covenants (who have the capital necessary to join a consolidator) are attractive propositions for consolidators.
The trustees and sponsoring employers of the targeted schemes should act as the protectors of members.
The fiduciary obligations placed on trustees will require them to be satisfied that any move is not expected to be to the detriment of the members, and most trustees will want to feel that there is likely to be a meaningful improvement for them.
This will inevitably require trustees to weigh up the existing employer’s covenant against the strength and expected upsides of a consolidation model. Employers will also be concerned not to fall foul of the Pensions Regulator’s moral hazard powers or to cause problems for their workforce.
Warehousing holds promise
It is important to bear in mind that the emerging consolidators do not have the same structures or solutions.
One alternative in this new market provides a different proposition: a consolidation vehicle that offers an interim step on the path to buyout.
This would work as a warehouse for schemes’ assets and liabilities until the assets are sufficient to allow a move into the ‘gold standard’ insurance market.
The cost for the employer is closer to what they would expect buyout to cost over time and therefore lower than today’s price; and the intention is to transition to buyout, rather than stay out of the safe haven of the insurance market indefinitely. The concern of arbitrage (which is argued by some to put consolidators into a position of unfair advantage) therefore does not arise.
This approach recognises that the best home for long-tail liabilities of this nature is the insurance market.
After all, insurers have been managing this type of risk for longer than anyone else and their regulatory landscape continues to develop to meet the particular challenges faced by these insured risks.
It facilitates an acceleration of derisking for both members and sponsors, without compromising the end game.
Do not write off consolidators
Consolidators do hold the future for certain DB schemes. The question is how best to do it. Employers will engage because they have the opportunity to remove significant volatility from their balance sheets, for good, at a price they are willing to pay today.
Trustees will be incentivised if they can be persuaded that the model is in the interests of the members. Members can benefit from scale, with the advantages that confers.
That proposition becomes even more attractive if the clear medium-term plan of the consolidator is to move the assets into the insured buyout space.
Caroline Kurup is a partner in the pensions team at law firm CMS’s London office
