Superfunds have set their sights on almighty chunks of the defined benefit universe, but in conversation with trustees who may find themselves approving consolidation deals, Pensions Expert finds that the market for 'buyout-light' may be narrower than expected.
In the six months since the project was announced, the consolidator has secured and then lost the services of a high-profile chief executive in Alan Rubenstein, former head of the Pension Protection Fund.
Head of origination Marc Hommell has also left the fund, along with Warburg Pincus, one of the project's private equity backers.
Yet despite the drama, the PSF still has its sights set on winning an almighty chunk of the UK’s defined benefit business.
The consolidator vehicles where they are severing covenant have got to be prepared to kiss a lot of frogs before they land their prince
Steve Delo, Pan Governance
Luke Webster, chief financial officer at Truell’s Disruptive Capital and Rubenstein’s replacement at the helm, estimates the PSF's target market at between £200bn and £250bn in “liabilities that are suitable as of today”.*
Earlier this month, he said: “As more schemes close, we would expect that to grow to about £500bn over the next five years."
In comparison, the total DB liabilities in the PPF universe stand at around £1.6tn, albeit valued on the PPF’s section 179 basis. Still, realising that ambition would involve one company taking on responsibility for nearly a third of the pensions accrued in the UK.
Clara Pensions, the only other consolidator to emerge thus far, aims instead to hold assets before eventually transferring them to an insurer, and has a more conservative target of £5bn in its first five years.
Trustees still wary
Trustees, it would seem, are less sure of the suitability of commercial consolidators for wide swaths of the market, and in conversations with Pensions Expert board members and their advisers have poured cold water on Webster’s heady ambitions.
Some are suspicious of watering down the protections provided by insurers under the Solvency II directive. A trustee of a banking scheme who asks to remain anonymous says despite superfunds’ current cooperation with the Pensions Regulator, the lack of formal regulation for commercial entities in the pensions arena is worrying.
“There need to be rules governing capital adequacy, stress-testing, solvency, and is there a case for being less onerous than what’s already there?,” he asks, adding that a solution ending up in the bulk annuity market “has got the potential to work”.
Others are simply sceptical that the money injected into a consolidation vehicle could not be put to equally good use in the scheme.
“If superfunds are going to be the solution to everything then you are relying on efficiencies bridging the funding gap,” says Brian Spence, founder of Dalriada Trustees. “There’s also a lot of efficiencies you can get without needing to merge the schemes.”
Spence says a “culture change” could benefit the pensions industry, with trustees currently spending hours in meetings “listening to investment managers who set their own agendas”. Concrete steps like cash flow-driven investing could eliminate the balance sheet volatility that proves so irksome to sponsors, he adds.
Looking past marketing claims
There are situations in which transferring to a commercial consolidator might see a weak covenant exchanged for a meaningful injection of cash into the scheme, and therefore represent a sizeable gain in terms of member security.
Steve Delo, managing director of trustee company Pan Governance, points to schemes with a weak UK sponsor owned by a wealthy multinational as the ideal target.
UK schemes have a weaker claim to assets in this scenario, and the parent may be happy to stump up cash to rid itself of balance sheet volatility.
But equally, he says complex enhancements trustees may have secured for their covenant could make it “quite complex to actually extract themselves to one of these vehicles”.
He says: “Severing the covenants link needs to be very carefully thought through. There are probably scenarios where the trustees could conclude they are better off but they are going to probably be limited ones,” and calls the PSF’s £500bn claim “a marketing aspiration”.
Weaker covenants may provide happy hunting
For trustees to sign off on a transfer into a superfund, they will have to be assured that the covenant they give up is worth less than the extra funding they receive – a hurdle not just for boards but also for ambitious consolidators.
If schemes have a strong covenant, they should not approve a transfer, on the basis that they are likely to be able to pay their benefits in full via self-sufficiency or a bulk annuity contract.
With gilt yields and funding levels generally rising, that may put many schemes in a position where they are too well off to escape scrutiny by the regulator if they approve consolidation.
“I would think it slightly odd if a trustee moved into a consolidator two, three years from buyout,” says David Fairs, the regulator’s executive director for regulatory policy, analysis and advice. “The onus is on trustees to say, ‘What are our options here, is buyout realistic?’.”
If well-funded schemes are off the menu for consolidators, schemes with a weaker backer may be a more realistic prospect. Analysis by the Pensions and Lifetime Savings Association has suggested that employers best suited will be those in what the regulator and PPF call covenant group 3, and selected employers from covenant group 4, the weakest classification.
Conflicts for trustees?
Many in the industry were pleased to see notable trustees take up position on the board of Clara Pensions earlier this month. However, the appointments do bring with them conflicts of interest.
Namely, a trustee could find themselves on both sides of the negotiating table, or at least facing a colleague from their firm.
Alan Pickering, Clara Pensions' first chair of trustees, sees this as a conflict to be managed carefully, not unlike where a trustee firm is involved with two schemes during corporate activity.
“All trustees can stand aside from their trusteeship during a project,” he says, adding that his duty not to endanger Clara Pensions would likely mean stepping back from the ceding scheme during discussions.
In fact, he plans to use his experience on regular schemes to deliver a proposition that is truly beneficial to the industry and members, and says Clara Pensions' insurance endgame gave him more comfort about taking the job.
“As a ceding scheme trustee I would want reassurance that the receiving consolidator wasn’t going to give my members short shrift… [and] was going to honour both the quality of the benefits and the quality of the service to which I hope my members have become accustomed,” he says.
Can weak employers afford it?
Of course, employers in these groups are typically cash-strapped. The PLSA has previously discussed the possibility of payments being made in instalments, although no proposition has yet come to market.
If they are able to pay the cost of entering a superfund, trustees might reasonably ask why that money was not put into the scheme at a previous juncture.
“If an employer does come along and says, ‘We’d like to move to a consolidator’, clearly there’s a significant cash commitment that will be needed. Trustees will need to ask, ‘Well where did that money come from, why wasn’t it at the last valuation?’,” says Rob Dales, director at JLT Employee Benefits.
From a company perspective, it may however be much easier to borrow the money needed for contributions if they are an exit fee rather than plugging funding hole that could reopen, Dales explained.
Nonetheless, there is an increasing tendency to see ‘buyout-light’ consolidators as being suitable for a specific tranche of the DB universe.
“We generally suggest that the targetable market for these consolidators is 10 or 15 per cent of the market,” says Alan Baker, Mercer’s DB risk leader.
Superfunds will need patience
That would still leave between £162bn and £244bn for consolidators to chase, and indeed some deals do appear to be getting through to advanced stages.
Webster estimates that the PSF has made contact with between 20 and 30 schemes. Of those, around a dozen have progressed to “well-developed conversations”, with “a smaller number... further along the line”.
However, trustees can be a flighty and cautious bunch. “The consolidator vehicles where they are severing covenant have got to be prepared to kiss a lot of frogs before they land their prince,” says Delo.
Regulation still far away
One thing that might give trustees more certainty is a formal regulatory environment. Fairs admits that the current environment, where superfunds are voluntarily complying, is “a little bit uncomfortable”.
He anticipates that regulation of the nascent sector may look similar to the authorisation regime for defined contribution mastertrusts, with additional capital requirements.
However, this looks some way from completion. Royal London director of policy and former pensions minister Steve Webb holds out hope for a pensions bill in 2019 despite Brexit hangovers, but cautions that it will be some time before superfund regulation is passed and implemented.
"You need to assume that the regulatory regime for superfunds will be the current one for the foreseeable future," he says.
*An earlier version of this article incorrectly quoted Luke Webster as predicting that the Pension SuperFund would take on between £200bn and £250bn in liabilities. This was in fact his estimation of the total target market for the company.
