Pensions Playbook: Investing in the UK

Andrew Block

Hello and welcome to our series, Employment and Benefits Unpacked, where we dive into the many employment, benefits and mobility issues facing organisations across jurisdictions. Each episode will be hosted by a different Mayer Brown partner from our global employment and benefits group. We'll be offering fresh perspectives and insights for employers, HR professionals and in-house council. You can subscribe to this series on all major platforms. I'm your host for this episode.

I'm Andrew Block and I co-head the Pensions team in our London office. I'm delighted to be joined by Gareth Davies, who is a senior associate in our London Pensions team. Today, we're going to be looking at Pensions issues which arise when investing into the UK. Before we make a start, if you'd like us to cover a particular topic in a future episode, please email us at unpacked@mayerbrown.com. So let's get going.

Our focus today is to demystify the types of UK pension arrangements. We'll also spotlight the regulatory and funding dynamics that matter on deals and then look at the new hot topic of surpluses and how they might be used in practice. Let's start by mapping the terrain. Defined benefit, defined contribution and collective defined contribution with the odd non-standard arrangements still out there. We're not going to look at bespoke arrangements for executives such as international self-invested personal pensions or small self-administered schemes, we'll be here all day. But if you are interested in UK bespoke arrangements for senior people, please do drop me a line. One other point before Gareth talks about the different types of schemes. In the UK, all defined benefit and many defined contribution schemes operate through trust-based structures rather than contractual arrangements. It's crucial to understand that a UK trust is not the same as a US trust. Here, trustees are the decision makers and act as fiduciaries with duties imposed on them both by general law and specific pension legislation. And hybrid arrangements exist and we'll come on to them later. So now over to Gareth, who is going to talk about the different types of scheme in a bit more detail.

TYPES OF UK PENSION SCHEMES

Gareth Davies

Thanks, Andrew. So if I start with defined contribution or DC schemes, because they're generally the most straightforward types of arrangements in the UK. So they are quite similar to what's called a 401k in the US. And that's the type of pension scheme that most employers now provide in the private sector for ongoing benefit accrual.

And effectively, it's case of making contributions for the employee and the employee making contributions on a monthly basis. Those money go into the member's pension pot, which is invested and intended to grow over time. And then it is used on retirement for various different ways. So from an investor's point of view, you would be looking at what the employer's liability is towards those schemes.

And from an employer's perspective, the risk profile is pretty well contained. So the commitment is to a contribution structure. So making a certain percentage of pay as a contribution to the scheme on a monthly basis. Making sure that the employer's on top of that. Making sure that the employer automatically enrolls workers into the scheme, which is a requirement in the UK, and being on top of any statutory communications to employees about their pension arrangements. So relatively straightforward. That said, the regulation is starting to tighten for DC schemes in the UK. So we're now shortly going to have a regime called the Value for Money regime, which is moving away from employers just looking for the cheapest arrangements and trying to encourage them to consider value for money in pension schemes, which might not be the cheapest arrangement, but it's looking at things like longer term governance, investment performance, and retirement outcomes and member engagement and so on. And what that means for employers is that there will now be a more engaged process in choosing and monitoring what scheme they offer to members. And also there's a general pressure towards consolidation. So lots of smaller schemes in the UK.

Being encouraged to consolidate into larger schemes, which will have economies of scale, theory, better governance and access to more sophisticated investment strategies. So investments in things like private assets. So that's defined contribution schemes. If I now move on to what are called collective defined contribution pension schemes. So these are a very new type of scheme in the UK. There's currently only one of them, which is the Royal Mail pension scheme. At the moment, the government is looking to expand this type of vehicle, but so far there's only one. And the idea is that they are defined contribution schemes, but rather than leaving the members eventual pension outcome entirely to investment returns, the idea is that there's a target income for the member, but it's only a target and it's not guaranteed. And the collective side of them is that unlike a normal defined contribution pension scheme, there's an element of risk-sharing between the membership. Risks that members live longer than anticipated and risks relating to investment, those are shared across the membership. They're not just born on an individual basis. So that, to that extent, they're different to normal DC schemes from an employer's perspective and therefore from an investor's perspective.

The idea is that employer contributions are fixed just as they are for DC. So in theory, there is no additional financial risk on employers relative to a normal defined contribution scheme. So that's the idea. There is a risk that those types of schemes become more regulated over time, which is something like what happened to defined benefit in the pension schemes in the UK, which I'll come on to, in order to make what ought to be a target to become more of a guarantee. That's a risk that future regulation could tighten up around these schemes and it's difficult to predict where that might go. Certainly not the intention of the current legislation. But we shall see on that one. The other thing is these schemes do need scale. They would need, they can't start from scratch. There needs to be significant numbers of members in on day one for the risk pooling to work. And that's partly why there's only one of them at the moment, which is large.

Royal Mail pension scheme. So we shall see how this one develops. These schemes have been in operation in the Netherlands for some time. That regime is being reformed in the Netherlands because of defects that have been identified with it. There's a sense of a lack of transparency for members on how much money they've got set aside in the scheme and also a lack of transparency for members on their eventual pension outcomes.

So the Netherlands are a little bit further ahead on this and they're moving towards a slightly different arrangement. So we shall see whether or not the UK follows their lead. So we've spoken about defined contribution, collective defined contribution.

DEFINED BENEFIT:  FUNDING & DEFICITS

The rest of this podcast is talking about defined benefit pension schemes, which for investors in the UK are significantly, represent significantly more of a risk and far more complications.

And so they're often quite a large driver on transactions. And the main reason for that historically has been that a defined benefit pension scheme, it provides a guarantee to the member as to what benefit they'll get on retirement. And for that reason, there's a possibility of a deficit arising in the pension scheme and the deficit has to be met by the employer. So the way they normally work is that there's a formula.

It would normally be years of service as a percentage of final salary and the employer stands behind it. So if the schemes assets are insufficient to be able to meet the benefit promise, that creates a deficit which the employer has to stand behind and that creates risks for investors. It creates a lot of volatility on funding. It's very sensitive to markets, forces and a balance sheet exposure.

And so when there's a funding fall short, there's a need to put a recovery plan in place. And that may also mean having to put the contingent support brought in from other group companies. So the way that the funding works is that every three years, schemes, DB schemes have to do an actuarial valuation. And then there's monitoring of the funding level in between that.

And the scheme will have its own way of valuing its liabilities. If the valuation shows that the liabilities exceed the assets of the scheme, or if the scheme still has got members building of benefits, that means the employer will need to make contributions to the scheme over a period of time. And as I've said before, most Tribal sector employers in the UK do now have defined contribution arrangements in place, particularly for newer employees, but there are still lots of defined benefit schemes out there, which are either legacy schemes or they are still in place for benefit accrual for members who would join the company a long time ago, the time at which they could join the scheme. So that's the way funding works. Another point to bear in mind in investments and transactional activity is something called the employer debt regime, or what's known as the Section 75 regime.

And that's effectively a debt that can be triggered under the legislation on certain events happening. And one of which is where an employer ceases to participate in a scheme with multiple employers, for instance, if it's subsidiary that's sold outside of the group. And that debt can be quite large because it’s effectively the amount of money the scheme would need to be able to go and secure its benefits with an insurance company, which is a very, it's the most expensive way of measuring the scheme liabilities.

And particularly in relation to schemes heavily in deficit or industry wide schemes, where we've got lots and lots of employers participating, those debts can be quite material and they can crystallise in quite an unexpected way. So often cause difficulty on transactions if they're not planned for. There are ways of managing them which don't involve paying them. Paying them is one option, but there are other ways of managing them. But that normally requires quite careful engagement with the trustees of the pension scheme and possibly the UK's pensions regulator. So another concept for the defined benefit scheme regime is called the employer covenant. And that's effectively the strength of the employer's backing of the scheme from a financial and legal perspective. And transactions will often have an impact on covenant, which might get the trustee concerned. So for instance, heavily leveraged transaction, granting security.

That may put the scheme in a worse position because generally pension schemes in the UK are unsecured creditors of the employer. And so they might suffer in an insolvency waterfall.

DEFINED BENEFIT:  THE PENSIONS REGULATOR'S POWERS

I've already mentioned the pensions regulator. The pensions regulator has got some quite strong powers which allow it to be a key player in transactions.

And one of them is known as the moral hazard set of powers. It effectively allows the pension's regulator to pierce the corporate veil and go against group companies which aren't employers, and that could include investors. It could also include, in some cases, individual directors to provide funding for a scheme. And those might be used in a scenario where a transaction, for instance, by introducing additional debt, puts the scheme in a worse position.

So they often focus investors minds in a transactional context. And the other kind of power is criminal, the power of prosecution for criminal offenses, which got introduced in 2021. So those are really only aimed at the most serious forms of conduct. So for instance, deliberate asset stripping of the employer that supports the scheme. They can be quite severe penalties up to seven years in prison.

But as I said, they're only really meant to capture the most extreme forms of conduct. They're things which boards generally worry about, provided that the board thinks about the pension scheme in the context of a transaction and documents, what it's doing, documents as considerations. As long as it takes those steps and creates a paper trail in practice, the risk of those criminal powers being used is pretty low indeed.

So that's defined benefit schemes and deficits. I'll pass on to Andrew now to talk about surpluses and DB schemes.

DEFINED BENEFIT:  SURPLUSES & STRATEGIC OPTIONS

Andrew Block

Thank you, Gareth. So surpluses are the topic on everyone's mind at the moment as UK defined benefit schemes are generally moving into a position where they are in surplus. So first question, what is a surplus in this context? So in simple terms, it's where a scheme's assets exceed the present value of its liabilities on the chosen measurement basis. And as Gareth has said, for these purposes, the three most important ways of measuring the present value of the liabilities of a defined benefit scheme are either by reference to the cost of buying out all benefits with an insurance company, which is known in the UK as the buyout basis, or by reference to funding at a level at which no more employer contributions are needed for the scheme to be able to pay benefits, and that's the self-sufficiency basis, or by reference to funding at a level at which the scheme is expected to reach buyout funding if employer contributions continue and investment returns are at least as good as assumed, and that's called the technical provisions basis.

Now policy signals matter here. The government has for the last few years pressed the UK's pensions regulator to adopt a posture that supports the wider UK economy, including by acknowledging the scope for surplus to be released back to employers to recycle back into the wider UK economy. The pensions regulator has become much more open to this idea and legislation currently going through Parliament provides a mechanism for this to happen. It depends on the scheme being funded at or above the self-sufficiency level and to the scheme's trustees agreeing, so you can expect trustees to want some of the surplus used for benefit improvements. The government has hinted that it may change the law to allow these to be in the form of cash payments. Another popular alternative where a scheme provides both DB and DC benefits is to allow surplus to be used to pay employer DC contributions. And there are ways that this can be done even if the employer's DC pensions are provided through a separate scheme, such as a master trust.

But you need to be aware of accounting optics. An accounting surplus does not always translate into a realizable surplus that can be extracted or redeployed. Cross-border groups may have additional complexity. For example, while buying out a defined benefit scheme, which we'll come onto in a minute, can materially reduce risk. Under US accounting rules, it can also result in a charge on your balance sheet. So if you have a scheme in surplus, what are your strategic paths?

Well, one option is a buy-in. This is a contract with a life insurer under which the life insurer agrees to pay future pensions and lump sums in return for a one-off premium. This moves investment and longevity risks to the insurer. And this can be done for all or for a slice of the scheme's liabilities. It can also be done as a long-term measure or as a short-term measure leading to a buy-out, the transfer of all pension liabilities to an insurer such that the scheme can be wound up. Another option is to move to a consolidator.

There is currently only one of these in the market, but legislation has been passed to set out a framework for these, and we expect another shortly to be approved. These are vehicles which allow schemes which are almost funded to buy out to transfer their liabilities to another vehicle, which will invest their assets such that buyout funding will be achieved. And from the sponsor's point of view, it allows companies to get the risk created by defined benefit schemes off their books earlier than would otherwise have been the case.

There are various gateway tests which must be met before a scheme can transfer to a consolidator and so this option will only be available to a narrow range of schemes. Alternatively, there is a credible path to run on where a well-funded scheme is maintained with an appropriate risk managed strategy, potentially enabling surplus generation over time, although governance, investment discipline and member communications are critical. This can allow for the surplus extraction in the way I described earlier. Finally, there may be another option, where a third party takes over the scheme entirely, as happened recently when Stagecoach's scheme transferred to Aberdeen, which is a fund manager. This is a new and developing area and it's not clear whether this transaction was a one-off or is now a new way of managing pension liabilities. Gareth.

KEY TAKEAWAYS FOR INVESTORS

Gareth Davies

Thanks, Andrew. So to wrap up what we've spoken about, I think from an investor's perspective, this is about looking and seeing what kind of schemes the UK business has in place, particularly identifying if there's any defined benefit schemes in scope at an early stage. And if so, understanding how that scheme's funded, understanding the strength of the employer covenant behind it, understanding what powers the trustees of that scheme might have.

And then thinking in advance about a strategy for engaging the trustee of the scheme and potentially the pensions regulator if it's got a significant deficit. Being wary that if the scheme is in deficit, the trustees may well seek some form of mitigation if the transaction has an impact on the covenant. So that might be additional cash or a guarantee from a group company or some other format. And if the scheme's in surplus, giving thought to strategically what

Is there an option from what Andrew has discussed as to end game planning for that scheme and whether the trustees of the scheme or the existing employers looking to take plans to use the surplus already? So that brings us to the end of the episode. Andrew, thanks so much for joining me today and helping to shed light on the pensions issues arising from investments in the UK. For our viewers and listeners, there are more episodes to come.

And please do check out our Employment and Benefits Unpacked page on the Mayer Brown website or your preferred streaming platform. And if you'd like to discuss any of the issues we've covered today, please do get in touch. And if any suggested topics for future episodes are mentioned, please do send them to unpacked@mayerbrown.com. But until next time, thank you for joining us.