We recently advised a pension scheme on a buy-out of its defined benefit (DB) liabilities with an insurer. In the run up to the transaction, the employer and the trustees looked very carefully at whether the scheme had enough assets to make the transaction possible. It was touch and go, but in the end the assets were just enough.
This made me think about how important taking benefit de-risking action as part of the journey to full funding can be. On its own, each benefit de-risking step does not have a transformative effect on funding. But, as part of a wider programme of funding and investment action, benefit de-risking can make the difference between getting to 100% funding on a buy-out basis and not.
So what are the main benefit de-risking steps which employers should consider?
- Closure to future accrual – Many schemes have already taken this step and others are getting there by default as their remaining active members retire or leave. It helps by limiting the growth of funding risks associated with defined benefits, including inflation, interest rate and longevity risks.
- Pension increase exchange – Members are offered a larger flat rate pension instead of an increasing pension. The terms of the exchange can improve the funding position of the scheme as well as helping to control inflation and longevity risks.
- Enhanced transfer values – Members are offered favourable terms to transfer the value of their benefits out of a DB scheme to a defined contribution (DC) scheme. This can improve the funding of the scheme immediately as well as reducing the total liabilities that the employer and trustees have to deal with.
- Flexible retirement option – This involves offering members the opportunity to transfer the value of their benefits out of a DB scheme to a DC scheme as part of the normal retirement process. It can provide similar advantages to enhanced transfer values.
- Trivial commutation – Members with small pensions may be offered the option, or sometimes required, to commute (i.e. exchange) their pension for a lump sum. This reduces liabilities and administration and can make buy-out easier.
For the last four steps, it may be necessary to follow the industry code of practice on incentive exercises. This helps to ensure that members make informed decisions, and reduces the risk of future claims of “mis-selling”. It will also be necessary to consider any accounting impact.
All these steps should be considered by employers as part of the sensible management of DB pension liabilities.