The imperative of proactive pension management

As funding levels improve and regulatory environments evolve, treasurers now face a multitude of options to manage and mitigate defined benefit pension risk
 

The landscape of defined benefit (DB) pension schemes in the UK is undergoing a seismic transformation – but what are the practical considerations that will help treasurers take advantage of opportunities and make informed decisions that will enable their organisations’ long-term financial goals to be met, while continuing to protect the scheme members’ pension benefits?

Turning a challenge into an opportunity

DB pension schemes guarantee to pay retirees a predetermined amount based on salary history and years of service. Once the cornerstone of retirement planning, DB pension schemes can now present considerable challenges for companies because of their significant long-term financial obligations in combination with uncertain and volatile geopolitical and investment markets. 

Therefore, despite their decline in new membership, DB pension schemes remain a material concern for many organisations. For treasurers, managing DB pension schemes might not always be at the top of their priority list. However, not proactively engaging can result in missed opportunities.

A key point to remember is that pension schemes are operated by independent trusts, not corporates. Success is therefore achieved when corporates and trustees collaborate to protect the security of members’ benefits.

Collaboration enables treasurers to act swiftly when favourable market conditions arise to turn challenge into opportunity. In what follows, we provide three no-regret actions that treasurers can take now to add value to the pension scheme and the organisation.

Action 1: Define risk appetite

As the stewards of their companies’ financial health, treasurers must calibrate valuation methods, corporate contributions and investment strategies to ensure pension schemes are managed in alignment with the corporate financial objectives:

• Valuation methods: understanding the different ways to value a DB pension scheme is essential. Treasurers need to be aware of how actuarial assumptions, accounting standards and market conditions can impact the valuation and, consequently, the company’s profitability and balance-sheet strength.
• Corporate contributions: determining the level of cash contributions that the company can sustainably make to the pension scheme is the second step. This involves balancing the goal of achieving sufficient funding to reach self-sufficiency or buy-out, while also managing the impact of funding volatility on the scheme. Treasurers must weigh the desire to maintain investment returns that help close any remaining funding gap with the need to manage the scheme’s financial stability.
• Investment strategies and illiquid assets: the uncertainty around the valuation of illiquid assets increases the overall uncertainty of the scheme’s valuation. Treasurers should seek independent advice on the valuation of illiquid assets and regularly review the strategy for managing those assets in the context of the scheme’s journey-plan timeframes.

Practically, defining risk appetite means setting measurable levels of risk across these three areas. Subsequently, treasurers should regularly assess and adjust these levels to ensure they remain appropriate as market conditions change.

Action 2: Have a clear strategic direction on the endgame

As funding levels of DB pension schemes improve, companies are increasingly exploring endgame options. There are a range of internal and external stakeholders with competing priorities, and treasury is the obvious place to steer engagement.

Below are the primary endgame options, along with their respective advantages and challenges.

• Insurance buy-in/buy-out: this strategy involves purchasing an insurance policy that guarantees the pension payments, effectively transferring the risk to an insurer. If insurance is the preferred route, treasurers should be ready for meticulous planning to achieve the best price from the transaction.
• Run-on: the company and trustees could be aligned in running-on the scheme where there is a strong funding buffer, a de-risked investment strategy and a strong employer covenant. Additionally, running-on need not be indefinite; it can be a temporary strategy to improve insurer pricing or capture further upside for the company. The recent UK Department for Work and Pensions consultation aims to facilitate surplus extraction, potentially enhancing the appeal for schemes to run-on. However, the timeline and specifics of these changes remain uncertain.
• Alternative solutions: in between risk transfer to an insurer and running-on, options such as raising first loss capital, captives and superfunds offer new avenues for managing pension risk. In summary, treasurers should conduct a comprehensive evaluation of all available endgame strategies to determine which is the most suitable, and seek expert advice to validate the chosen strategy.

Action 3: Develop an effective communication strategy

In our recent webinars with the ACT, we emphasised the importance of having an effective communication strategy. Treasurers need to ensure that all stakeholders, including trustees, scheme members, shareholders and corporate leadership, are well-informed and aligned on strategy. 

Here are two steps to developing a robust communication strategy:

• Form a joint working group: consists of representatives from key stakeholder groups, including trustees. This group should meet regularly to discuss the scheme’s performance, funding status and strategic decisions. A joint working group can ensure that strategic decisions are made with a comprehensive understanding of all stakeholder perspectives.
• Use stakeholder engagement as a platform for communication during M&A: the pension scheme remains an important stakeholder during M&A, even for well-funded schemes. Proactive communication during M&A can minimise disruption to the wider deal process and reduce the risk of value dilution for the company – for example, by finding the optimal non-cash solution. It is also more important than ever that sponsors use an M&A deal as an opportunity to retest and formalise the scheme strategy with the trustees, post-deal.

Conclusion

The evolving DB pension scheme market in the UK presents challenges and opportunities for treasurers. As funding levels improve and new regulatory frameworks emerge, treasurers have a chance to turn challenge into opportunity. By defining their risk appetite, establishing a clear endgame strategy and developing an effective communication strategy, treasurers can proactively manage pension risk. Embracing a proactive approach delivers long-term value for all stakeholders.

About the author

Andreas Vermeiren is a director at Cardano

This article was taken from Issue 3, 2024 of The Treasurer magazine. For more great insights, members can log in to view the full issue.

Register for relevant ACT webinars:
ACT Webinar: Part 1 – Defined benefit pension schemes: How do they work and what are the key implications for treasurers? 
ACT Webinar: Part 2 - Defined benefit pension risk -– getting the job done