This paper aims to highlight the concept of consolidation and its appeal to both trustees and consolidators across both defined benefit (DB) and defined contribution (DC) markets. Our DB Consolidation Brochure, July 2019, provides further information as a guide to the options. Continue reading the whitepaper above to learn more.
The pensions landscape has shifted dramatically over the past decade. Buy-outs, fiduciary management and sole trusteeship, among others, have had a significant impact on the profile of pension schemes.
The identifiable, consistent trend is consolidation. This can be on several levels: assets, liabilities and decision-making parties. The harder one looks, the more consolidation can be seen as a prevalent and persistent trend. Demand for consolidation from trustees continues to rise.
This note aims to highlight the concept of consolidation and its appeal to both trustees and consolidators across both defined benefit (DB) and defined contribution (DC) markets. Our DB Consolidation Brochure, July 2019, provides further information as a guide to the options. Not all consolidation options are suitable for every scheme; however the march of consolidation will make it inevitable for almost all trustees to consider which solution makes most sense for them.
What do we mean by consolidation?
The UK government has put pressure on trustees to maintain higher and higher standards and has regularly suggested suitable consolidation options. The Pensions Schemes Bill set out a framework for Collective DC in October 2019.
In turn, the Pensions Regulator (tPR) has been increasing the governance burden on trustees. Rigour around long-term targets and new requirements for Statements of Investment Principles makes it harder for trustees who are not working professionally within pensions full-time. This has led to increasing concern that the onus of compliance is outweighing current trustee expertise. DB consolidation recently hit the headlines with the launch of two ‘commercial consolidators’.
They offer trustees the chance to consolidate liabilities and assets with other schemes, transferring both to a third party. This is a similar level of consolidation to conducting a buy-out (albeit with different cost dynamics and initial expectations). Trustees can also opt for a pared back version, retaining control of their liabilities (and therefore funding level) while consolidating their assets using a fiduciary manager.
Within DC, tPR’s authorisation regime on DC master trusts has endorsed consolidation to bulk arrangements. Indeed, in its June 2019 publication, ‘The current master trust market’, tPR explicitly stated: “We expected the introduction of authorisation to drive consolidation of the market”. Similarly, Collective DC schemes offer members the chance to pool, and spread, their investment risks while unlocking more investment options.
Identifying the trend and similarities through the lens of consolidation
What are the advantages of consolidation?
Less trustee time obligation
Outsourcing decision-making allows trustees more time to focus on strategic aims and areas previously neglected eg fee transparency.
Risk reduction in many forms
Covenant/ regulatory/ demographic/ investment risk can all be reduced and sometimes removed, giving greater comfort and certainty of outcomes.
Scale and cost efficiency per member
Insurers and consolidators have greater scale and ability to run a cost-effective solution. As schemes mature, the cost per member increases due to a number of fixed costs for pension schemes operating independently.
More sophisticated investment strategy
Typically, there is a positive correlation between the size of the pool of assets and the sophistication of strategy (more bargaining power with underlying managers and it better justifies input from investment experts).
For instance, the credit universe has expanded into a broader and more sophisticated universe partly driven by the search for yield in the current ‘lower for longer’ yield environment. See our note on Bank Capital Relief, June 2018 as an example of how esoteric this can get. Private debt is much more prevalent within portfolios since the global financial crisis as banks have stepped away from lending. As is leveraged DB Liability Driven Investment and diversified DC de risking glidepaths.
Improved bargaining power over fees
Asset management fees are one of the major known drags on investment performance. Grouping schemes’ assets gives investors a much stronger bargaining position which in turn helps drive commercial negotiations. This may be in a direct way, such as for some fiduciary approaches, or indirect, reducing insurer costs and likely premiums.
Assessing the commercial dynamics
An important dynamic is that consolidation is also attractive to consolidators. Across all these forms of consolidation, control over a greater asset base helps unlock benefits, in both terms and performance efficiencies.
Bulk annuities (buy-outs and buy-ins)
Insurers belong under a different regulatory regime to pension schemes, so transferring liabilities across to an insurer requires high funding levels. Despite this funding cost, the market has exploded in recent years.
The mutual benefit of insurers gaining control over greater pool of assets (generating investment returns) and trustees passing across their responsibilities (and concerns) has continued to push trustees and companies in suitable funding positions to transact.
Collective DC aims to address the challenge of members bearing the investment risk in DC schemes (as opposed to companies in DB schemes). Members are pooled together to allow greater synergies when investing and share investment risks.
The incentive for companies to offer Collective DC is akin to other forms of consolidation that pool assets.
Especially in the case of an expanded investment opportunity set – for instance, the inclusion of illiquids becomes much more acceptable.
We await changes in pensions law to permit Collective DC schemes; once through we expect to see major providers developing Collective DC offerings (this could change soon and happen quickly).
Two firms, The Pension Superfund and Clara-Pensions, have hit headlines offering trustees yet another consolidation option.
This option has arisen as the commercial consolidators are not currently expected to fall under Solvency II requirements and will instead be regulated by tPR. This means greater flexibility in the assets that they hold against liabilities, both in terms of how they are invested and in the level of assets they are required to assign to each pool of liability risk. They can therefore explore marginally riskier investment options than insurers and expect to receive marginally higher returns on the asset pool. This means they can accept schemes at lower funding costs than full buy-out.
So far there have been two contrasting ways the consolidators will be run:
- The Pension SuperFund – This runs a pooled self-sufficient portfolio paying each benefit until there are no members drawing benefits. Profits are shared between private investors (two thirds) and the scheme’s members (one-third).
- Clara-Pensions – This solution acts as an intermediate step to buy-out. Clara-Pensions runs the portfolio until it is ready for buy-out. Profits are distributed to investors once the scheme has been sold to an insurer.
While these solutions are embryonic, they could be a significant step for the market. Other methods of consolidation (such as buy-outs or fiduciary management) that have arisen recently have grow rapidly.
Fiduciary management/ master trusts
The real power of fiduciary management and master trusts is the outsourcing of the technical investment conversation, especially for lay trustees. The explicit cost of a professional outsourced party (ie the fiduciary provider or master trust) can be partially offset by greater fee negotiating power (under most fiduciary models). And this is no different to insurers and consolidators who also have these costs to meet, although the costs become implicit within the funding premium charged.
For DB schemes so far, moving to one of these arrangements has also sped up the path to buy-out, with many schemes now moving from fiduciary arrangements to buy-out contracts.
A significant barrier to change can be a slow-moving trustee board, often without sufficient time and without direct industry experience. Consolidating decision-makers into one professional firm or person can have a significant impact on how quickly progress can be made.
In turn, quicker progress allows more topics to be considered, itself aiding the expansion of the investment opportunity set and leaving time to focus on other matters such as driving down costs.
So what's the catch?
As with everything, there are two sides to this coin...
- Loss of control. Trustees who want very high levels of customisation are likely to find that they must sacrifice decision-making responsibility to a third party when moving to a consolidator. This affects both DB trustees and sophisticated DC members who prefer complete investment flexibility, and who may have to accept a smaller range of investment funds within master trust arrangements (those that are deemed suitable by the new trustee).
- Cost. As more is asked of external parties, costs typically increase (although these can be offset to some extent by negotiating down underlying manager fees).
- Balance sheet impact. Liabilities are valued differently in company accounts than by insurers and completing a buy-out can have a negative impact on the balance sheet.
- Potential funding shortfall on bulk annuity purchase. This may be a result of an instantaneous asset shock which may require the company to make up the shortfall in funding from the current position to buy-out.
- Loss of future growth. Once buy-out is complete, the company foregoes any surplus funds that may be accumulated over time – known as a ‘trapped surplus’.
- Except for the buy-out/commercial consolidator option, other consolidation methods do not remove all risk. Even if the scheme is well-funded, market volatility could impact the consolidators’ ability to meet benefits and, in a worst-case scenario, put the members into the Pension Protection Fund; the government back-stop for severely under-funded schemes.
Conclusion: is consolidation a good thing?
Thus far, evidence points to consolidation as being positive for pension schemes.
There is increasing demand for buy-out and fiduciary management. Similarly, sole trusteeship has seen significantly higher take-up recently as companies find different ways to change their governance structures to keep up with the fast-developing investment market.
The main driver of consolidation seems to be the benefits to both parties of consolidation. Insurers and commercial consolidators can reduce their investment costs; fiduciaries are able to take advantage of more complex investment options to reduce risk without impacting returns. In turn, this has given the benefit of more time to focus on other matters such as driving down costs. All of these have contributed to rapidly improving funding levels over recent years.
We are only in the early stage of development in these solutions. Buy-outs and fiduciary options are around a decade-old; the master trust regime has changed significantly recently; and commercial consolidators and collective DC are still embryonic.
Time will be the true judge but consolidation certainly has momentum.
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