Defined Benefit Pensions and the UK Productive Finance Agenda

As part of the UK government’s drive to promote economic growth, the Department for Work and Pensions (DWP) has launched a call for evidence on how Defined Benefit pension schemes could use their assets more flexibly without compromising the security of promised benefits – and without undermining the fiduciary duties of trustees.

Why is it important?

Over the last year, we have seen significant improvements in funding levels for many Defined Benefit pension schemes, with a large number now expected to have exceeded buyout funding levels.

Most closed Defined Benefit schemes are continuing their de-risking investment journey with the ultimate aim of an insurance company buyout. Looking ahead, we will likely see demand for buyouts outstripping availability.

If we are genuinely seeking the best outcomes for pension savers, are there alternative solutions (for these extremely well-funded schemes) that not only focus on protecting members’ accrued benefits, but also create opportunities for benefit enhancements?

In securing benefits fully in the insurance framework (with the very small risk of insurer insolvency) a great deal of investment return potential is sacrificed. It is possible to seek some material additional return running on a pension scheme in the pensions framework while encompassing only a small downside risk. However, trustees would be far better placed to consider this approach if there was some form of full benefit protection guarantee.

What’s included in the government’s call for evidence?

The government’s call for evidence includes exploring changes that would incentivise Define Benefit schemes to invest more assets in UK Productive Finance (including providing equity and funding to UK businesses, including start-ups, infrastructure and private equity, as well as longer term investments, typically in illiquid assets).

We are supportive of new approaches that could deliver better outcomes for pension scheme members and therefore welcome this call to evidence.

However we believe that if changes were introduced that did incentivise Defined Benefit schemes to invest in Productive Finance, then it is extremely likely that a global approach would be taken, with only a fraction of assets invested in UK-specific assets.

Ultimately, pension schemes must be run for the benefit of their members. If the government wants to encourage investment in UK Productive Finance, then it will need to provide something back to pension schemes to enable this to happen.

Is there a way to meet the Government’s objectives?

This paper seeks to outline a potential solution for well-funded closed Defined Benefit pension schemes that:

• Focuses on the security of members’ accrued benefits and delivering better member outcomes.
• Enables scheme sponsors to be discharged from any future obligations to the pension scheme (if a minimum funding level is met) while also having the potential to share in any surplus assets created.
• Allows consolidation of smaller pension schemes, facilitates a better investment approach to contribute to the UK Productive Finance agenda, and over time, delivers a national wealth fund alongside the drive to net zero.

A potential solution to meet the above aims could be to create a ‘Pension Growth Fund’ sitting in the pensions’ framework.

This pension fund could be backed by a newly created entity (the ‘Productive Finance Fund’) which is supported by a Crown Guarantee (i.e. it is underwritten by the state) backing full benefits.

To minimise the likelihood of the guarantee ever biting, the solution would be aimed at closed Defined Benefit schemes that are extremely well funded – for the sake of simplicity, assume this broadly equal to fully funded on a buyout basis.

How could the Pension Growth Fund work?

When a scheme reaches the entry-criteria funding position, the trustees could choose to transfer all assets and liabilities into the Pension Growth Fund, with the link to the sponsoring employer falling away at the point of transfer.

This would be an alternative option to running on the scheme with existing sponsor covenant or transacting with an insurer.

The Pension Growth Fund would run on an ongoing basis. Its investment strategy would be designed to protect accrued benefits, but also to generate excess assets over the long term. Over time, an excess pool of assets would be expected to be created.

It should be noted that this would not require an aggressive investment strategy and would support continued effective functioning of the gilt market.

This surplus generated could be split with a proportion used to increase members’ benefits and the remainder paid from the pension scheme to the Productive Finance Fund as a refund of surplus.

35% would create additional tax revenues, the balance would remain in the Productive Finance Fund, or potentially a proportion could be paid to the original sponsoring employers.

The assets in the Productive Finance Fund would be retained as additional security for the pension scheme benefits (and could be called upon as contributions if required), but otherwise these surplus assets would remain in the Productive Finance Fund to create a national wealth fund.

As all benefits are eventually paid out of the pension scheme, all that would remain is the Productive Finance Fund.

Could government support work?

It should be noted that a Crown Guarantee for a pension scheme is not a new concept.

An excellent case study is the Mineworkers Pension Scheme which has been able to take a different investment approach to most pension schemes due to the government support that ultimately stands behind it. Since privatisation, this has enabled the trustees to enhance member benefits with the government also benefitting as they are entitled to a share in the surplus assets generated.

A key difference here is that, by design, the starting funding position of schemes eligible to enter the Pension Growth Fund would be much stronger than schemes such as the Mineworkers Pension Scheme at the point when its Crown Guarantee was provided.

What are the potential benefits of a Pension Growth Fund backed by a Crown Guarantee?

The provision of a Crown Guarantee would enable the longer term investment strategy required to create surplus assets. By focusing on extremely well-funded schemes, the likelihood of the Crown Guarantee biting is de-minimis.

In return, the Pension Growth Fund could be designed so that a proportion of its assets could immediately be invested to meet the UK Productive Finance agenda and over time a national wealth fund would naturally emerge, which could invest fully in UK Productive Finance.

The Pension Growth Fund would look to complement other consolidation models. Pension trustees would have another option for their scheme’s long-term objective, which would aim to secure full members’ benefits and provide potential upside for their members. Insurance company transactions would still be an alternative choice, but the Pension Growth Fund would alleviate some of the future challenges of demand outstripping supply for the insurance sector.

From the sponsoring employer’s perspective there would be an alternative approach to remove any future obligation to the pension scheme (once it’s reached the entry funding level requirement) and the solution could potentially allow these employers to share in some of the future surplus assets generated.

How ZEDRA can help

We look forward to continued debate and innovation in this area and would encourage the industry to use the opportunity presented by the call for evidence to think big to benefit pension scheme members and society as a whole.

We would welcome the opportunity to collaborate with partners (for example with benefit consultant firms, legal firms, and asset managers) to further investigate the potential design of creating a public Pension Growth Fund backed by a Crown Guarantee, which could deliver better member outcomes and encourage investment to meet the UK Productive Finance Agenda.

If you would like to discuss our proposal for a Pension Growth Fund in more detail, please contact Douglas Hogg.