Roundtable: The rise of the superfund
Adam Saron, Chief Executive Officer, CLARA Pensions
Antony Barker, Managing Director, The Pension Superfund
Jay Shah, Chief Origination Officer, Pension Insurance Corporation
Moderator: Angela Tyrrell, Senior Vice President, Longevity Leaders
ANGELA: What is longevity risk and how has it traditionally been managed?
ANTONY: All of us are dealing with the settlement of pension promises. Life expectancy has seen an upward trend over the last twenty or thirty years, albeit that the rate of pace of increase has slowed down recently. These changes have been driven in part by people making better lifestyle choices, but also by medical advances such as major organ replacements or improving cancer survival rates. The question is “how do you fund this extended lifespan?” This is a major challenge for pension sponsors and insurance companies as well as governments and regulators.
Many defined benefit (DB) pension schemes were largely set up in the 1960s and 1970s, almost as a way of deferring salaries for their workforces. For a few decades it was a fairly easy ride for these companies driven by few guarantees, high equity status, rising stock markets and dividend-based actuarial valuations. Since the 1990s the investment strategies of these schemes have focussed instead on fixed income investments which mirror the change in value, if not the size, of those original pension promises. But that doesn’t get away from the dual problems of longevity risk or inflation risk that drive how long for and how much you have to pay.
There are some well-established ways of hedging and de-risking inflation, either through using government securities or other assets delivering inflation-linked income. The challenge for us all is how to de-risk longevity, both at a trend level and as a step-change. There aren’t that many natural hedges in the market, and historically corporate sponsors have looked to transfer that risk to an insurance company like the Pension Insurance Corporation (PIC).
JAY: The longevity risk hedging market is increasing year on year. Our estimate for 2019 was around forty billion pounds worth of transactions taking place, a significant increase on previous years. While transaction numbers are growing, they are still a small slice in the context of the entire DB universe, even just in the UK.
PIC offers bulk annuity products to the UK market in the form of buy-ins and buy-outs. It’s a relatively straightforward proposition and structure offering a highly secure product to provide pension benefits for members of defined benefit pension schemes within the insurance regulatory system. There are various safeguards in place providing a hundred percent guarantee for all benefits even in the very unlikely event that an insurer fails.
ANGELA: So, what is the superfund model, and how does it differ from traditional insurance?
ANTONY: At the request of government, Superfunds are offering an alternative to move that legacy risk from one closed occupational pension scheme to another ongoing occupational pension scheme. That is largely what our structure is at The Pension Superfund, a tax- approved Pension Protection Fund eligible occupational pension scheme trust. Instead of being supported by an operating company covenant it is supported by a financial covenant in the form of a partnership holding material financial commitments from the former sponsor and new external capital providers, that should ensure members get at least 99% certainty of receiving their promised benefits in full. Consolidation is a common practice in many industries to get economies of scale and better governance and we are using existing trust structure to bring those benefits to the pension industry.
Within that model we will also be hedging longevity, which we see as a very high risk particularly from a step-change perspective. While we periodically might use insurance-type solutions, our business model is not (unlike CLARA’s) explicitly to move liabilities on to insurance companies. We’ll probably look to go directly to reinsurance through a captive model when it makes sense to do so.
ADAM: The outcome that CLARA will achieve, from the perspective of the sponsor, is the same as what The Pension Superfund propose. We allow the sponsor to fulfil their pension obligations by removing that obligation to us and CLARA as a consolidator takes on the risks. Longevity risk is a big part of that. But where our approach differs markedly from the Pension Super Fund is the other group of stakeholders not yet mentioned, the member. Our model is designed to be member- first.
The way we achieve that is, like The Pension Superfund, we provide new external capital. We do expect the transferring sponsors to pay their share of historic obligations, but crucially the capital that we provide travels the full journey with members. When a scheme comes into CLARA it becomes a section of the CLARA Pension Trust. The capital that we provide is dedicated to that section, and neither the capital nor the return on that capital comes out until every member has their full benefits secured in the insured market.
The way that we like to describe the model is that CLARA is a bridge to buy-out. I guess that’s the other big difference between us and The Pensions Superfund – we’re explicitly not a run-off model. We are very conscious that as a bridge to buy-out, when we come to buy that insurance contract, we are effectively buying longevity protections within it. We are very aware that at some point in our lifecycle we will need to be buyers of longevity protection. Like any risk it needs to be managed, at the right time and at the right price.
ANGELA: Why are these new models needed?
ADAM: When you look at the UK market for private DB pension schemes, the vast majority are closed to new members and increasingly closed to future accruals. There are currently two big consolidators in that market. At one extreme you have the insurers consolidating pension liabilities and assets out of pension schemes into insurers very successfully for thirteen or fourteen years. I think since the insured market has existed the total value of bulk annuity insurance is about 150 billion against probably 2.2 trillion of remaining liabilities. Insurance is making a difference but too slowly.
At the other extreme where you have sponsor failure, the Pension Protection Fund is the consolidator. But in between these two extremes there are no other solutions. The market is crying out for alternative ways to manage longevity risk.
ANTONY: The size of that hinterland is enormous. Perhaps one to two percent of funds manage an insurance buy-out in a year. Another one to two percent end up, unfortunately, entering into the Pension Protection Fund (PPF) following the insolvency of their sponsor. Despite the significant value of insurance transactions this year and last, it is not keeping pace with the growth in pension liabilities due to their annual inflation and statutory revaluation increases. Hence the total problem is still getting bigger.
There are about five and a half thousand defined benefit pension schemes still in existence in the UK. Their sponsoring companies have a legacy financial problem – there is rarely an HR benefit still associated with running the final salary scheme, and a lot of them closed ten or fifteen years ago - using up a lot of management time and a lot of corporate capital. If they have the money to do so they can offload the problem to an insurance company. If not, they need an interim measure.
All three options – insurers, the Pension Protection Fund and superfunds - are trying to deal with the same problem but at different ranges on a spectrum. There are more complementary areas than there are areas of difference.
JAY: I’m in agreement with Antony and Adam about the issue itself. There are a large number of smaller pension schemes in the UK suffering from, among other things, poor funding levels, poor governance as a result of their size and lack of buying power leverage for asset management or administration providers. But I don’t think that the superfund is necessarily the right solution to the problem.
The concern I have with the superfunds –and I’m talking generically rather than with regard to Antony or Adam’s specific models – is that they don’t address this issue. Various superfunds coming to market are trying to position themselves as being very different from insurance companies, which I don’t think is true. An insurance company is guaranteeing that they will pay the right pension to the right person at the right time with no cutbacks. They are able to do that because they source capital from private investors looking to make a return on the risk. Insurance companies and superfunds seem to be doing the same thing and making the same promise. I think it’s quite dangerous to expect DB pension members to make a legal distinction between one that is technically a pension fund and one that is technically an insurance company, when they are doing essentially the same thing.
Like ourselves, superfunds will be run as commercial organisations looking to make a profit for their shareholders who are putting in the capital. For that to work commercially, the price that a superfund would charge to a pension scheme for essentially the same product that an insurer offers can’t really diverge far from the existing insurance model.
What superfunds are really offering is the same guarantee and product as bulk annuity insurers, but with a lower level of security. In itself I don’t have an issue with that as long as it is made explicit. If it is to be made explicit it should be governed by exactly the same regulations as insurance companies, with an explicit deduction from capital that superfunds have to hold. A customer can then see that if a superfund holds less capital it comes with a higher level of risk. We shouldn’t fool ourselves into thinking that somehow you can provide a cheaper proposition with the same level of security. If the price is cheaper, it’s because it’s a riskier proposition. Customers ought to be able to fully understand that.
ADAM: From our perspective most people are able to understand quite clearly that while consolidation is about making pension schemes safer, it’s not providing the same level of security as insurance. In CLARA’s case we are offering a bridge to that the purchase of an insurance product. Employers and trustees understand that the cost for the additional security is that it’s not quite as secure as insurance. Both we and The Pensions Superfund are incredibly clear about that. I don’t think there’s anything wrong with saying that we’re making pensions safer, but maybe not quite as safe as insurance.
I think every trustee, if they could wave a magic wand, would love the option to buy-out for their members. Insurance is like the Rolls Royce to get you through your pension – it’s big, its comfortable, its safe. But if you can’t afford a Rolls Royce, does that mean that your only other option is to walk? Do you know what, a Volvo is a pretty decent car and it’s probably going to get you where you need to be.
ANGELA: What about the regulatory framework, how does that differ for superfunds vs for insurers?
JAY: The regulatory framework for insurers is stringent – painfully stringent at times. But it works and its properly understood. Currently for superfunds there is a question mark as to whether they should be regulated by the Department for Work and Pensions (DWP) or the Prudential Regulatory Authority (PRA). If they are to be regulated by the DWP it is generally accepted that the Department would need to scale up volume and skills base of people to do so. It begs the question would we really build a second regulator to do essentially the same job? So that suggests that superfunds ought to be regulated by the PRA.
ANTONY: It’s important to get the clarity between government departments and government agencies. They’re all staffed by the same individuals who often rotate across government. So, I struggle to see how the Pensions Regulator would have a hiring challenge. I set up the Pension Protection Fund and it was very easy to get people to transfer across from industry or from the public sector to join that lifeboat fund. I don’t see the staffing side being a challenge.
JAY: I agree in that it’s entirely possible for them to get the resources to do that. But what would be the point? Why create two very sophisticated regulators essentially to do the same job? Why not have the PRA regulating two superfunds if by and large, the oversight required should be either identical or at least very similar to insurance companies?
The superfund model has been described as a good option for some schemes given where they are right now, while not necessarily providing the same gold standard that insurance companies represent. But we have to acknowledge that pension schemes as they stand in the UK are significantly underfunded, a situation that has been allowed to evolve under the current pension regulatory regime. So how is it right to create a new model under that same regulatory regime and ignore the insurance regulatory system which has done pretty well over the last several decades?
ADAM: I absolutely agree that insurance is the gold standard outcome for members of closed DB pension schemes. As a member-first solution that’s exactly why our solution is built as a bridge to the buy-out market. But the reality is that consolidators are pension schemes, and pension schemes are already regulated not by the DWP but by the Pensions Regulator. They are a speciality regulator in the private market to the tune of about two trillion pounds worth of pension liabilities and have been doing so fairly successfully. The bulk annuity market is much smaller. In that sense, insurance is the exception, albeit a growing exception and a valuable one.
There is also a crucial difference between being a pension scheme and an insurance company. It’s a subtle one, but important. A pension scheme is comprised of two balance sheets – the scheme itself which is governed by an independent board of trustees, and the financial interest controlled by the pension sponsor. In an insurance company, there is a single balance sheet. There is one board of directors who, unlike the trustees who owe their fiduciary obligation to members, owe their fiduciary obligation to shareholders. That said the combination of the Financial Services Compensation Scheme and the PRA provide a very valuable protection.
ANTONY: I’m pleased that Adam mentioned the Financial Services Compensation Scheme because we should acknowledge that insurance companies can fail. Individually, insurance companies can’t guarantee the promises that they make. However as an industry they can, through the backstop of the Financial Services Compensation Scheme. The pensions industry now has similar backstop in the Pension Protection Fund. I think we can agree that if companies never failed there would be no need for a lifeboat fund of this kind. There’d be no need for bulk insurers, or for consolidators either. But companies do fail, and there needs to be an exit route for trustees to secure an outcome for members.
Trustees are looking to pay people’s pensions with higher degrees of certainty and a lesser degree of risk. There is no “no risk” solution. That’s why the Financial Services Compensation Scheme exists. Yes, insurance is the gold standard, but there need to be alternatives.
I’m sure Adam is in the same position as us of being approached by a lot of smaller pension schemes. They might have flaws in their data, they might be too small, they might have too many deferred pensions. It doesn’t really matter whether they’ve got the money to do a deal or not, they’re getting roundly refused by insurance companies who aren’t interested in taking them on as a liability. It’s a real challenge, particularly for those coming out of PPF assessment whose only source of ongoing funding is the existing assets of the scheme. The longer the situation perpetuates, the worse the deal is for the members in the arrangement.
ANGELA: There’s no doubt that the longevity risk market is gathering steam. 2019 was a record year for bulk annuities. To wrap up, I’d like to know what each of you see 2020 bringing?
JAY: We can look at the pattern of the last few years. In 2017 the bulk annuity market was twelve billion. In 2018 it was around twenty-four or twenty-five billion. Last year it was upwards of forty billion. I don’t know whether volumes in 2020 will be equivalent to 2019 but it certainly wouldn’t surprise me if they are similar. It’s certainly going to be a significant market.
ADAM: We would expect similar volumes to 2019. We do expect there to be more competition amongst the bulk annuity providers and potentially new entrants in that market, which for us as the ultimate buyers of that product is very exciting. But closer to home we are hoping to get to a point of being approved by the pensions regulator and moving on to our first transactions.
We’ve given Jay a hard time today, but he makes a number of fair points. We are a commercial operation and we’re very much looking forward to transacting. The pensions regulator has been incredibly diligent in its dealings with us. Jay will be happy to hear that they have been giving us a suitably hard time too, as is only fair. That process will take as long as it takes, and we’ll cooperate to get over the standard that they set. Hopefully we look forward to taking on our first members next year!
ANTONY: I forecast it being the first of a number of record years of schemes transferring into commercial consolidators, if only on the basis they couldn’t have done it before. It also will continue to be another strong year for insurance companies as the market expands and risk transfer in its varying forms becomes increasingly affordable.
At the end of the day we’re all trying to deal with the same problem in slightly different ways. I do have discussions with other insurance companies about the opportunities for insurers and consolidators to come together. Perhaps the analogy is, we’re operating in two very large fields on the same farm, but occasionally it will make sense to work together across the hedge.
Ultimately, we want to ensure that the risk of providing pensions is not stranded with companies and individuals who are not either skilled, resourced or funded to be able to deal with it. That opportunity is probably best transferred to organizations like those that the three of us offer. No doubt others will come into the market in the future and lead to a superfund industry that is not just members first, but members better.
This article is an extract from the Longevity Trends 2020 report.
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