Date: 2023
Author: Dean Wetton Advisory

The improved funding position of defined benefit (DB) pension schemes is evident according to data
from the pensions industry, where 4,440 schemes are now in surplus with an aggregate surplus of
£379bn while only 691 are in deficit.

The main reason for the change in funding levels was the sharp rise in gilt yields following the Truss
mini-budget of 2022 that caught investors off guard and saw gilt yields rise by some 3%. The result
meant that scheme liabilities fell overall by around 35%.

The fallout has had a silver lining for sponsoring employers who find themselves with lighter liabilities
on their balance sheets or even better yet, a funding surplus. Of great importance to a sponsoring
employer and trustee board is whether such a reduction in scheme liabilities changes anything when
considering a buyout and wind-up of their scheme.

A buyout is when an insurance company takes over the responsibility for meeting future member
benefits and completely removes the risks of investment, member longevity, inflation, interest rates
and running expenses from the employer. A buyout ultimately enables the scheme to be wound up.
Buyouts are now a lot more affordable than they were 9 months ago but there is still a relatively high
premium to be paid. For example, a very prudent assumption of discount rates applied by a scheme
actuary would be the risk free rate (in other words gilts) plus 0.5%. On the other hand, an insurer
considering a buyout may assume a discount rate of gilts minus 0.5%. To put this buyout premium
into context, a scheme with assets of £10 million could pay a price premium of c £1,5 million to an
insurer. This is exacerbated further by the fact that insurers are currently inundated by schemes
wanting to wind up, therefore creating a demand premium for buyouts that favours the insurer.

For a financial director of a sponsoring employer or the scheme trustee, the high interest rate
landscape means there is a larger trade-off between maintaining the scheme (such as running costs)
and the potential upside of unwinding their actuarial prudence, the latter being ‘given’ to the insurer
at buyout. Combined with the high demand for buyouts, we believe there is an argument in favour of
exploring an alternative strategy, running the scheme on a ‘low dependency’ basis.
Low dependency means that schemes need to be funded in such a way that they are in a state of ‘low
dependency’ on their sponsoring employer. The Department for Work and Pensions is drafting
regulations designed to drive DB schemes towards low dependency funding levels. While the
regulations are aimed at mature schemes, the rapid change in the interest rate landscape could
make the regulations compatible for a wider group of schemes.

For a scheme to achieve sustainable low dependency it is important that the investment strategy
caters for drops in future interest rates and that the risks associated with lower interest rates are
locked out of the scheme.

A successful low dependence strategy should provide a number of potential benefits to a DB
scheme and its sponsoring employer:

  • investment risk is typically lower;
  • there should be less funding dependency on the employer;
  • funding costs are usually lower than a typical buyout; and
  • the sponsor would pocket any un-wound actuarial prudence profits when the scheme is
    eventually wound up (these usually pass on to the insurer)

While buyout may still be the best outcome for DB schemes, the recent market turmoil has given
funding employers the opportunity to explore other end-game options available to them.

Together with our fiduciary partners, LGT understand the complexities around end-game strategies
for DB schemes and appreciates that there is not a one-size-fits-all approach