As DB schemes gain greater flexibility to extract surplus, the ABI’s Robyn Smith argues that lessons from insurance regulation could help ensure greater freedom is matched by robust safeguards for members.
The Department for Work and Pensions’ (DWP) proposals to make surplus more easily accessible give defined benefit (DB) trustees a wider range of endgame options to consider. As those options expand, it becomes increasingly important to understand how different endgame approaches compare.
Run-on and buyout should not be viewed as a binary choice. Both can, for example, accommodate enhanced member benefits, the return of surplus to the sponsoring employer, longevity insurance and opportunities to capture upside. Nor does a decision to run-on preclude buyout: a scheme may choose to run-on for a defined period before ultimately moving to buyout.
There are, nevertheless, important differences between the regulatory frameworks underpinning these endgames. Regulation of DB schemes is overseen by the Pensions Regulator (TPR), whereas insurers are regulated by the Prudential Regulation Authority (PRA).
The two have different histories and take fundamentally different approaches to regulation. Yet both seek to support the delivery of the same promise to members: the payment of their benefits in full. There is therefore scope for the two regimes to learn from one another.
The insurance rulebook
Insurance regulation is more prescriptive and underpinned by a quantitative capital regime, while the pensions framework places greater reliance on the judgement and discretion of trustees. The proposals on surplus extraction illustrate this distinction particularly clearly.
Rather than relying solely on prescribed quantitative thresholds, trustees would ultimately be required to exercise judgement, including in determining whether a scheme is funded on a low dependency basis.
The definition of low dependency underpins the proposed surplus extraction framework. It’s the threshold at which surplus could be extracted; the threshold at which indicates there is a low likelihood of a scheme requiring further employer contributions; and the funding level at which a scheme must “least as likely as not” be expected to maintain over a three-year period.
There are merits in retaining some judgement within the definition of low dependency, as schemes vary widely. But given the significance of the decision to extract surplus and TPR’s inability to veto surplus payments, there’s a strong case for adopting a more quantifiable low-dependency definition.
This wouldn’t be entirely new territory for TPR. The Fast Track approach for DB schemes already establishes parameters against which valuations can be assessed. Where a scheme satisfies those parameters, there’s less likelihood that its valuation will attract further regulatory scrutiny.
Low dependency funding
A similar approach could be considered for low dependency. This might, for example, involve specifying a minimum or model assumption against which schemes could benchmark themselves, such as a defined discount rate.
Schemes could also be required to demonstrate resilience to specified adverse scenarios through stress testing of funding levels, investment strategy, liquidity and longevity risk. Such an approach could provide greater substance to concepts such as being “highly resilient to short-term adverse changes in market conditions”, while retaining sufficient flexibility to reflect scheme-specific circumstances. Importantly, the necessary detail need not sit in legislation and could instead be developed through TPR guidance.
That brings us to the role of buffers. Although buffers are discussed in the consultation, they are not mentioned in the regulations. Both the insurance and superfunds regimes recognise the importance of maintaining a financial cushion in addition to the assets used to meet schemes’ liabilities. For DB schemes extracting surplus, a buffer could provide protection against risks that are inherently difficult to capture in a point-in-time valuation.
The potential importance of that protection becomes clearer when considering the effect of surplus extraction on future funding resilience. Pensions Policy Institute research found that extracting surplus so that funding fell from 120% to 105% increased the probability of subsequently falling below full funding from 26% to 70% over a 25-year period.
Finally, there is a practical lesson that can be drawn directly from insurers’ experience of interacting with DB schemes: the importance of good data. Insurers frequently find that schemes approach the insurance market without their data being sufficiently complete. Addressing those issues shouldn’t be something that happens only when a scheme reaches buyout.
Ultimately, the objective shouldn’t be to make pension regulation look like insurance regulation. Rather, it should be to identify where the experience of regimes designed to protect long-term pension liabilities can help ensure that greater flexibility over surplus is accompanied by appropriate safeguards for members.
Robyn Smith is a long-term savings policy adviser at the Association of British Insurers (ABI).
