2023 was a remarkable year for defined benefit pension schemes. For many schemes and their sponsors, the world has changed: funding conversations are less about how to address deficits but instead focus on how best to respond to much improved funding positions. Sarah Brown, Chief Actuary at Buck, A Gallagher Company, considers how these changes came about and what opportunities and challenges this environment is creating for sponsors.
What has changed?
According to data recently published by the PPF, the funding of defined benefit schemes compared to the cost of securing benefits with an insurance company improved by £588bn over the year to 31 March 2023. This improvement in funding has been driven largely by an increase in the yields available on Government bonds: broadly, as these yields rise, the cost of securing benefits with an insurance company falls. Further, the majority of schemes use these bond yields to value their liabilities for their formal actuarial valuations, which are used to determine future contribution levels. This means that we are seeing the level of contributions needed to eliminate pension scheme deficits also falling.
This improvement is not the same for all schemes due to differing initial funding positions and investment strategies, and funding positions remain volatile. As a result, it is important for those responsible for pension schemes to ensure they review their funding position regularly, as well as monitor the strength of the sponsor. The inflationary pressures of 2023 will have affected some sponsors’ ability to support their schemes, so the improvement in funding levels may not necessarily have translated to an increase in the security of benefits for all.
What are schemes doing in response to the change?
For many schemes, this change in the funding position means that they can now afford to secure benefits with an insurance company, perhaps after a moderate cash injection from the sponsor. This has led to a significant increase in activity in this market. We expect 2023 premium volumes to be between £50 and £60bn, significantly surpassing the previous record of over £40bn in 2019.
So, where will the market go? We are observing that demand from pension schemes is outstripping insurers’ supply and that is not likely to be solved in 2024. In the final quarter of 2023, insurer pricing increased by around 2-3% more than we would expect based on the movement in gilt yields alone. This may be a sign of market forces in action as demand for buy-out increases.
For those who do not wish to secure benefits, or for whom buy-out remains out of reach, any improvement in funding might trigger considerations about whether to change investment strategy to lock-in gains and reduce risk going forwards.
We are also seeing an increase in discussions about how any surplus arising in the scheme should be used.
Some trustees are seeking discretionary pension increases for their members, noting that recent high inflation will have eroded some of the spending power of individual pensions (as not all pensions increase in payment, and where increases are given, they are often capped).
However, sponsors often feel that any surplus should be returned to them once promised benefits have been secured, especially where they have had to make significant cash injections in the past.
The first step for most is to understand what is permitted under the scheme’s rules. Once this is understood, discussions around the use of any surplus can be held alongside those around the long-term funding and investment strategy for the scheme.
So overall, the changes are leading to wider strategic discussions about the future of the scheme and how it will be managed.
What does the future hold?
Against this backdrop, the Government has announced that it wishes to encourage schemes to invest their assets in “productive finance” and is consulting on reforms to enable this. One area being considered is whether mechanisms can be put in place for members and sponsors to share in the benefits of any surpluses that may emerge from taking additional investment risk.
In contrast, over the last 20 years, schemes moved increasing proportions of their assets into Government bonds and other instruments, such as interest rate swaps. This was partly in response to regulatory pressures and to valuation approaches that assess liabilities using the yields on these instruments. It remains unclear whether it is too late for this to be reversed.
So, the future is exciting for defined benefit schemes. While many may stay on their current course, others may now be able to plot a new journey. And with improved funding levels, there are a range of options available.