'What next for DB pension market?'

The industry has shifted its focus to endgame strategies as more schemes are in surplus, recovery plans are shorter and funding bases are stronger. But how did we get here and what does it mean for the future?

The UK DB pensions landscape has changed a lot in the past 18 months as a result of rising gilt yields, innovation from pension providers and a new direction in government policy.

It will continue to change as the government enacts the policies outlined in the Mansion House reforms and the chancellor’s Autumn Statement, and as many schemes shift their strategic focus.

The industry is no longer focused on rescuing schemes in deficit; after years of paying down deficits, schemes are now thinking about surplus management and endgame strategies.

How did we get here?

As central banks sought to combat rising inflation, caused in part by the Ukraine/Russia conflict, monetary tightening has sent long-term nominal and real gilt yields up by around 350 basis points since early 2022.

The increases in yields are equivalent to a fall in the value of a typical DB scheme’s liabilities of around 40 per cent.

Revised longevity expectations have also played a part. Even though the long-term effects of the Covid-19 pandemic is still unknown, mortality is still higher than it was before the pandemic, which suggests that mortality rates are unlikely to return to pre-pandemic levels in the short term.

Reduced longevity assumptions could shave up to 2 per cent off schemes’ liabilities.

What does it mean?

Higher gilt yields, lower assumed longevity, sponsor contributions and strong asset returns have led to UK DB schemes being better funded than they were 18 months ago.

Earlier this year The Pensions Regulator estimated that more than 75 per cent of ‘tranche 18’ schemes – generally those with valuation dates of December 31 2022 and March 31 2023 – will be in surplus once valuation results are finalised, compared with 27 per cent of those schemes three years ago.

The industry is now focusing on endgame strategies after decades of talking about clearing deficits.

There’s still variation among schemes, driven largely by the extent of interest rate and inflation hedging.

Schemes with less hedging have typically benefited the most from recent market movements, and many schemes that had large deficits have jumped materially forward in their de-risking journeys.

Even schemes with more stable ongoing funding levels have improved their buyout positions. TPR estimates that around 25 per cent of schemes can afford to fully insure – a dramatic shift from the position just a year earlier.

What’s next?

With many schemes much closer to buyout affordability than they expected to be, trustees and sponsors are thinking about how to discharge scheme liabilities.

The industry is now focusing on endgame strategies after decades of talking about clearing deficits, de-risking investments and reducing reliance on sponsor covenant.

Most schemes will be considering whether to buy out their liabilities with an insurer at the earliest opportunity or become self-sufficient and run off liabilities.

Schemes considering running on could use DB surpluses to support DC provision, or offer discretionary increases to existing DB members.

Some sponsors may prefer to keep surplus (and assume risk), rather than pay away profits to an insurer. This could become more attractive if the government enacts measures to make surplus extraction from DB schemes easier.

It’s consulting on measures to do so, with the aim of incentivising investment in higher-returning assets.

Important detail is still to come, and reducing the 35 per cent tax on surplus refunds to 25 per cent is unlikely to move the dial much in isolation, though it may be read as a statement of broader intent to make changes.

Schemes that want to insure must plan and prepare carefully to get the best deal, and need to take a targeted approach to the insurance market.

As more schemes have become ready for buyout, the pension bulk annuity market has boomed. We expect new transaction records to be set in 2023, and demand is unlikely to wind down in the near term.

The first transfer to a superfund happened this year, paving the way for other pension schemes to do the same.

Trustees and sponsors should carefully consider which endgame is right for their scheme, and be aware of evolving options in a landscape that’s likely to keep changing for years to come.

Laura McLaren is a partner at Hymans Robertson