UK: DB Superfunds are getting closer
The concept of DB superfunds in the UK (so called “commercial consolidators”) has been around for some time, but the publication of an interim regulatory regime from the UK Regulator brings these vehicles a step closer to transacting. With the economic effects of Covid-19 affecting many employers, superfunds may now offer a real alternative for those sponsors who are looking to settle their DB plans but are unable buyout their liabilities with an insurer in the near term.
In June, The Pensions Regulator (TPR) in the UK published the eagerly-awaited details of the interim regime for superfunds.
Broadly, superfunds are pension plans established to consolidate the defined benefit (DB) assets and liabilities of unconnected employers into a single, larger pension arrangement. The link to the original employer is broken, so instead of support from covenant or ongoing contributions from a company, member security comes from capital provided by external investors who hope to eventually make a profit.
Superfunds will not be subject to the same stringent capital requirements applying to insurance companies. This means they can potentially offer more attractive pricing, albeit a lower level of protection for members, than a traditional bulk annuity transaction, which is usually the only other option available to employers looking to settle their pension obligations in the UK. They may be particularly attractive to employers and trustees experiencing difficulties with the economic effects of Covid-19 but where securing members’ benefits with an insurer is out of reach.
There are two solutions being marketed at present – the Pension SuperFund (PSF) and Clara-Pensions (Clara). In this blog we explore what the new rules will mean for PSF and Clara, and any other new entrants into the market.
Initial assessment of superfunds
TPR has been clear that, before it will even consider clearing any individual transactions, it expects to assess each prospective entrant to the superfund market. This will include understanding the superfund structure, checking key individuals running the superfund are “fit and proper persons”, as well as seeking comfort that there is a strong trustee board in place, with adequate management of conflicts of interest.
Given that TPR has now been in detailed discussions with PSF and Clara for some time, we expect the assessments should conclude shortly, and the first transactions will then begin to be processed.
Funding and investment requirements
After a transfer to a superfund, pension plan liabilities will be backed by both the assets held within the superfund plan and a separate capital buffer. TPR has been fairly prescriptive about its expected funding levels for superfunds:
- The superfund will initially need to be fully funded (without the capital buffer) on a “technical provisions” basis which is at least as cautious as a set of assumptions specified by TPR.
- The capital buffer will be risk-based (i.e. a higher-risk investment strategy will require more capital to be held) and set at a sufficiently high level that, when combined with the plan assets, there is a probability of at least 99% that the superfund will be fully funded in five years’ time, alongside a separate longevity buffer.
- There will be “funding triggers” requiring the superfund’s trustees to take certain actions (i.e. either merging the assets from the capital buffer into the superfund, or winding it up), providing protection to members and the Pension Protection Fund (which takes on pension obligations of insolvent employers in the UK, but with some benefit reductions) in the event of poor performance.
TPR has also set out its expectations for superfunds’ investment strategies. In particular, the capital buffer must be invested in a manner appropriate to a pension plan, and there will be limits on investment concentration and the holding of illiquid assets.
We expect that trustees of transferring plans will take comfort from the robust funding and investment arrangements that TPR requires the superfunds to adopt and the proposed supervision of superfunds. While this stops short of requiring the superfunds to capitalise to the same level as insurers, in our view these new options should provide a secure alternative for plans unable to afford an insured buyout.
TPR is placing restrictions on the ability of superfunds to extract profits from transferring plans. Other than fees, costs and charges (which must be “appropriate, transparent and fair”), superfunds will not initially be able to withdraw funds from either the plan or the capital buffer, unless members’ benefits have been secured in full with an insurance company.
This restriction will be in place for the duration of the interim period (i.e. until formal legislation is passed), and will be reviewed within three years if legislation has not been passed by then.
It remains to be seen whether this initial restriction on profit-taking will cause any problems for either of the initial entrants to the superfund market, or dissuade any of the other potential entrants or their investors. It is important to remember, however, that any stake in a pension vehicle is by definition a long-term investment.
Transaction clearance and ongoing monitoring
Once the superfunds are up and running, any transaction with an individual plan will initially be subject to “clearance” from TPR. Amongst other things, the clearance process will involve TPR inspecting the work that the transferring plan’s trustees have done to satisfy themselves that the transfer is in their members’ interests, and in particular that a buyout transaction would not otherwise be possible within the foreseeable future.
The superfunds will also be expected to provide ongoing monitoring information to TPR, for example in order to confirm that the funding position of the plan remains healthy and robust to investment market shocks.
Where might demand for superfund transactions come from?
The funding sweet spot
One scenario where superfunds should be attractive is where plans are in a funding “sweet spot”; where buyout is not affordable but a superfund transaction is. However, plans that were previously in that sweet spot may no longer be there because:
- the funding level fell following the market turmoil during March as a result of the Covid-19 pandemic; and/or
- the sponsor is no longer able to spare the cash to make the transaction feasible.
On the other hand, plans that were previously considering buyout, but cannot now go ahead in the short- to medium-term for the same reasons, may see superfunds as a good alternative where sponsors are keen to settle benefits sooner rather than later.
Availability of capital
Superfunds might also be popular where external capital is available (e.g. from a purchaser or overseas parent) to settle pension benefits.
This capital may now be harder to come by, but there are causes for optimism:
- Opportunistic investors will be on the look-out for cases where businesses look undervalued and hope to profit from their resurgence; and
- The disruption could prompt more corporate restructuring exercises, with pensions risk being dealt with as part of the process, particularly in light of Brexit concerns.
A further source of business for superfunds may well be distressed plans, potentially as part of a “pre-pack” administration process but also for plans coming out of the PPF’s formal “assessment” process. Part of this process involves assessing whether the plan is likely to be able to secure more than the PPF level of benefits in the insurance market; however, it will take time for plans with employers who become insolvent now to be ready for a “PPF+” transaction if that is their outcome.
In theory, superfunds should be able to secure a higher level of benefits for a given level of assets than can be secured in the insurance market, though this difference will be more significant for some plan than others. There are a number of reasons for this, but fundamentally it comes down to the level of risk; based on the interim regime superfunds are subject to lower capital requirements than insurance companies, and are able to price more attractively as a result.
This is a developing area, and trustees will have different views on whether the difference in benefits is appropriate given the additional risk being taken, but it is certainly something worth considering as part of the process of ultimately settling the benefits.
What happens next?
Although this is a big step forwards, it does not mean we expect to see a flurry of transactions in the short-term. Both PSF and Clara are now in the process of obtaining their formal authorisation from the Regulator, after which individual deals can be submitted for clearance. We therefore expect to see the first transactions later on this year or early next year. There are also a number of potential entrants to the market, so we wait with interest to see what other models any new entrants may come up with.
The final regulatory framework for superfunds remains in development (albeit this is likely to look similar to the interim regime), and ultimately will need to be set out in legislation. Whilst this is unlikely to happen for a number of years, this does not prevent employers and trustees pursuing this kind of transaction if they believe it will benefit them.