Lightening the Load of UK Defined Benefit Pensions

Protecting against company failures has been a central tenet of the construction industry for decades, but when UK contractor Carillion collapsed in January 2018, its pension scheme had a shortfall in excess of £1 billion, leaving 27,000 members facing potential cuts to their retirement benefits.

Defined benefit (DB) pension plans were once a cornerstone of UK employee benefits, providing an effective recruitment and retention tool for companies and a valuable benefit for employees. But while DB pensions are now only a legacy benefit for the majority, they remain very much a financial burden for many firms. A combination of low interest rates, increased life expectancy, and tougher pension regulations has driven up the funding requirements for almost all UK pension plans.

Yet, despite the seemingly endless cash requests from pension plan trustees, when a company fails, its pension plan rarely has enough funds to provide members’ benefits in full.

So why, despite the best efforts of pension trustees and regulators, as well as the billions that have been contributed to UK pension plans, does this keep happening? And is there a better way of doing things?

The problem

The crux of the issue is the vastly different costs of paying members’ benefits depending on whether the sponsoring company is solvent or not. While the sponsor is in good financial health, the scheme typically invests in a mix of government bonds, corporate bonds, and equities, and some allowance is made for the expected returns on those assets; this reduces the amount of money the pension plan needs to hold at any given time. However, if the sponsor goes insolvent, the pension trustees must try to secure those benefits with an external provider, which typically makes little allowance for returns above government bonds; this places a much higher value on the liabilities.

The difference between these two scenarios is enormous: over £400 billion for pension plans in the UK. The vast majority of pension schemes are on a journey to close this gap through a combination of cash contributions and investment returns, but the sheer scale of the gap means that many will not reach their target for decades, if at all.

A better solution

Understanding this difference is the key to creating a better solution. The problem is not that sponsors of pension plans as a whole are unable to support their plans, but that losses are so heavily concentrated in the handful of schemes where the company has failed. A mechanism is needed to smooth out these losses so that the overall cost can be reduced while additional support is provided to the handful of companies that fail. What we need is “insolvency protection.”

Surety bonds are routinely used in the construction industry to protect firms against losses from subcontractors and suppliers going insolvent, and the same tool can be used to finance DB pensions more efficiently. In addition to protecting the interests of scheme members and trustees, it is worth noting that this method of DB financing can also offer valuable benefits to the sponsor, such as by easing liquidity pressures through reducing the requisite level of capital contributions to the scheme. This approach is gaining traction in the pension industry, having now been used dozens of times, from small schemes to the large schemes of FTSE 100 and Fortune 500 firms.