Defined benefit superfunds: questions and answers

What are superfunds and why are they topical now?

The conventional defined benefit pension model generally involves a company contributing to a trust fund, which provides the benefits promised to employees or former employees. If the contributions to the trust fund and investment returns are not sufficient to meet the promised benefits, the sponsoring employer company must make further contributions.

Superfunds are an alternative model to the above. Under a superfund consolidator, the trustees of a pension scheme trust (the ceding scheme) transfer the assets and liabilities of the ceding scheme trust to a pension scheme operated by the superfund. A new unrelated superfund employer (backed by a capital buffer) replaces the financial covenant provided by the ceding scheme’s employer. The capital buffer comprises capital invested by a superfund’s third-party backers and a contribution from the ceding employer. Assuming the superfund consolidator is successful, this process is replicated so that multiple defined benefit schemes are consolidated into one larger pension arrangement. The superfund backers would in time aim to generate a surplus to provide a return on their investment (see below regarding value extraction).

The Pensions Regulator (TPR) has recently published guidance for those setting up and running defined benefit superfunds. The guidance sets out the standards that TPR expects superfunds to meet pending the introduction of longer-term legislation that will apply. In the TPR guidance, the term superfund means, collectively, the superfund corporate entity, the capital buffer and the superfund pension scheme.

Will there be a mass exodus to superfunds?

Corporate groups have long grappled with the volatility surrounding defined benefit pension schemes within group companies. Up to now, the only way of completely removing that volatility was for the pension scheme to secure all benefits with an insurance company (buy-out). For many companies/groups, the extra funding needed to top up scheme assets to the level required to buy-out benefits, has been out of reach.

Superfunds are a potential, less expensive alternative to insurance company buy-out. It might therefore seem logical that existing sponsoring employers with access to sufficient resources would push for superfunds over buy-out. However, the new TPR guidance specifically provides that TPR does not expect a superfund to accept a transfer of a pension scheme to it, where that pension scheme has the ability to buy-out or is on course to buy-out ‘within the foreseeable future (for example, within the next five years)’.

It may also be the case that the top-up contribution that an existing employer would be required to make to the superfund is itself beyond reach. Unless the employer is in a position to source extra funds to meet any required capital contribution to the superfund, continuing with a longer-term payment plan to the existing pension scheme may be preferred. In addition, it will be up to the trustees of the existing scheme to decide if the financial covenant provided by the existing scheme employer, is better than that offered by the superfund. If it is, clearly those trustees should not agree to a transfer to a superfund.

Does the new TPR guidance apply to employers and trustees of pension schemes?

Whilst the guidance applies to superfund operators, it also contains useful insights for employers and trustees that might be considering a superfund as a potential future option, as follows:

Pension Protection Fund (PPF) eligibility

• Member protection in the event of the failure of a superfund is an important consideration for trustees in deciding whether to agree to a transfer to a superfund. Unlike in a buy-out situation, members transferring to a superfund will not have access to compensation provided by the Financial Services Compensation Scheme. However, TPR does require that a superfund pension scheme is PPF eligible although, as set out below, superfunds will have funding related triggers that should make the likelihood of a call on the PPF low.

Clearance applications

• The ceding employer will be required to make a clearance application to TPR. Clearance applications are required for ‘type A’ events. Type A events are those that are materially detrimental to the ability of a pension scheme to meet its pension liabilities. The starting point is that the transfer to the superfund is potentially materially detrimental, and that the ceding employer will need to demonstrate that it has put in place mitigation to address any material detriment. For example, if the ‘proxy’ employer covenant represented by the superfund’s capital buffer is not as strong as the existing covenant provided by the ceding employer, the ceding employer may need to procure a top up payment to the superfund capital buffer. Clearance is a statement from TPR that it will not use its anti-avoidance powers in relation to a transaction conditional on the applicant disclosing all relevant facts and circumstances including the potential material detriment and mitigation measures.
• As part of the clearance application, TPR expects to see evidence of the transferring trustees’ due diligence regarding the superfund. This suggests that there will need to be a strong degree of collaboration between the ceding employer and the transferring trustees in connection with the clearance application notwithstanding that it is the ceding employer that makes the application, i.e. that they will both need to be ‘on the same page’ regarding the appropriateness of the superfund.

Information to be provided by the superfund

• TPR expects superfunds to provide ceding employers and transferring scheme trustees with full and transparent details of the superfund offering, fees, funding and investment objectives, and the superfund’s methods for achieving these objectives. TPR will itself look closely at this information in order to understand the expectations that the superfund is setting for the transferring scheme and its members. TPR may also send separate information requests to the superfund in connection with a proposed transfer. There will be comfort for trustees in knowing that they are not ‘going it alone’ regarding a proposed superfund transfer and that TPR will be closely involved in the process.

Superfund financial sustainability

• The TPR guidance sets out capital requirements for superfunds. These will have an impact on the amount that a ceding employer may expect to pay as a ‘top-up’ to the pension scheme assets that transfer to the superfund.
• The capital requirements are analogous to but much less onerous than the minimum capital requirements prescribed under legislation for insurance companies. The overarching objective of the superfund capital requirements is for there to be a very high probability of the superfund paying members’ benefits in full. TPR states that the reference in Department for Work and Pensions consultation to a 99% probability has guided TPR’s risk appetite in setting its capital requirements.
• Capital requirements will be based on: (1) a funding level that meets the superfund pension scheme’s technical provisions (TPs); and (2) an additional risk-based capital buffer. The requirements will also take into account enforceable trigger events that the superfund should have in place (see below).
• The superfund pension scheme must set TPs using prudent assumptions chosen in accordance with minimum requirements prescribed by TPR, and contained in an appendix to the guidance.
• The capital buffer should be risk-based. In respect of market risks, the superfund must tailor the buffer to the superfund’s circumstances. For example, a higher risk investment strategy would require a larger buffer. The market risk element of the buffer is required to be at a level that, when added to the superfund pension scheme’s assets, there is a 99% probability of funding at or above the minimum TPs in five years.
• In relation to liability risk, TPR considers that the capital buffer should include a reserve to cover rates of future improvements in longevity risk that are greater than those assumed in connection with the TPs.
• All transfers to a superfund must meet the capital requirements on a ‘standalone’ basis.

What are the other notable contents of the TPR guidance?

Trigger events

• TPR expects superfund governing documentation to include two funding related triggers, a low-risk funding trigger and a wind-up trigger:
  • Low-risk funding trigger: At any point where the superfund pension scheme assets plus the risk based capital buffer equals 100% of TPs, all funds in the capital buffer must flow into the superfund pension scheme, unless there is an additional capital injection.
  • Wind-up trigger: If the funding level (measured using the Pension Protection Fund (PPF) funding basis under section 179 of the Pensions Act 2004) falls to a set level, the superfund must wind up its pension scheme.

Prohibition on value extraction

For an initial period, the superfund or its investors should not extract funds from the pension scheme or the capital buffer unless the superfund buys out member benefits with an insurer. TPR will keep this under review and update its position within three years.

In addition, the superfund should not use surplus value in the pension scheme or the capital buffer to support new transfers into the superfund. All transfers into a superfund must meet the capital adequacy test on a standalone basis. For a new transfer, TPR expects that if the transferring scheme assets and contribution from the ceding employer do not meet the capital adequacy test, the superfund backers will need to inject fresh capital.

Fees, cost and charges

Fees, costs and charges should be appropriate, transparent and fair, and not designed to circumvent the prohibition on value extraction. If a superfund is unsure whether a fee, charge or cost would amount to profit extraction, the superfund personnel should contact TPR.

In setting fees, costs and charges, there should be benchmarking against those applying in the market for pension schemes of similar scale and complexity.

Investment arrangements relating to superfund’s capital buffer and pension scheme

• TPR sets out investment principles that it expects superfunds to follow. The aim of the principles is to ensure that a superfund invests assets appropriately, concentration risks are limited and the assets are realisable and transferable for full value. The principles take into account that in the short term, some superfunds may not get market support, may fail or may exit the market. In those circumstances, the superfund pension scheme may have to transfer to another superfund or be run on by the trustees (e.g. after a low-risk funding trigger event).

Operating standards

Much of the guidance sets out standards of governance and oversight that will apply to superfunds. Some of the relevant points covered are:

• TPR will carry out a detailed assessment of whether those persons identified to fill key roles within the superfund are fit and proper.
• Superfunds will need to demonstrate that their corporate board and trustee board are well-governed, with appropriate checks and balances in place. TPR expects superfunds to comply with relevant sections of the UK Corporate Governance Code.
• There should be a clear and comprehensive policy for dealing with conflicts of interest relating to superfund trustees.
• Superfund trustees should have a clear and documented process for obtaining and addressing members’ views and complaints.
• TPR will require detailed information to enable it to understand the superfund’s systems and processes. This includes the IT systems used in scheme administration and the processes used to administer the superfund. Where administration or other key functions are outsourced, TPR will require details of the party involved, the range of tasks outsourced and the appointment process.
• Superfund trustees will need to demonstrate that they have functionality and processes in place to manage member data.