To run on or buy-out

Whilst the total value of defined benefit (DB) scheme liabilities being transferred to an insurer in the first half of 2024 has been lower than expected, the number of transactions (134) has eclipsed another record in the UK, the highest number of deals ever recorded for a six-month period. The UK derisking market is expected to remain strong into 2025 and beyond.

New legislation and increasing DB surpluses

New UK legislation which came into force in September 2024 requires sponsors and trustees to document a long-term objective for their DB scheme, whether that be to run-on, transfer to an insurer or transfer to a commercial consolidator. They must also agree and document a funding and investment strategy on how they will ensure a scheme is funded and invested consistently with that objective going forward.

According to PwC’s Buyout Index, the surplus of the UK’s 5,000+ corporate DB pension schemes grew to £330bn at the end of October 2024 from £300bn at the end of September 2024. With the introduction of the new DB funding and investment regime and such strong surpluses, many sponsors of the largest UK DB schemes are evaluating their long-term strategies. This includes considering whether, and if so when, insurance remains the best option for them and their scheme’s members, or if they should run on their scheme, and if so for how long and under what conditions, to generate additional surplus. This debate was further elevated by the publication of the UK government’s consultation in March 2024 on how they could make it easier for trustees of well-funded schemes to make payments from surplus to employers and scheme members, in the hope that employers will then use that cash for new capital investment in the UK. There is clearly also more to come from the government on future investment and surplus options for UK DB schemes.

We have also seen examples in members forming action groups, such as the BP Pensioner Group, to bring public attention on sponsors or trustees in two key areas - discretionary pension increases in times of high inflation and non-mirroring of discretionary benefits when insuring.

Understanding risk irrespective of your long-term strategy

Whichever option is taken, one area deserves attention from both sponsor and trustee: are the risks which remain the sponsor’s responsibility post buy-out properly understood and mitigated? Acceptable mitigation requires a full understanding of how and when those risks can arise.

In the case of scheme investments, delaying a buy-in, for example, may facilitate the run-off of illiquid assets, meaning that sponsors do not run the risk of a funding gap caused by illiquid asset haircuts on early sale (which may also achieve a more competitive process with insurers when the scheme is taken to the market as a more attractive, easily transactable prospect).

What about uninsured liabilities? These can arise in three main areas:

• uncertainty as to benefits, for example where amendments to scheme rules are invalid or do not accord with the parties’ intentions at the time;
• data errors, such as not accurately recording changes in membership; and
• administration errors, where schemes have not been administered in accordance with their governing documentation and overriding legislation. 

The due diligence process is crucial as it provides a solid foundation to the sponsor assessment of the risk of uninsured liabilities emerging in the future which will help inform its end-game strategy. Completing full due diligence before going to the insurance market will ensure greater certainty over the final premium paid. Furthermore, the extent and outcome of the due diligence process will inform any decisions as to mitigation, including whether to purchase run-off and missing beneficiary insurance or the more expensive residual risk insurance which insures against unknown member benefit entitlements not included in the insurer data and benefit specification (subject to material exclusions).

Whilst the due diligence process is trustee led, from a governance and reputational perspective the sponsor should be aware of the risks for which it is contingently liable. We have seen a huge variation in approach to due diligence from trustees. The sponsor should input into the process to ensure that it:

• understands the due diligence carried out and the risks of the methodology adopted. It is vital to understand what has not been looked at. For example, have predecessor scheme trust deeds, vaulted papers and adviser files been reviewed? What steps have been taken to verify the benefit specification; how will member data be checked – if on a sample basis, what is the sample size and how will it be selected; what data items will be recalculated and how?;
• understands any points raised by the insurer or the trustee’s advisers in addition to the matters identified by the trustee and how these are responded to;
• is involved in deciding how to resolve any issues identified e.g. where scheme benefit changes are proposed in order to align governing documents and administration practice;
• is involved in agreeing the terms of any bulk purchase annuity or residual risk policy with the insurer which addresses the issues identified and understands the consequences of those terms.

We recommend that the scope and process for due diligence is jointly agreed by the trustee and the sponsor at the outset (i.e. in advance of any transaction) so that both parties are aware of the level of comfort to be provided by the exercise. The strongest level of comfort will require the sponsor, the trustees, the scheme’s legal adviser and the scheme administrator to work together to review a wide range of documents, data and calculations. In particular, any due diligence scope should be considered separately from the question of what, if any, insurance cover to purchase. Through early and ongoing involvement, the sponsor can be more comfortable with the likelihood of uninsured risks emerging that may ultimately remain its responsibility post buy-out.