Regulatory Change and Illiquidity

Periodically, there are macro changes in the wider pensions landscape that can have meaningful effects. Right now, two in particular stand out: SWoSS and consolidators. Before diving into the details of each though, it is worth considering the big picture options available to pension funds.

A pension fund exists to pay pensions. Success or failure is defined by whether pensions get paid or not. Previously, schemes have ultimately had two options- run the scheme off themselves (self-sufficiency), or pass the problem to an insurer (buyout). Both have pros and cons. For example, the first is cheaper and generally allows the scheme to take less asset risk, but keeps the risks around for longer.

Now, the changes. The first is the PPF’s regime for schemes without a substantive sponsor (“SWoSS”). Before SWoSS, if a scheme could not afford a buyout at the point when its sponsor went insolvent, it would have to enter the PPF and do a partial buyout with any surplus (above PPF funding). Under SWoSS, eligible schemes can continue to run on a self-sufficiency basis, paying a higher version of the PPF levy.

It is worth caveating that the SWoSS regime is new, currently being refined, and may not be kept long-term. However, if it stays it could be meaningful.

To run, schemes would need to be well-funded on a prudent basis, and reasonably de-risked. Even then, not all schemes may be eligible- some may be too small for it to be practical, and some may be excluded by specific wording in the scheme rules. For those that can run, however, this allows schemes to continue beyond their sponsor failing. As even a strong sponsor has a significant chance of insolvency over a 20 year horizon (the typical duration of a scheme), this ability to keep going can make paying full pensions meaningfully more likely. This in turn makes self-sufficiency more attractive.

The second major shift is the likely introduction of consolidators. This is a new potential third options for schemes, between the two traditional solutions of buyout or self-sufficiency. While less secure than a buyout, they would be cheaper, and they could in some cases both discharge the trustees’ liability and improve the scheme’s covenant. To some extent the business model is a regulatory arbitrage against insurers, in that consolidators would not have the same solvency and capital requirements, and we can debate what the regulation should be around them. At a practical level though, these may well be the best option for some schemes. This is particularly true if SWoSS becomes more widely adopted, and if moving to a consolidator allows a scheme to use SWoSS (e.g. if it were too small on its own for the admin and legal work to be feasible), or a variant of SWoSS designed especially for consolidators.

Both these changes offer new opportunities for pension schemes. Moreover, it is unlikely that these will be the last two changes in the DB landscape. This means it is worth taking a step back and thinking in terms of liquidity. The biggest advantage of keeping a portfolio liquid is that it retains the ability to be adjusted as the world changes. And things can change quite meaningfully. For example, suppose an asset were attractive to insurers but not to consolidators. Locking into such an asset would limit a scheme’s ability to change tack, and this could become a very tangible cost. It’s therefore important to ensure that when a scheme accepts illiquidity it is getting sufficiently compensated for it.

[Originally featured in Actuarial Post]

Author: Alex White

Alex joined Redington in 2011 as part of the award-winning ALM team. He now runs the research function within that team, designing and improving models. He is one of 6 members of the firm on the Investment Committee, and also specializes in LDI. He is a fellow of the IFOA, and holds an MA(Hons) in Mathematics from Robinson College, Cambridge. In his spare time, Alex trains Fujian White Crane Kung Fu and static trapeze.

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