Overview
As can be seen from the above quote (from TPR), DB commercial consolidators (or “superfunds”) attract polarised views. Following the publication, on 18th June, of TPR guidance setting out minimum standards for such schemes, a significant barrier has been removed to the use of superfunds. TPR was acting under some pressure from recent market developments, including new capital investment models. The guidance will apply to these new models as well as the more conventional “consolidator” models already in the market.
The guidance, which has immediate effect, is intended as an interim regulatory regime pending the eventual introduction of a new legislative framework, which is likely to take a number of years to put in place. It replaces TPR’s December 2018 guidance; and whilst the existing guidance for sponsoring employers and trustees, who are considering a transfer to a superfund, has not yet been updated, TPR says this will happen over the coming months. That said, there are points in the new guidance that will impact on sponsoring employers and trustees who are considering a transfer to a superfund.
Whilst some see the new superfunds as a welcome development in the pensions’ landscape, there has been some concern, including from the Bank of England, that superfunds offer a lighter touch than the highly regulated insurance environment which applies when pension benefits are bought out with an insurer.
What is a superfund?
Superfunds are set up to accept bulk transfers of assets and liabilities from other DB pension schemes. They are intended to provide a lower-cost alternative to insured buy-out for sponsors wishing to separate themselves from their DB liabilities. TPR has said that they want the superfund to enable 100% of members’ benefits to be protected to a high degree of certainty.
As “occupational pension schemes”, they are subject to the occupational pension schemes’ DB scheme funding regime, rather than insurer solvency requirements. Transfers in of benefits can be made under existing Department for Work and Pensions (“DWP”) legislation governing bulk transfers without member consent. And, as the guidance makes clear, existing DWP legislation on scheme funding, governance and investment will apply to them (although they are outside the ambit of TPR’s current consultation on the DB Funding Code of Practice).
Currently, two superfunds are operational, Clara and The Pensions Superfund (“TPS”). Others are apparently “waiting in the wings”. The superfunds are structured so that the liability of the sponsoring employer is replaced by a corporate entity acting as “scheme employer”, backed by a capital injection to a capital buffer. The capital buffer is funded by third party investor capital and contributions from the original employer, and is to be available to the superfund scheme trustees in defined circumstances (“trigger events”). The superfunds have a sponsoring employer to enable them to remain eligible for compensation under the Pension Protection Fund (“PPF”).
Throughout its guidance, TPR refers to the capital buffer as being a “proxy” for the employer covenant. The term “superfund” refers to the overall structure of corporate entity, pension scheme and capital buffer.
As mentioned, publication of the guidance is in part a response to the emergence of new business models for individual DB schemes, involving special purpose vehicles (“SPVs”) (in some cases backed by 3rd party capital), which envisage the SPV replacing the existing sponsoring employer at some point in the future. One UK pension scheme has already transacted to secure member benefits in April this year using capital provided by a third party investor with a capital provider. Capital is "locked in" alongside scheme assets from the outset, allowing scheme members to benefit from an additional layer of security in addition to the existing sponsor covenant. . Even though there is no element of “consolidation”, TPR believes that these models pose some similar risks to members and the PPF as do transfers to superfunds, and it wants their development to be controlled in a “managed and robust” way. It says that the guidance will apply to them at the point that the SPV replaces the sponsoring employer, so the arrangements need to be structured in such a way that the scheme is in compliance immediately from the time of replacement.
There are risks while the superfund market develops. TPR are mindful that some models may not get market support, may not achieve critical scale, may fail or may decide to exit the market.
The updated guidance
TPR first published guidance on superfunds in December 2018, to coincide with publication of the DWP consultation. The guidance has been updated following a “targeted” consultation on three specific areas (capital adequacy, value extraction, and investments) last year. TPR’s response to that consultation has been published alongside the updated guidance.
TPR says that the new guidance is neither exhaustive nor prescriptive, but that it will rely on it in any regulatory action it may take. It notes that all its existing powers are available to it when regulating superfunds (and these are of course to be strengthened by provisions in the Pension Schemes Bill, currently making its way through Parliament).
The guidance covers: TPR’s initial assessment of the superfund; ongoing supervision (each superfund will have its own TPR supervisor); and scrutiny of transfers in and out (which will involve further assessment of the superfund).
Key points for employers and trustees in relation to the latter are:
- Employers looking to take advantage of superfunds (called “ceding employers”) are expected to apply for clearance in relation to a transfer, as it involves removal of the employer covenant. TPR says transfers to superfunds will be a new category of “Type A” event i.e. potentially materially detrimental events. According to the guidance for trustees (see more on this below), clearance will be granted only if TPR is of the view that any detriment to the pension scheme has been adequately mitigated.
- TPR have said that they do not expect a superfund to accept the transfer from a ceding scheme that has the ability to buy-out or is on course to do so within the foreseeable future (on the meaning of “foreseeable future”, the guidance provides, “for example, in the next five years”). There seems to be less emphasis on this gateway than was proposed in the DWP consultation on a legislative framework, suggesting that TPR will be more interested in the circumstances of a particular ceding scheme rather than adopting a “one size fits all” approach.
- Ceding trustees will need to provide evidence of extensive due diligence as part of the clearance application (and we touch on some of the themes below). This will be covered in the further guidance for trustees. David Fairs (Executive Director of Regulatory Policy, Analysis and Advice for TPR) is reported as saying:
“We’ll set out very clearly what we think trustees should take into account before they go into a superfund, so it will be very clear to them the amount of due diligence we expect them to do, the levels of understanding they have, the information they should get from the superfund before they enter into a transaction.”
To support this, TPR expect superfunds to provide prospective ceding employers and trustees with full and transparent details of their offering, their associated fees, their funding and investment objectives, and their methods for achieving their objectives.
- For the new kind of business models referred to above, trustees and employers will need to understand the ramifications of the requirement that the guidance will apply at the point at which the SPV becomes the sponsoring employer.
- It is interesting to note that superfunds will have to offer transfers out, on which additional guidance will follow.
Requirements for superfunds: key points
The guidance sets out the minimum standards that a superfund must meet, including that the pension scheme element is:
- a “registered scheme” for tax purposes, and
- eligible for PPF entry.
The superfund must be financially sustainable and have adequate contingency plans to manage funding level triggers as well as to ensure an orderly exit from the market. In developing its guidance, TPR explain that the indication of 99% probability of members’ benefits being paid in full has guided its risk appetite when setting its requirements. In short, this includes a requirement for liabilities to be calculated using specific assumptions and for additional assets to be held in a capital buffer, available to the trustees of the scheme in specified events. The superfund will have to be funded on a prudent basis, including an “expectation” of a discount rate of 0.5%.
The superfund will have to demonstrate that it is run by fit and proper people, capable of being supervised by its trustees, and that it has effective governance arrangements in place. It must have sufficient administrative systems and processes to ensure that it is run effectively.
The main points of relevance in the guidance for sponsoring employers and trustees considering a transfer to a superfund are:
- in relation to governance, in particular conflicts of interest, where the superfund trustees are warned to be particularly alert to adviser conflicts, and conflicts arising from membership of a corporate group,
- the systems and processes of the superfund will be assessed first as part of the initial assessment and then again in the context of a proposed transfer-in,
- the financial reserves of the corporate entity should be ring-fenced, with a proportion being held in cash. TPR also says it will need to understand details of any debt and equity financing arrangements,
- on the funding and capital requirements, as noted, the guidance uses the “99% probability of members’ benefits being paid” benchmark set out in the DWP consultation. This means the superfund must be funded to a level set out in TPR’s capital requirements, which covers both the technical provisions (“TPs”) (on which TPR sets out its minimum expectations) and capital buffer. In a segregated scheme, such as Clara, the section that wishes to admit a new scheme must be funded to that level; and in a non-segregated scheme, such as TPS, the entire scheme must be funded to that level.
Additionally, all transfers-in must meet TPR’s capital requirement on a “standalone” basis, with fresh capital being required to achieve this; a superfund will not be able to write new business if these funding levels are not achieved,
- the capital buffer will be risk-based such that “when added to the scheme’s assets, there is a 99% probability of the scheme being funded at or above the minimum TPs in five years”. In terms of setting TPs, the guidance covers TPR’s minimum expectations for the approach superfunds should take to inflation, mortality, commutation and certain demographic assumptions, as well the discount rate to be used,
- scheme documentation must include two funding triggers: the first, set at 100% of TPR’s TP funding basis, will result in funds in the capital buffer flowing into the pension scheme; and the second, set at 105% of the relevant PPF liabilities (as assessed in accordance with s179 of the Pensions Act 2004), will result in the scheme winding up and the members being transferred out to another registered pension scheme,
- there will be a prohibition on the extraction of surplus funds from the capital buffer or pension scheme unless relevant benefits are bought out in full with an insurer. In addition, surplus value cannot be used as capital to support new transfers-in. All transfers-in should be able to meet the capital adequacy test on a standalone basis.
The prohibition will be reviewed within three years of the new framework being published. The review will be informed by TPR’s experience of the operation of the regime and by any DWP policy developments,
- fees, costs and charges should be “appropriate, transparent and fair”, and in line with market levels. TPR will not set prescriptive limits, but it will expect superfunds to demonstrate to TPR that they have benchmark fees, costs and charges in line with schemes of similar scale and complexity. Trustees and employers considering a transfer should be made aware of all fees and charges associated with the transfer,
- the guidance sets out minimum investment principles for scheme assets and for the capital buffer. Assets in the latter should be invested as if the Occupational Pension Schemes (Investment) Regulations 2005 apply. Maximum allocations will apply to investments, including a 5% limit of the total issuance of a security and 2.5% limit of the issuers total debt and equity issuance. (Buy-in policies are excluded from these limits.) There are also limits on illiquid assets, as provided for in FRS102, and restrictions on in-house pooled funds.
What a sponsoring employer needs to consider
The transfer will be a new category of “Type A” event, as this is potentially a “materially detrimental event” to the pension scheme, such that clearance will be required. TPR expects that a transfer will only proceed where any top-up payment or other mitigation agreed as part of the transfer into the superfund fully mitigates any detriment.
As part of planning for a transfer to a superfund, the employer will need to ensure the trustees have carried out sufficient due diligence on the transfer and have the appropriate resources to do this. The trustees will need detailed advice on whether any detriment to the scheme has been adequately mitigated and ensure the scheme could not achieve a better outcome through other means.
As well as the financial cost of a transfer to a superfund, and the extensive due diligence process the trustees will need to carry out, the sponsor will need to consider the quality of the discharge it receives from the superfund in respect of any future liability in relation to pension benefits. It will also want to consider the potential reputational risk associated with the possible failure of a superfund.
What trustees need to consider
A transfer to a superfund will clearly have implications for the scheme covenant and security of members’ benefits due to the exchange of the employer covenant for increased funding with a finite capital underpin. Assessing the viability of a transaction will require advice on the covenant offered by the superfund, as well as careful consideration of the alternate possibilities of buying out scheme benefits in full with an insurer or retaining the link with the sponsor.
As a preliminary matter, trustees will need to check that this transfer is permitted under the scheme’s trust deed or whether a rule amendment is required.
In their assessment of the transaction, trustees will likely need to take into account matters such as the scheme’s current funding position, any DRCs, professional covenant advice, actuarial advice on the future funding of the ceding scheme, and the funding position and long term objective of the superfund. In the latest guidance, TPR says it will require evidence of the ceding trustees’ due diligence in relation to this.
Under general trust law principles, trustees will need to demonstrate that the transfer power in the scheme rule is being exercised for its proper purpose. The DWP consultation, referenced in TPR’s current guidance for trustees, sets out what factors should be taken into consideration. Legal advice should, “include all of the usual considerations, such as advice on conflicts, including adviser conflicts of interest. It should also look at whether [trustees] have the power to make the transfer and, if [they] do, whether it would be appropriate for [them] to do so. This advice should also set out issues where [trustees] should take appropriate covenant, actuarial and investment advice”.
Trustees will also need to bear in mind the differences in the protection offered compared with insured buy-out if the superfund fails: members of a superfund will be entitled only to compensation from the PPF compared with likely 100% compensation from the FSCS.
Finally, a thorough data cleanse will be required: superfunds are unlikely to offer the all risks protection available on an insured buy-in.
Again all this is likely to be a time-consuming process. Under current guidance, ceding trustees are expected to inform TPR of their intention to transfer “at the earliest opportunity – at least 3 months” before the planned transfer.
Next steps
Although the Government has confirmed it is working on legislation, no date has been set. (David Fairs at TPR anticipates that this may take up to five years to put in place.) Guy Opperman, Pensions Minister, welcoming the updated guidance, emphasised that the TPR regime is “interim” and that market participants should not assume that the permanent regime will automatically replace this interim one. In particular, he said it may set alternative conditions, including more prudent requirements.
In the meantime, there is more detail to come on the new regime, in particular in relation to:
- the position for ceding trustees and sponsoring employers (updating the existing guidance),
- ensuring there are enforceable protections in superfund documentation, and
- TPR’s expectations in relation to reporting by superfunds.
Our view
TPR’s temporary regime gives the green light to Clara and TPS to apply for authorisation and, assuming that is forthcoming, to complete the transactions that they have been working on. In terms of timing, a spokesperson for TPR is reported as saying that it will have completed its assessment of the two emerging superfunds by the end of this year. TPR will then need to review any application from an employer for clearance to transfer into a scheme
In the meantime, although the guidance requires superfunds to be funded so as to meet the promises to members with a high degree of certainty, they do not offer the same levels of member security as does insured buy-out.
Careful consideration and risk analysis will be needed, both for trustees and sponsors. A gateway issue is the likelihood of buyout funding being reached, and how that is assessed. Ultimately, a central question will be: what level of confidence do the trustees and sponsor have, in a range of possible scenarios, as to the best outcome being scheme run off, buy-out, or transfer to a superfund.
