Few employers seem to have sensed the opportunity that the revolutionary changes to Britain’s pensions landscape could bring to their balance sheets. However, this in my mind is the single most positive implication of the changes to UK pensions that came into force on 6 April 2015.
The new flexibility is designed for defined contribution (DC) schemes. But members of some 6,000 defined benefit (DB) pension schemes can also transfer the value of their benefits to a DC arrangement just before retirement. Some DB schemes already inform members approaching retirement about their option to transfer benefits and reshape retirement income. Typically, they might offer a higher tax-free lump sum and a higher pension, with the caveat that their pension is no longer inflation indexed or passes to the spouse after the member’s death.
Based on KPMG data from these exercises around a quarter of those who are eligible to transfer out at retirement normally do so. But given the significantly higher levels of flexibility since April we anticipate around a third of pension scheme members will transfer out of their scheme. To put this into context, the UK private sector has around £1.5 trillion of defined benefit pension liabilities, with roughly half of this amount due to members who have yet to retire.
This means over the next 10 to 15 years we could see £250 billion of pension liabilities transfer to personal flexible arrangements and coming off corporate balance sheets.
Reduced DB pension liabilities means corporate sponsors will be underwriting less DB pensions risk over time. It also means many schemes will be in a better position to be able to ‘buy out’ the whole scheme with an insurance company, removing the liabilities from the corporate balance sheet altogether.
Take a scheme with £110 million of assets and £100 million worth of liabilities as measured on the corporate balance sheet. To transfer the whole scheme to an insurer, typically incurs a premium of perhaps 25 percent above the balance sheet liability – in this example raising it to £125 million.
That means the employer needs to write a cheque for £15 million to top up the scheme assets to £125m.
If instead, a third of the members transfer the capital value of their benefits out of the scheme to access the new flexibility, then the liabilities left in the scheme will shrink by £33 million over time to £67 million. Assets will also shrink by a similar amount to £77 million meaning the cheque needed to buy-out the full scheme falls to £7 million.
The net result is that many companies would have a far better chance of transferring their whole scheme off the corporate balance sheet to an insurance company. For the pensions system as a whole, this would reduce the risk of calls on the Pension Protection Fund that must take on underfunded DB schemes if the corporate sponsor fails.
To achieve this we need to shake up DB pensions by starting to educate members about their choices and which options might be relevant to their retirement.
Developing new pensions legislation typically takes years and the speed at which this legislation moved from design to implementation by has been unusually quick. Industry must not use that as an excuse in failing to provide adequate and timely support and education to scheme members. Such an outcome would be a disservice to members of DB schemes and waste a great opportunity to manage down companies’ risks emanating from defined benefit schemes.