Until recently, the end goal for most pension schemes meant one thing: a buyout. These days, however, we are seeing a proliferation of alternative options come on board – including self-sufficiency and cashflow matching.

These alternative options allow the scheme run to its course without paying a premium to an insurance company, which might be the right decision for the sponsor of the scheme. Meanwhile, The Pensions Regulator (TPR) has also been shining a spotlight in this area, issuing new requirements for Defined Benefit (DB) schemes to publish their ‘long term financial destination’ in their Chair’s statement.   

This continues to be a hot topic between trustees and sponsors. But what’s the right destination from the point of view of the scheme’s individual members? As they see it, the worst scenario is one which puts their benefits at risk – for example, if the sponsor goes into liquidation and the scheme moves into the Pension Protection Fund (PPF) with a cut to their benefits. Clearly, achieving buyout eliminates any impact from a sponsor bankruptcy. However, transferring the scheme to an insurance company replaces that risk with the possibility that the insurance company is unable to pay benefits – which is protected against via robust regulation and prudent margin requirements.

For a well-funded scheme setting its sights on a buyout, the decision is clear. However, with buyout remaining an unaffordable target for many schemes, what does that, in turn, mean for members?

Unless your scheme is one where buyout is realistically achievable, there are three potential options: 

1. Take more risk now in order to get to buyout in a similar timeframe, with the gap being funded either through higher investment returns or sponsor contributions. However, this approach may expose members to greater covenant risk, if returns do not materialise as expected.
2. Keep risk on the table for longer and take more time to achieve the goal. This reduces the immediate pressure on the sponsor to support a higher risk strategy, but exposes members to the sponsor for longer. 
3. Change the target. Although TPR requires DB schemes to consider their long term objectives, they haven’t specified exactly what that target should be. Schemes could therefore consider a more realistic target (such as self-sufficiency or cashflow matching) to construct a plan, with a manageable level of risk spread out over a more reasonable timeframe. That would also avoid any prefunding of insurers’ profit margins.

Imagine you are planning a dream family holiday to a theme park in the US. If the trip is easily within your budget, then everyone is happy. If not, is it worth taking more risk to get there – for example, by putting the cost of the holiday on finance? Or to get there at a later date by saving for longer? Or, perhaps, on the other hand, better to target a more achievable goal, such as a theme park in Europe rather than across the Atlantic. 

The decision about how to fund your dream holiday is a very personal one: wait too long and there’s a risk your children will be too old to enjoy it! Likewise, there’s no single answer for a pension scheme. What would members choose if they were making this decision themselves? Should members in fact be surveyed to get their thoughts? 

At KPMG, our answer is to suggest taking an integrated risk management approach to incorporate all aspects of funding, investment and covenant. We’ve also helped clients implement both buyout and other long-term destinations such as Cashflow Driven Investing (CDI). However, throughout we believe it is also crucial to take account of how the destination impacts the underlying beneficiaries. 

For more information, please contact Tim Barlow and Jennifer Roe.