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Survey Report

New kids on the block – a look at Third Party Capital Solutions

Chapter eight of the 2021 de-risking report

Pensions Corporate Consulting|Pensions Risk Solutions|Pension Board and Trustee Consulting|Pensions Technology
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By Will Griffiths and Tom Ashworth | January 19, 2021

2020 was another breakthrough year in pensions, where we saw the first arrangement in which third party capital was provided directly to help a pension scheme support its journey to buyout. In this article Will Griffiths and Tom Ashworth explore Third Party Capital Solutions (TPCSs), looking at how these may be used to benefit both pension schemes and their sponsors.

Investors taking on pension liabilities and putting their own money in to back these with a view to making a return is neither new (bulk annuity providers) or an area that hasn’t seen recent innovation (superfunds). However, TPCSs takes this in a new direction by offering schemes a “helping hand” in the form of a capital buffer to support the journey plan of the pension scheme, while retaining the link between pension scheme and sponsor.

Figure 7 - Comparison of solutions for defined benefit pension schemes
Capital injected by provider? Trustee remains in place? Sponsor link remains in place? Flexibility to change strategy in future? Supported by pension or insurance regime?
Run-off N/A Yes Yes Yes Pensions
Third Party Capital Solutions Yes Yes Yes Limited Pensions
Superfunds Yes No Yes or No No Pensions
Buy-in Yes Yes Yes Limited Ultimately pensions
Buyout Yes No No No Insurance

 

How does a TPCS work?

One approach is for a ‘capital buffer’ from the capital provider to be held outside of the pension scheme and structured in such a way that it is paid into the scheme if pre-agreed funding thresholds are not met at agreed dates in the scheme’s journey plan.

In this article, we have focused on a TPCS that is structured to support a journey to buyout, but many of the aspects covered are equally relevant to a TPCS designed with a self-sufficiency end game in mind.

With the funding target and time period to reach this target in mind, the capital provider will agree with the trustees an investment strategy, which will also need to make allowance for providing a return on the capital provided. Once the investment strategy has been agreed, the trustees will typically not be able to change it without the agreement of the capital provider. Other actions during the journey plan may also need to be agreed – for example member option exercises.

With the TPCS in place, the pension scheme will otherwise operate as normal. The trustees, the sponsor and both parties’ advisers will continue with the same responsibilities as previously.

There are some key pros and cons of using such an approach:

Pros

  • Greater certainty
    • Capital buffer provides the pension scheme with additional protection against downside risk.
    • The availability of the capital buffer provides the trustees with greater comfort to target higher returns on investments.
    • Potential for a reduction in sponsor contributions.
  • Sponsor protection
    • Sponsor enjoys greater certainty regarding the requirements the pension scheme places on the business.
    • Sponsor benefits from the downside protection afforded by the capital buffer.

Cons

  • Risks
    • Control of the investment strategy is passed to the provider of capital limiting the ability to react to events or change course.
    • The downside is only protected to the extent of the capital buffer. Should the buffer be exhausted, the scheme is exposed to further downsides.

At the end of the agreed period there are then broadly three possible scenarios (as illustrated in Figure 8). Two of these will lead to the benefits being bought out in full, but only one leads to the capital provider making their expected return.

Flow diagram showing the possible outcomes under the TPCS
Figure 8 - Possible outcomes under the TPCS

How does a TPCS compare with the alternatives?

The two other options available to pension schemes who can’t yet afford buyout (over and above the ‘normal’ direct funding of a pension scheme by the sponsor) are either to break the link with the sponsor and transfer the liabilities to a third-party superfund or for the sponsor to agree to put in place some form of contingent funding.

The barriers to a third-party transfer are often significant – the pension scheme can’t afford buyout or the trustees don’t want to lose the sponsor covenant by moving to a superfund.

Likewise, contingent funding from the sponsor may bring its own challenges for sponsors – for example, tying funds up in an escrow account means they can’t be used elsewhere to support the business and lenders (either current or future) will look negatively on assets which have been promised elsewhere in the event the sponsor gets into difficulty.

This leaves a space for a TPCS to play a role where the scheme is not fully funded on buyout, and the sponsor is not able to / would prefer not to provide additional support to the scheme (either directly or contingently) in order to support the scheme taking additional investment risk in order to progress along its journey plan.

It is worth bearing in mind with TPCSs that, unlike the bulk annuity market, it is likely that the products available are not identical products nor are they likely to be provided by similar organisations, making comparisons more challenging. This feature will mean sponsors and trustees will need to complete detailed due diligence before entering into a TPCS. However greater freedom to structure a TPCS may well enable pension schemes to negotiate terms that best meet their specific need.

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Pension scheme characteristics that TPCSs will favour

 
From our discussions with a number of capital providers actively considering these deals, a pension scheme which meets the following criteria will be attractive to them:

  • Total liabilities in the range of a few £10m to a few £100m
  • Around 85% funded on buyout
  • A significant proportion of the total liability is in respect of deferred members
  • Relatively robust sponsor so as to reduce the likelihood of needing to deal with the complexities in the case of sponsor insolvency

Such a pension scheme would achieve the balance of offering the capital providers with sufficient opportunity to make a return on their investment, whilst at the same time being in a position that putting in place a TPCS is beneficial to both the trustees and sponsor.

Conclusion

While still a new area, it would already seem that the right TPCS will be an attractive proposition to some trustees and sponsors. For pension schemes where this is the case then we believe the two key areas to assess will be:

  • Does the additional security from the capital buffer provide a fair trade off for handing over control of the pension scheme’s assets, or would maintaining the status quo be preferable?
  • Are the trustees and sponsor comfortable with both the counterparty and the contractual terms they are offered?

2021 is likely to be pivotal for the development of the TPCS market – having already had the first case of this type completed, will this momentum be built on and the solutions available get further refined or will activity fizzle out? Based on conversations with clients, we expect this to be an area that many pension schemes now start to give serious consideration to.

Next chapter - Predictions for the 2021 UK de-risking market

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Tom Ashworth
Director
Willis Towers Watson

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