Pension consolidators are emerging as an effective solution to manage defined benefit pension plan risk.
By Tom D. Evans, Victoria Sander, David J. Walker, Shaun M. Thompson, Paul R. Lawrence, and Catherine Campbell
As inflation soars and market uncertainty creates additional volatility for UK defined benefit pension (DB) plans, PE firms now have a new option at their disposal to manage portfolio company pension risk — to transfer a portfolio company’s DB plan to an external consolidation vehicle.
A novel solution?
The first pension consolidator has emerged in the UK market, offering PE owners the option to transfer portfolio company DB liabilities. In December 2021, the UK Pensions Regulator cleared Clara-Pensions as the first pension consolidator, or “superfund” (for the purposes of companies transferring responsibility for DB funding obligations to a third party consolidator) paving the way for the fund to absorb UK DB assets and liabilities. We expect other superfunds to follow, widening the options for managing DB liabilities for PE owners.
This method of managing pension risk is especially welcome following the introduction of the Pension Schemes Act 2021, which was a game-changer for companies that sponsor a DB pension plan, and any shareholder of such a business. The new regime grants enhanced “moral hazard” powers to the Regulator and provides for criminal liability (punishable by up to seven years’ imprisonment and/or an unlimited fine) for acts or omissions deemed detrimental to a DB plan in circumstances where appropriate mitigation has not been provided. Shareholders of a portfolio company that sponsors a DB plan thus face greater theoretical risk from the Regulator’s powers.
Why use a consolidator?
Superfunds act as an umbrella vehicle into which disparate DB plans can be transferred. If a DB plan is transferred to a superfund, the consolidator assumes responsibility for the plan’s liabilities. This will substantially reduce Regulator moral hazard risk for PE owners, result in a much clearer and crystallised pension liability for the portfolio company at transfer of the scheme, and a cleaner and simpler future exit for the PE owner on a sale of the business. A transfer to a consolidator removes a DB plan from the scheme sponsor’s balance sheet, eliminating ongoing contributions payable to the plan, triennial valuation processes and the need for future negotiations with pension plan trustees. In substance, the plan exchanges the right to future support from the scheme sponsor with the covenant of the superfund.
While superfunds are not subject to Solvency II capital requirements, which impact the price at which traditional insurers are willing to take on DB plan liabilities, they must satisfy a detailed and rigorous approval process operated by the Regulator to be approved as a consolidation vehicle, including the level of capital buffer which they must maintain to support transferred plans. Each transfer is also subject to further approvals. PE owners that transfer portfolio company DB plans to a superfund can therefore do so in the knowledge that the Regulator has approved the vehicle and the specific transfer.
Where is the catch (and cost)?
Any transfer to a superfund will come with an obligation to provide additional upfront funding (the exact amount likely to depend on the demographic of the DB plan’s members, the quality of its data, the shape of the investment portfolio, and its current funding position), in addition to all current plan assets and ongoing contributions in order to meet a minimum capital adequacy level to support that transfer. Such payment is expected to be lower than that required to be paid to a traditional insurer in a buy-out transaction, but, depending upon the plan’s funding levels, may require a material up front contribution.
A transfer to a superfund could take several months or longer, and deal teams should consider the anticipated ownership horizon of the PE owner. Consolidator transfers also require a legal and financial audit of the relevant DB plan and the provision of data for due diligence purposes to be conducted by the superfund. Any historic non-compliance would be scrutinised (which may result in additional liabilities being identified). We recommend that PE owners conduct a legal health check of the DB plan prior to engaging with a superfund.
A transfer to a superfund requires consent of the DB plan trustees. Trustees generally would be expected to support a proposed transfer (as it would bring the DB plan closer to the trustees’ ultimate goal of securing all members’ benefits in full), but the transfer should still be discussed with them early in the process and prior to engagement with a superfund or the Regulator. A key trustee consideration will be the exchange by the plan of the future sponsor’s covenant with the security created by the capital provided by the superfund. The trustees may have concerns about a proposed transfer, particularly depending on the additional funding that would be provided to the plan.
Whilst superfunds are bringing a new option to the pensions market, the buy-out offering of traditional insurers will continue to be an attractive and viable option for many DB plans (particularly those that are well funded). Superfunds are generally not viewed as direct competitors to insurers, because Regulator guidance requires plans not to transfer to a consolidator if there is a realistic chance of achieving a traditional insurance solution within five years.
Early indications are that superfunds are likely to offer an attractive alternative to traditional pension buy-out transactions at a time of enhanced Regulator focus on DB pensions, and are likely to prove a useful tool for PE owners of portfolio companies with DB pension plan obligations.
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