Pensions De-risking

Many pension schemes engaging in endgame planning have illiquid assets in their investment portfolio and recent events may have increased the percentage allocation to illiquid assets. This can give rise to certain issues. Two of these issues (with some thoughts as to solutions) are set out below.

Issue 1: Timing mismatch

The timeframe over which illiquid assets mature or unwind may not align with the scheme's general endgame timeline. For example:

• Scenario A: the scheme may be fully funded on a buyout basis, but only when the illiquid assets are taken into consideration, and the full economic benefit of those illiquid assets may not be fully realised for several years, creating an apparent liquidity barrier to an insurance transaction.
  
  
• Scenario B: the scheme may have sufficient liquidity to secure benefits and wind-up but may seemingly be prevented from doing while its illiquid assets are still unwinding.

One obvious approach is to sell the illiquid assets on the open market. This will often mean taking a 'haircut'. This may be convenient in certain circumstances but may be viewed by some trustees (and sponsors) as handing expected return to a third party and presenting difficult decisions as to when to sell.

A variation on the above is a sale of the illiquid assets to the sponsor. Whether this is viable may depend on the sponsor having (i) sufficient available cash for the purchase and (ii) a willingness to accept the risks associated with holding the illiquid assets as they unwind (e.g. the investment may not perform as expected, there may be an obligation to make additional investments such as meeting capital calls attached to fund interests etc.).

Alternatively, schemes may choose to explore whether an insurer is willing to accept illiquid assets as part of a portfolio of assets used to meet an insurance premium. However, even if an insurer is willing to accept illiquid assets, whether this route is attractive to trustees (and sponsors) is likely to depend on the level of any haircut the insurer intends to apply and the impact on the insurer's pricing.

In Scenario A, certain sponsors may agree to lend to the trustee on a temporary basis and for the purpose of providing liquidity to the scheme, enabling a transaction which would otherwise be thwarted by the scheme's liquidity position.  

In Scenario B, rather than wait for the illiquid assets to unwind as scheme assets, we are aware that consideration is being given in various cases to a potential return of surplus to the sponsor 'in specie'. A return of surplus to the sponsor will usually be subject to a 35% free-standing tax charge. This is relatively straightforward where surplus is to be returned as cash but how would this tax apply if the surplus is returned in specie? The valuation of illiquid assets is considered below.

Any potential transfer of ownership of the illiquid assets will obviously require careful consideration (including, for example, whether consent is required from a third party and/or whether any third party has pre-emption rights, allowing them to purchase the illiquid assets).

Issue 2: Valuation of assets

The timeframe over which illiquid assets mature or unwind may not align with the scheme's general endgame timeline. For example:

The approach to the valuation of illiquid asset will obviously depend on the nature of the asset. In the case of an investment fund, in many cases the trustee will receive regular (e.g. quarterly) updates of the fund's net asset value ("NAV"). NAV will often vary over time (which may mean that NAV upon which the trustee is relying could be quite stale). The market value of the asset (e.g. NAV less the 'haircut' that a buyer would apply when acquiring the fund interests) may also vary over time.

Where trustees intend to sell illiquid assets, the market value may arguably be more relevant than the NAV for the purposes of their endgame strategy and regular price monitoring and price discovery processes may be appropriate.

As noted above, in the event that the trustee and sponsor are considering a return of asset in specie, the value of the asset is also likely to be relevant for the purposes of the tax payable.

We expect the approach to illiquid assets to form a significant consideration for a growing number of schemes as they embark on the final leg of their de-risking journeys.

For example, we recently worked with a corporate client to deliver a multi-phased strategy for DB pension de-risking. The transactions involved several innovations, including flexibility with the insurer around premium payments and residual risk cover and a bespoke, employer-funded liquidity buffer arrangement to help navigate short-term considerations in relation to  the scheme's illiquid positions. The latter helped lock in favourable insurance pricing at a time when the trustees might otherwise have wanted a larger liquidity buffer to transact.

The resurgence of pension scheme surpluses

Pension scheme surpluses were very much a theoretical consideration for trustees and sponsors of defined benefit pension schemes in the early parts of this century. However, with many schemes finding themselves to be in a much stronger funding position as a result of improving gilt yields, surpluses are now firmly back on the agenda as sponsors look to avoid "trapped surplus" scenarios. Dan Naylor, Sheamal Samarasekera and former Pensions trainee Niall Fitzpatrick have published an article on the key considerations for both trustees and sponsors when dealing with surplus scenarios including the alternatives available to a return of surplus to the sponsor. Click here to read the full article.

Pension Scheme Surpluses: no deficit of choices 

In this four-part "in conversation" series, EY-Parthenon partners Karina Brookes and Eimear Kelly and Travers Smith partners Dan Naylor and Joseph Wren discuss pension scheme surpluses, drawing out some important topics for consideration by trustees and sponsors.

Key themes from the discussion include the advantages of advance planning, the need for schemes and sponsors to respond to dynamic circumstances which can change scheme funding levels rapidly (such as the LDI crisis), and the ways in which good outcomes can be achieved both for members and for other stakeholders including the sponsor.

Listen to the series online.