What trustees need to know about transferring to a DB superfund

Out-Law Guide | 17 Aug 2020 | 3:20 pm | 12 min. read

The Pensions Regulator has published interim guidance for defined benefit (DB) superfunds, which provides trustees with comfort that superfunds are a legitimate way of managing their pension liabilities.

The move is welcome in the current economic climate and could lead to the development of a superfund market running parallel to the bulk annuity market in years to come.

However, transfer to a DB superfund is a complex process. Trustees need to consider a wide-range of legal and regulatory issues in assessing whether transfer to a DB superfund is the appropriate "end-game" solution for their scheme members.

What is a DB superfund?

DB superfunds have a different risk profile to traditional DB pension schemes – transfer to a DB superfund represents a shift from an "all risks" to a "defined risks" environment.

The transferring employer is replaced by a special purpose vehicle employer to preserve the superfund's Pension Protection Fund (PPF) eligibility and the employer covenant is replaced with a capital buffer consisting of capital from external investors and also, depending on the consolidator structure and the funding level of the transferring scheme, an upfront employer payment for entry.

DB superfunds allow employers to remove pension liabilities from their balance sheet without paying an insurer to secure the benefits. They do not provide the highest level of protection offered by buy-out with an insurer and the price to the employer would typically be lower to reflect this.

The regulatory framework – what's the latest?

On 18 June 2020, TPR published guidance on the regulatory framework it will apply to DB superfunds in the “interim period” before there is a legislative framework.

The regulatory framework gives much-needed comfort to trustees and employers considering a transfer that DB superfunds will be approved by TPR and transfers to a superfund expressly "cleared".  

It is clear that prospective transferring employers and trustees will need to carry out significant due diligence of the DB superfund to show TPR that the transfer is in the best financial interests of members.

As part of the clearance process, we expect TPR will require trustees to show how members' benefits will be more secure on transfer to a superfund and, in practice, there will be a higher bar to transfer than currently required by the bulk transfer laws or trustees' fiduciary and statutory duties.

TPR will operate a two-stage clearance process, where the superfund will need to discuss any proposed transfer with TPR, before the transferring employer applies for clearance in relation to the transaction. We expect this process will allow TPR to clear transactions quickly on receiving an application because it would have approved the capital adequacy and financial security of a superfund already and assessed the parameters of the proposed transaction.

TPR does not expect a superfund to accept a transfer from a transferring scheme that has the ability to buy-out or is on course to do so within the foreseeable future, for example, in the next five years.

Transferring to a superfund – issues for trustees to consider

To transfer to a DB superfund, trustees will need to bulk transfer members' benefits without consent. In our view, it is legally permissible to bulk transfer to a DB superfund, but it is worth noting that the DB superfunds are evolving and the transfer route may differ between the superfunds.

To transfer to Clara Pensions, there needs to be a payment from the transferring employer to the Clara employer so that the bulk transfer is a consequence of a financial transaction under the preservation laws.

Given The Pension Superfund has been registered as an occupational pension scheme by HMRC recently, it is possible that the transfer route has been adapted to reflect this status - previously the transferring employer needed to become a statutory employer in the Superfund structure and apportion its liabilities to another employer after a short period - and so trustees, in conjunction with their advisers, will need to assess how the structure of the superfund reflects the existing preservation laws.

Trustees will need to satisfy themselves that they have the power to make the transfer under their scheme's governing rules and legislation, and they should make the transfer, taking into account their fiduciary and statutory duties to beneficiaries.

Bulk transfer without consent

Trustees are potentially subject to a higher bar to transfer to a DB superfund than ordinary bulk transfer exercises.

The Department for Work and Pensions (DWP), TPR and PPF have all suggested that trustees will need to be convinced that members' benefits will be more secure in a superfund than under the current scheme, in order to demonstrate that transfer is in members' best interests.

In practice, trustees will need to evidence to TPR as part of the due diligence and clearance process that they are satisfied members' benefits would be more secure in a superfund, which puts significant emphasis on trustees' actuarial and covenant advice. 

Is buy-out possible in the 'foreseeable future'?

Transfer to a superfund is prohibited for schemes reaching buy-out in the foreseeable future.

However, it is interesting that the regulatory gateway isn't a focal point of the guidance – this suggests that TPR may adopt a subjective approach to foreseeability of buy-out. At a time of market turbulence, it is difficult to calculate with any certainty the prospects of reaching buy-out in 5 years, which potentially gives TPR flexibility to weigh up risk to the PPF and security of members' benefits against the realistic prospects of buy-out.

Trustees will need to be prepared to explain to TPR the rationale and assumptions underpinning any conclusion that buy-out is not a realistic prospect within the foreseeable future, and what they consider the foreseeable future to be.

How will the covenant compare before and after the transfer to the superfund?

Trustees need to assess the strength of the conventional employer covenant they are giving up, and consider how this compares to the financial security offered by the superfund, in particular the capital buffer supporting the scheme.

TPR similarly expects an independent covenant assessment to be an essential component of the trustees' considerations, covering:

  • The detriment caused to the transferring scheme by removing the employer covenant and the extent to which this is mitigated as part of the transfer into the superfund;
  • The employer's ability to pay additional contributions and an assessment of the contributions the trustees could otherwise reasonably expect to obtain;
  • The estimated return to the transferring scheme upon a hypothetical insolvency of the employer;
  • Analysis of the support provided to the scheme/benefits before and after consolidation and the impact on member security by severing the link to the current employer;
  • Whether there are other sources the trustee or TPR could pursue which could achieve a better outcome for the scheme, such as immediate buy-out with an insurer.

It is only in exceptional circumstances that TPR would consider it acceptable not to obtain expert covenant advice.

Actuarial and investment advice – comparing member outcomes

TPR expects trustees to take actuarial and investment advice considering how the projected outcomes for members compare if the scheme transfers to the superfund and the scheme remains with its sponsoring employer.

In practice, to carry out this analysis, trustees will need the DB superfund to provide projections that take account of matters such as cash flows from the superfund's capital buffer, and its investment strategy.  They will also need to consider the funding and investment strategy of the transferring scheme and how they would expect this to change over time as the scheme matures.

Superfund financially sustainability and critical scale

In practice, this should be addressed by the covenant, actuarial and investment advice the transferring trustees receive and the capital adequacy measures imposed by TPR on the superfunds.

Trustees would need to ensure that the capital adequacy measures of the superfund and security of members' benefits are not affected by the need for future business.

Access to the capital buffer

The transferring trustees will need to make sure they understand the circumstances in which the superfund's trustees and any investors will have access to any capital buffer, as this will be very important to the financial sustainability of the superfund.

To ensure that the incentives of those running the superfund are aligned with members’ interests, during the interim period, TPR will not permit a superfund to extract any value from scheme assets or the capital buffer unless members’ benefits are brought-out in full.

Trustees would need to see evidence of these restrictions within the superfund's governing documents.

Funding level triggers

The transferring trustees will need to make sure they understand any funding level triggers that the superfund applies.

Trustees would need confirmation that the superfund has included a low risk funding trigger and wind-up funding trigger in its legal arrangements. The low risk funding trigger is set at scheme assets plus capital buffer falling to below 100% of the liabilities calculated on the "technical provisions" basis, at which point the capital buffer would come under the trustees’ control.

The wind-up trigger is set at 105% of the value of PPF liabilities. This is done in line with section 179 of the Pensions Act 2004 to protect against a claim made to the PPF.

How will the trustees engage with TPR and any clearance process?

TPR expects trustees to notify it "at the earliest available opportunity" if they have decided in principle to transfer benefits to a DB superfund. This means at least three months before the planned transfer. TPR expects the notification to outline the trustees' rationale and evidence that transferring to a superfund will enhance member security. Trustees should be prepared for TPR to scrutinise their rationale for the proposed transfer in detail.

TPR also expects employers to apply for clearance before the transfer takes place. As part of the clearance process, TPR will assess whether any detriment to the scheme has been adequately mitigated and ensure the scheme could not achieve a better outcome through other means.

Trustees should be prepared to engage with TPR during any clearance process. They will need to understand any potential detriment caused by the transfer and how this is being adequately mitigated. Trustees will need to consider how best to use their influence, having regard to the interests of the employer and scheme members.

Balance of powers

As with any bulk transfer to another occupational pension scheme, the transferring trustees will need to understand where the balance of power lies under the superfund's governing trust documentation, in areas such as funding, investment, scheme amendment, winding up, and control of the capital buffer, and consider how this compares to the position under the transferring scheme.

Will the superfund be eligible for PPF entry?

DB superfunds, as occupational DB schemes, are expected to be eligible for the PPF. This is supported by the fact that the PPF has published a methodology for calculating the PPF levy for DB superfunds.

In practice, PPF entry will probably be a remote possibility for DB superfunds. This is because DB superfunds are required to include provisions to automatically trigger the winding up of the scheme before the funding level drops below the level for PPF entry and the proposed capital adequacy requirements are sufficiently stringent to make the risk low. Nonetheless, trustees will want to check this point.

Tax considerations

The transfer must be a "recognised transfer" from one registered pension scheme to another, as set out in section 169 of the Finance Act 2004, and trustees will also need to ensure that transferring members retain any tax protection, such as primary, individual, enhanced and fixed protection. In most circumstances, members will retain these protections on transfer, but trustees will need to ensure that members do not accrue further benefits in the receiving scheme in respect of enhanced and fixed protection and, as an additional safeguard, seek to ensure that the transfer is in connection with the winding-up of the transferring scheme.

The trustees would also need to ensure that the transfer satisfies the requirements of a "block transfer" under the tax rules and members retain any right to a protected pension age from age 50 and/or protected pension commencement lump sum. To be considered a block transfer under the tax rules, there must be a transfer in a single transaction of all the sums and assets of a member and at least one other member in the transferring scheme. This is an important point to address in the context of a partial transfer from a hybrid scheme to ensure that members are not disadvantaged by the transfer.

Discharge of liability

Trustees would also want to ensure that they continue to be protected from liability after transfer and during winding-up of the transferring scheme or section. Trustees would typically want to ensure the employer meets the expenses of winding-up and they should review their existing insurance policy to ensure it provides sufficient coverage and includes any claims and liability arising from winding-up in respect of missing beneficiaries.

Trustees would need to consider how to structure the timing of bulk transfer and winding-up so that those members eligible for a winding-up lump sum (WULS) are not transferred prior to winding-up being triggered. Typically there will be two tranches of transfer; the first for those members who are ineligible for a WULS and the second for those members who are eligible but elect not to take it.

Once the bulk transfer is complete, there will be limited assets left in the transferring scheme. Trustees may wish to obtain a binding agreement from the transferring employer to take out an appropriate insurance policy with the premium to be met by the employer, together with an indemnity from the employer for any claims not covered by the policy.

How will trustees get protection in respect of 'residual risks'?

It is generally expected that DB superfunds will not agree to accept transfers on an "all risks" basis. This means superfunds are unlikely to accept responsibility for residual risks such as liabilities relating to data errors, or the liability to provide benefits to beneficiaries that have been missed during the transfer process.

Trustees will need to be as sure as they can be that their data is complete and accurate before proceeding with a transfer. They should also consider whether they can get insurance protection in respect of any residual risks the DB superfund isn’t willing to take on.

What does a transfer to a DB superfund look like?

DB superfunds will not take on all the risks from a transferring scheme. Instead the risks taken on by superfunds will be defined. Both DB superfunds in the market expect benefits to be fully identified and are unwilling to assume "unknown unknowns" or legal risks relating to the transferring scheme.

As a result, the transaction would be structured in the same way as an insurance buy-out with a benefit specification setting out members' rights to be transferred and the liabilities which the superfund will take on.

Transferring trustees will need to prepare for the transaction as they would a buy-in/buy-out and ensure that they have complete and accurate data. Ideally they should carry out a data cleanse prior to transacting.

Trustees will need to understand how and to what extent data will be verified and how the employer payment may vary depending on the outcome of this data verification. The data verification process is likely to critical for trustees, given the longer any data verification takes, the longer they will be "on the hook" and unable to discharge their liabilities.

What is the target market for DB superfunds?

At a fundamental level, the DB superfunds' target market will be employers and trustees:

  • who are looking to de-risk/transfer DB scheme liabilities;
  • for whom buy-out is not realistic or desirable in the foreseeable future – most likely due to affordability, and;
  • who operate schemes that are sufficiently well-funded so that they can afford a DB superfund's cost of entry.

So, at a very basic level, a DB superfund's business model will rely on the cost of entry being cheaper than the cost of buying out with an insurer.

Employers and trustees may be particularly keen to explore the commercial consolidator option in the following scenarios:

  • Where the scheme is relatively 'immature', with significant deferred liabilities – these liabilities are harder to buy-out with an insurer, whereas pensioner liabilities may be easier and more cost-effective to secure with an insurer;
  • Where trustees are particularly keen to improve funding swiftly and protect members benefits against the risk of sponsor insolvency;
  • M&A transactions where there is a driver for paying cash in return for a clean break from DB liabilities;
  • Employers participating in non-sectionalised schemes with 'last man standing risk' may see the value in transferring their share of assets and liabilities to a superfund. The rationale is that it may be possible to secure member benefits at a lower cost than the 'section 75 debt' otherwise needed to achieve a clean break from these schemes.