Aon Hewitt Retirement Investment Consulting. Escrow. reconciling stability and surplus. December Risk. Reinsurance. Human Resources.

Transcription

1 Aon Hewitt Retirement Investment Consulting Escrow reconciling stability and surplus December 2014 Risk. Reinsurance. Human Resources.

2 Summary Achieving long-term stability within a pension scheme is no easy task. In practice, reducing reliance on the sponsoring employer means holding additional assets, which increases the risk of a trapped surplus. This short note explores the risks of overfunding and introduces the concept of an escrow arrangement where a funding buffer is held outside of the scheme. This is a means of reaching a suitable compromise between financial efficiency for the sponsoring employer and security of members benefits. For trustees, willingness to work together with the sponsor to balance competing objectives may ultimately lead to higher contributions and a better chance of meeting future pension promises. Long-term stability requires a funding buffer There is no common definition of self-sufficiency in pension scheme investing, but we typically refer to a well-funded scheme with a low-risk investment strategy, such that there is minimal reliance on the sponsoring employer to pay further contributions. Protecting the scheme against falling into deficit and having to call on the sponsor for more money is no easy task, and means having to hold additional assets in the scheme. However, as our research shows, this quickly becomes inefficient, and increases the chances of overfunding the scheme. Pensions Stability Low-risk compromise We have carried out research into low-risk pension scheme investing and defined the concept of Pensions Stability. This identified a sweet spot which sensibly addresses downside risk, avoids tying up corporate assets and allows a reasonable chance of reaching a long-term buy-out target. We believe that a funding level of around % (including a funding buffer) on a gilts +0.5% p.a. funding target may be the definition of Pensions Stability which will suit many trustees and sponsors. Aon Hewitt Escrow. Reconciling stability and surplus 1

3 Overfunding can be a problem for sponsors A trapped surplus arises when the sponsor is unable to recover surplus funds from an overfunded pension scheme. In the UK, recovery is slow, difficult and costly. Slow refunds are generally only possible once all the liabilities have been fully secured likely to be in many years time. Difficult Scheme rules can permit or require trustees to enhance benefits before a surplus is returned to the sponsor. Costly any refunds are subject to a penal tax rate of 35%, compared to corporation tax relief that may be nil or dropping to 20% from April Trustees should care about these sponsor concerns because they can lead to reluctance to pay additional contributions. Whilst trustees would prefer to see cash being paid into the scheme, willingness to work towards a compromise solution may ultimately lead to higher contributions and therefore increase the likelihood of meeting pension promises. With deficits everywhere, why worry now? A trapped surplus may seem a rather dim and distant possibility, but there are good reasons why the risk of a trapped surplus may be greater than you think: Gilt yields are at historically low levels and, if yields were to rise, funding levels would improve Lower gilt yields mean that our actuarial assumptions require lower investment returns, and returns can surprise on the upside Schemes closing to new entrants and future accrual has taken away the ability to use up surpluses As part of our research on Pensions Stability, we carried out some asset liability modelling to consider how the funding level of a typical scheme may develop over the next 20 years. Our results show that, even for a scheme with a conservative funding target and a relatively low-risk strategy, a significant surplus can arise. For example, our analysis shows a wide range of possible funding outcomes for our 100m low-risk specimen scheme, and a 90% chance that the funding position will be between a deficit of 12m and a surplus of 45m after 20 years. Aon Hewitt Escrow. Reconciling stability and surplus 2

4 Alternative financing solutions Escrow arrangements Sponsors will become increasingly reluctant to commit contributions if they think it will lead to a trapped surplus. There are a range of possible alternative financing solutions that solve the problem of trapped surplus but the simplest is an escrow. The principle of an escrow is that assets are set aside by the sponsoring employer and held by a third party on behalf of both the sponsoring employer and the scheme. The assets in the escrow are then released to the scheme or sponsoring employer based on pre-determined triggers. Effectively the escrow acts as a buffer between the sponsor and the pension scheme, as shown in the diagram below. Future contributions paid into buffer Potential flow of cash out of buffer to scheme Fun fact The word escrow derives from the Old French word escroue, meaning a scrap of paper or a scroll of parchment; this indicated the deed that a third party held until a transaction was completed. Sponsor Buffer Pension Scheme Expenses Potential flow of cash out of buffer to sponsor Benefits Pros and cons of Escrow The key advantage of an escrow is the scope for money to be recovered by an employer efficiently. This can encourage the sponsoring employer to target a higher funding level, which provides better security for trustees and members. With trustee agreement, sponsors can use an escrow to retain greater control of the investment strategy, which may form a negotiation point in funding discussions. Further, the assets in an escrow are often retained on the sponsoring employer s balance sheet, which can be advantageous for the sponsor when being assessed by rating agencies, banks, industry regulators, and investors. However, there are certain challenges and disadvantages to consider. Tax is an important consideration, as tax relief is generally deferred until the contributions are paid from the escrow into the pension scheme. Importantly, investment returns on assets in an escrow will not benefit from tax relief that is generally available in the pension scheme. There are set-up costs and resources required but this solution is economic if at least 5M is put in escrow. Note the terms of the triggers that allow money from the escrow to move into the scheme or back to the employer can have a significant impact on the outcomes for the sponsoring employer. Aon Hewitt Escrow. Reconciling stability and surplus 3

5 Who is most likely to benefit? Individual circumstances will dictate which schemes should be most concerned about a trapped surplus and therefore have most to benefit from an escrow but key circumstances are summarised in the table. Scheme rules Scheme status Company tax status Refunds not permitted Investment strategy Frozen DB Scheme Don t pay tax High target return, low hedging, no de-risking triggers Funding target Well funded and prudent funding target More concerned Require/ allow benefit improvements before refund DB scheme closed to new entrants Expects to pay tax in future Medium target return, low hedging, no de-risking triggers Prudent funding target Refunds permitted Open DB scheme or DC section in same trust (with ability to cross subsidise) Expects to always pay tax Low target return, high hedging, has de-risking triggers Poorly funding and week funding target Less concerned Our research indicates that schemes not paying corporation tax or greater than about 85% funded using a gilts +0.5% p.a. funding basis should seriously consider diverting all future contributions into an escrow. Think about your scheme Each scheme is at a different point on the path to pensions stability. As Trustees it is important to understand whether the sponsoring employer is concerned about overfunding the pension scheme. Could the Trustees use overfunding solutions to negotiate on issues that are important to them? Given an escrow is there to avoid a trapped surplus, Trustees and employers must both understand the likelihood of overfunding. Finding out the current funding level, level of prudence in the funding target, contributions being paid and investment strategy are important steps to understand the position of the scheme. What is the tax status of the sponsoring employer? If the employer pays no corporation tax, and therefore receives no tax relief on contributions, the threshold at which a buffer is efficient is much lower. Trustees should take care to understand the escrow s assets, and how this fits with the overall risk profile of the investment strategy for the scheme. Conclusions Trustees should not be too quick to dismiss concerns from sponsors regarding a trapped surplus. Working together to reach a compromise solution can lead to a better long-term outcome, and alternative financing arrangements can provide a valuable negotiating tool. Please contact your usual consultant or lynda.whitney@aonhewitt.com if you would like a copy of the Escrow White Paper. Aon Hewitt Escrow. Reconciling stability and surplus 4

6 Contacts Lynda Whitney +44 (0) Callum Logan +44 (0) Sophie Moore +44 (0) About Aon Hewitt Aon Hewitt empowers organisations and individuals to secure a better future through innovative talent, retirement and health solutions. We advise, design and execute a wide range of solutions that enable clients to cultivate talent to drive organisational and personal performance and growth, navigate risk while providing new levels of financial security, and redefine health solutions for greater choice, affordability and wellness. Aon Hewitt is a global leader in human resource solutions, with over 30,000 professionals in 90 countries serving more than 20,000 clients worldwide. For more information on Aon Hewitt, please visit: aonhewitt.com Follow Aon on Twitter: twitter.com/aon_plc Sign up for News Alerts: Aon Hewitt Escrow. Reconciling stability and surplus 5

7 About Aon Aon plc (NYSE:AON) is a leading global provider of risk management, insurance and reinsurance brokerage, and human resources solutions and outsourcing services. Through its more than 66,000 colleagues worldwide, Aon unites to empower results for clients in over 120 countries via innovative and effective risk and people solutions and through industry-leading global resources and technical expertise. Aon has been named repeatedly as the world s best broker, best insurance intermediary, best reinsurance intermediary, best captives manager, and best employee benefits consulting firm by multiple industry sources. Visit aon.com for more information on Aon and aon.com/manchesterunited to learn about Aon s global partnership with Manchester United. Copyright 2014 Aon Hewitt Limited. Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone. Unless we provide express prior written consent, no part of this document should be reproduced, distributed or communicated. This document is based upon information available to us at the date of this document and takes no account of subsequent developments. In preparing this document we may have relied upon data supplied to us by third parties and therefore no warranty or guarantee of accuracy or completeness is provided. We cannot be held accountable for any error, omission or misrepresentation of any data provided to us by any third party. This document is not intended by us to form a basis of any decision by any third party to do or omit to do anything. Any opinion or assumption in this document is not intended to imply, nor should be interpreted as conveying, any form of guarantee or assurance by us of any future performance or compliance with legal, regulatory, administrative or accounting procedures or regulations and accordingly we make no warranty and accept no responsibility for consequences arising from relying on this document. Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. Registered in England & Wales. Registered No: Registered Office: 8 Devonshire Square, London EC2M 4PL Risk. Reinsurance. Human Resources.