It can be challenging for your Society to have a defined benefit (DB) pension scheme, even when closed, and the Scheme can give a number of headaches for management. These can include the amount of time spent running a scheme (for what increasingly tends to be former rather than current employees), the constantly increasing running costs, deficit funding that seems like a bottomless pit, and the increasing complexity and burden on Trustees feels more like the Scheme should be professionally run. Added to these headaches is the fact that the DB scheme impacts your PRA Stress testing.
The PRA stress testing requires you to model the impact of movements in interest rates and inflation on your DB scheme liabilities, which then impacts the amount of capital which you are required to hold.
The use of Liability Driven Investments (LDI) in your DB pension scheme assets could improve the capital position of your Society when carrying out the PRA stress testing. LDI achieves this by hedging the interest and inflation rate risk attached to the liabilities in the DB scheme. For example, by investing 40% in LDI investments you are able to hedge close to 100% of the funded liabilities of the DB scheme. We estimate that by implementing LDI a Society may be able to reduce their capital requirements by up to 50% (or perhaps even more, depending on the starting point).
For a lot of DB schemes LDI can be expensive and complex to put in place. However, other options are available to access LDI at an affordable cost. For example, by consolidating your scheme into a DB Master Trust arrangement which offers LDI as a standard part of the investment strategy, you could access LDI more efficiently. You would then be able to achieve the improvement in the capital position as well as receiving professional management of the pension scheme, and a reduction in running costs through the economies of scale which are achieved through grouping together a number of DB Schemes.
LDI isn’t just a paper exercise to reduce the capital requirements, but can be part of an approach to reduce the actual volatility in funding levels of your pension scheme over time. LDI can reduce or even eliminate volatility due to interest rate and inflation movements. This should give a much smoother path towards better funding in the future, allowing the Society to decide and focus on the targeted end-game (e.g. self-sufficiency or buy-out) and put in place a strategy to meet that target.
A guest blog for Associate Knowledge by BSA Associate, TPT Retirement Solutions.
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