Considerations for Defined Benefit Pension Schemes Implementing a Run-On Strategy
For defined benefit (DB) pension schemes contemplating a run-on strategy, the daily management of the scheme may appear largely unchanged. Assets will continue to be handled by the scheme, and benefit payments will be disbursed as they become due. However, as highlighted by Ortec Finance, there are several crucial elements that trustees and sponsors must evaluate meticulously before opting for this path.
Understanding Surplus Extraction and Risk Exposure
As surplus extraction increasingly becomes a probable outcome in a run-on arrangement, Ortec Finance emphasizes the necessity of developing a robust framework for surplus extraction. This framework must be refined and subjected to thorough stress-testing. Decision-makers must attain a holistic understanding of both the potential upside and downside risks prior to implementation.
Significantly, unlike in an insurer buy-in or buy-out setup, the funding risks—such as investment risk, longevity risk, and governance risk—remain the responsibility of trustees and sponsors. Hence, ongoing monitoring and proactive risk mitigation strategies are vital for effectively managing these exposures.
Investment Strategy Flexibility Offered by Run-On Approaches
One notable advantage of a run-on investment strategy, as pointed out by Ortec Finance, is its inherent flexibility, particularly regarding investments in illiquid assets. Risk modeling should be conducted to gauge the liquidity required for future benefit cash flows, and a cashflow-driven investment strategy remains an appealing option. The eligibility criteria for asset classes during the run-on phase are extensive and include more than just traditional instruments.
Key Components for Designing a Surplus Extraction Framework
Ortec Finance details several essential components that should be incorporated into any surplus extraction framework:
- Extraction Level: A specific liability-based funding level—such as 110% on a low-dependency basis—often triggers surplus extraction. To mitigate risks associated with market volatility, an additional prudential measure may require the average funding level to exceed this threshold over the preceding year.
- Extraction Rate: The surplus amount that can be extracted may simply be the excess above the trigger point. Alternatively, a staggered approach might be beneficial, such as extracting 50% of the surplus in the first year and increasing to 60% in the second year, ensuring a safety buffer against potential downturns.
- Recovery Contributions: In instances where funding deteriorates, recovery contributions act as a protective mechanism. These can be based on conditional top-up rules tied to a specific funding position at a chosen time or averaged over a set period, safeguarding member benefits from a widening deficit.
- Surplus Sharing: Sponsors may opt to retain all surplus generated or choose to share a portion with scheme members through discretionary indexation increases or direct payments.
Practical Application of Stochastic Modelling
In a related research paper, Ortec Finance utilized stochastic scenarios to project various investment strategies over a decade, evaluating their performance against metrics critical to run-on decision-making.
The hypothetical scheme analyzed in the study is 105% funded on a low-dependency basis of gilts plus 0.5% per annum, with a liability valuation of £3 billion on the same basis. The surplus extraction framework specifies that if the funding ratio surpasses 110% at year-end, excess surplus can be extracted. Conversely, should the ratio dip below 100%, a lump-sum contribution is triggered to restore the funding level to the 100% mark.
The focus of the results is the cumulative net present value (NPV) of net return—essentially, the surplus extracted minus any deficit contributions. Ortec Finance identifies this metric as vital for sponsor decision-making within this context.