Planning for success: what can Irish DB plans learn from recent global experience? | Insight Investment

How can the experience of funding improvements in UK, US and German plans inform Irish defined benefit (DB) pension plans?

DB pension schemes globally have seen big improvements in their funding position since 2022 as interest rates have risen. The rapid speed of change leaves many in a new paradigm, particularly those which are now in surplus. While most Irish DB pension schemes are still a number of years away from full funding, we see much worth in thinking ahead and reflecting on practices of DB schemes around the world.

Trends in global DB schemes

UK - At the end of April 2024 the aggregate surplus for the 5,050 UK DB schemes in the PPF 7800 index was estimated to stand at £458.3bn (a 148.8% funding ratio)¹. Many UK DB schemes will have experienced a rapid swing from deficit to surplus over the past two years with some bringing forward considerations and decision-making for what their 'endgame’ options.

Historically, the UK DB industry told itself that when a pension scheme could afford it, it could buy-out the pension scheme with an insurance company. And yet, now many schemes find themselves overfunded on a buy-out basis; this has opened-up new considerations around the potential use of surplus to enhance benefits for members and / or payments to the scheme’s sponsors.

This has prompted a recent UK government consultation on the future of DB pension schemes. It is expected that there will be a publication of UK government proposals later in 2024 (although the upcoming UK election may impact). One change we have already seen is a reduction in the tax on surplus extraction: since April 2024, any sponsor taking a share of surplus from their DB scheme will only be taxed 25%, the same rate as the tax on contributions, a drop of 10% from the previous 35% tax rate.

This change, and other proposals under consideration, could potentially bring a change where sponsors and trustees are encouraged and enabled to ‘run-on’ their pension scheme for the long term, with a view to utilising excess surplus to fund discretionary increases in benefits for members and refunds of surplus to sponsors.

Germany - German corporate pension plans were reported as having relatively lower levels of liability-hedging compared to international pension schemes in 2022. However, some plans have responded to rising interest rates by increasing their level of hedging, with many doing so at surprising speed to capture opportunities provided by market changes.

One way Insight has worked with some German pension plans to capture an improvement in their funding position has been with a mean-reversion trading strategy in euro swaps. The strategy works by selling euro swaps and then buying them back at a cheaper price within a pre-agreed trading range. One of our clients raised its interest rate hedge ratio from 5% at the end of 2021 to 57% by the end of 2023 in this way.

Additionally, as in the UK, some German plans that can now afford to undertake a buy-out are considering whether to run-on their pension plan for the long term instead.

US - One of the most interesting recent US developments has been initiatives of some companies to re-open their DB plan to new members. Contributions for new members are being paid from funding surplus with this surplus helping companies to save on employer contributions previously paid into its defined contribution plan.

According to the Milliman 2024 Corporate Pension Fund Study of 100 US public companies sponsoring the largest defined benefit plans², 48 were in surplus at the end of 2023, with 52 in deficit (21 had a funding level of 95%-100%). Of the plans in surplus, three had a funding ratio of over 140%.

More generally, we see US pension plans as somewhere between the UK and the German positions. Improvements in funding positions for US pension plans has led to some interest in insurance solutions for pensioners. There is also some interest in insurance solutions for members with smaller pension pots, simply for cost and efficiency reasons. We observe that company views on efficiency, and the impact on their balance sheets, is influencing planning for decision makers for US plans.

Planning for success

Improved funding for many DB schemes has to some extent arisen as a result of unhedged rate risk, but unhedged rate risk means such gains could easily be lost if interest rates fall. To protect gains, one strategy we are discussing with some fully-funded UK pension schemes is for a ‘matching pot’ of assets to cover liabilities, and a ‘surplus pot’ to invest for income or further growth; each will have different time horizons and return targets. This still puts a pension scheme in a position to undertake a buy-out when it chooses – and as time passes, all else being equal, a buy-out should become cheaper as deferred members retire. Also, we estimate (for DB plans in the UK) that the cost of running on a pension plan at full funding could be 10%-15% cheaper than conducting a buy-out with an insurance company.

The relevance of these developments for the better-funded Irish DB schemes is that there are clear ways to plan for future success. Trustees should agree on what the target for full funding might be (buy-out or running on the pension scheme), the time frame for achieving that target and the strategy to employ to get there.

While there has not yet a been market in Ireland for pension scheme buy-outs, one may emerge in future. For Irish DB schemes that are currently well funded, considering what a fully-funded position with surplus looks like will help define a path and strategy to move towards running-on the scheme in the future. In such a position, the pension scheme will also be able to appraise if options come to the market for buy-out.