Pension overhaul: Capitalizing on the tendencies transforming the United Kingdom's pension market
A quiet revolution is brewing in the UK pension scene. With one of the largest pension systems globally, featuring over £3 trillion in assets, it rivals Japan and the US in size.
Long-gone are the days when mammoth, multi-billion-pound defined-benefit (DB) pensions ruled the roost. Schemes like the BT Pension Scheme, with 270,000 members and £37 billion in assets, used to dominate the market — accounting for around half of the total assets in both public and private sectors combined.
However, Defined-Contribution (DC) schemes, the new kids on the block, are fast catching up. According to the Pensions Policy Institute, the UK pension system holds approximately £1.1 trillion in DB schemes and £500 billion in public-sector funded pension schemes, while £1.1 trillion, or 38%, is invested in private-sector DB schemes, and £500 billion (17%) in public-sector DC schemes.
Many UK public-sector pension schemes, such as those for civil servants, teachers, and NHS workers, are "unfunded," similar to a Ponzi scheme, meaning contributions are used to pay current pensioners instead of contributing to the total figure. Unfunded UK public-sector pension liabilities lie somewhere between £1.5 trillion and £2.6 trillion, depending on what you count and how you count it.
DB schemes promise a fixed income for life based on a member's salary and years of service. They were once the popular choice for pension structures, but they're now more common in the public sector than the private sector. Of roughly 5,300 private-sector DB schemes, only 505 (around 10%) remain open to new members, according to the Pensions and Lifetime Savings Association. Most schemes are effectively in run-off mode, as they're closed to new members and focus on paying the retirement obligations of existing members.
The number of members in the remaining private-sector DB schemes has dwindled from 14 million to 10 million since 2006, while the number of DB schemes itself has decreased from 7,300 in 2012 to 5,190 in 2024.
Cash Flow Boost for Companies
Higher interest rates have significantly affected DB schemes and their funding levels. These improvements in pension funding levels reduce the present value of future liabilities. Funds can also earn a higher return on their investments, usually in government and corporate bonds, due to the increased interest rates.
According to the Pension Protection Fund's (PPF) 2024 edition of The Purple Book, the net surplus in private-sector DB pension schemes surged to £219 billion last year, representing a funding ratio of 123.1%. This surge in funding levels has inspired pension-fund trustees to consider what's known as scheme "buyouts" to reduce their risk exposure.
DB pension schemes benefit members, but they can be hefty, unwieldy liabilities for the companies that offer them. Funding commitments can consume cash flows, reduce shareholders' returns and capital spending. BT's pension scheme is a perfect example: with £37 billion, it is twice the size of BT itself, and at the end of June 2023, its deficit was £3.7 billion, down from £8 billion in June 2020. The company paid £4.4 billion in contributions over the previous three years, which could have been used to modernize its telecoms infrastructure.
The shift in interest rates and funding levels have created an economic windfall for companies with well-funded schemes. Some have seized this opportunity to shift assets off their balance sheets with buyouts. The market for buy-ins and buyouts is currently valued at £50-£60 billion a year, generating substantial business for the UK's largest insurers.
Buy-ins and buyouts involve pension derisking strategies, whereby schemes transfer the risks associated with providing retirement benefits to a third party, typically an insurer such as Legal & General, Aviva, M&G, Phoenix Group, and Just Group. In a buyout, the pension scheme completely transfers its obligations to an insurer, while in a buy-in, the insurer assumes a portion of the scheme's liabilities. Either way, the end goal is the same: the risks of managing the pension assets are shifted off the balance sheet.
Rapidly Expanding Defined-Contribution Market
The defined-benefit pension market is slowing down as the number of scheme members declines. At the same time, the defined-contribution market is predicted to grow rapidly over the years, propelled by the world-leading auto-enrolment scheme introduced in the UK in 2012. Under the auto-enrolment system, employers are responsible for enrolling employees in a pension scheme, and contributions and retirement benefits are more variable (and less expensive for the company).
The minimum contribution is 8% of an employee's salary, with 5% coming from employees and 3% from the employer. Since the system's introduction, assets in DC pension schemes have nearly tripled from £200 billion in 2012, with projections suggesting the market size could hit around £1 trillion by the end of the decade.
DC pensions come in two primary segments: contract-based and trust-based schemes. These two segments currently make up roughly equal shares of the market. In a contract-based scheme, individual contracts are agreed between the scheme member and the pension provider, usually an insurance company or an investment platform. With a trust-based scheme, the company agrees a deal with a large pension master trust such as Nest or the People's Pension.
Aside from legacy DB and significant players in the defined-contribution market, around £500 billion of funds are held within self-invested personal pensions (SIPPs) and £300 billion in bulk and buyout annuities market.
Reviews and modifications are being constantly made to the pension sector, and discussions about the auto-enrolment system are ongoing, with many calling for the minimum contribution and age and salary requirements to be raised to bolster funding by £10 billion. Potential conversations about how pension funds can be urged to invest more in productive assets, such as infrastructure and UK equities, could have a significant impact on the UK equity market and investment providers specializing in alternative and private assets.
- The surge in interest rates has positively affected pension funding levels, allowing funds to earn higher returns on their investments, typically in government and corporate bonds.
- Higher pension funding levels have led to a reduction in the present value of future liabilities, making DB pension schemes more attractive for buyout options.
- Pension derisking strategies, such as buy-ins and buyouts, are becoming increasingly popular, with schemes transferring their obligations to third parties like insurance companies to reduce risk exposure.
- The UK's defined-contribution (DC) pension market is predicted to grow rapidly due to the auto-enrolment scheme introduced in 2012, with assets potentially reaching £1 trillion by the end of the decade.
