A summary of the key issues we have considered as part of the superfunds guidance review.
Background
When we published our updated superfunds guidance in August 2023, we said we would develop a specific mechanism for capital release. Following the Department for Work and Pensions (DWP’s) response to the 2018 consultation in July 2023, and some additional market feedback, we engaged further with stakeholders in November 2023. The response to this engagement is covered in Section 1.
We also saw the potential to introduce flexibility in capital adequacy expectations for schemes where the employer has become insolvent, and we engaged on this in February 2024. This response is covered in Section 2.
We received responses from key stakeholders, including pension consultants and industry trade bodies. We also commissioned external modelling from Mercer (PDF, 1.99MB, 49 pages) to inform our decision on the capital release mechanism.
We have now published our updated superfunds guidance confirming our position on capital release. The updates also include further clarification in the ceding trustee and employer guidance on residual risks and the practical application of some investment principles. We’ve also added clarification around the treatment of schemes with an insolvent employer.
This engagement response document sets out each area where we asked stakeholders for input, a summary of their responses, and our conclusions.
Capital extraction
1. Capital release parameters
For the interim regime, we judged it appropriate to adhere to the approach being taken forward by the DWP but to prudently set a higher capital release trigger at 66% of the capital buffer.
We asked
- Do you agree that we should align our approach with the DWP’s consultation response?
- Are there any particular downsides to this methodology that should be addressed and how?
- Do you agree with setting the trigger at 66% of the capital buffer to be more prudent than the DWP’s initial proposals?
- If you do not agree, please provide your reasoning for why it should be higher/lower than this.
You said
A number of responses referred to the balance between member security and commerciality. Some responses also described insurance practices, for example the use of a ‘target operating range’.
In general, the option of ‘X% above a minimum level of funding on the superfund technical provisions (TPs) basis’ was favoured for its relative simplicity, transparency and pragmatism.
Overwhelmingly, respondents thought that ‘X’ set at 66% was too high, that it was misaligned with the DWP’s direction of travel, and that the threshold was excessive when compared to insurers. There was also concern that 66% would discourage investment in productive assets, and that it may make the provision of capital-backed funding arrangements uneconomic in some circumstances.
Those who suggested an alternative for ‘X’ suggested 50% as indicated in the DWP’s consultation response. Another suggestion was to ensure that ‘X’ is set at a percentage which would broadly represent funding on a buyout measure.
Our response
Aligning with the DWP’s consultation response, we believe that ‘X% above a minimum level of funding on the superfund TPs basis, is the most proportionate and pragmatic solution. Accordingly, the capital release trigger will be at the point where capital adequacy is exceeded, and the surplus is more than X% of the capital buffer (ie the difference between the minimum total asset stack (TAS) and minimum TPs). By basing the additional margin on the buffer, we have linked the capital release trigger to the level of investment risk being run and we avoid penalising overcapitalised arrangements.
The modelling undertaken by Mercer shows the following.
- A trigger of 50%, but keeping all other expectations the same, would broadly fit with our current guidance expectations of a 99% chance of savers receiving full benefits.
- A 33% trigger would still result in a 98% probability of meeting members’ benefits. The DWP’s consultation response indicated that a 98% probability of benefits being met could be acceptable for the legislative regime.
Therefore, we will be setting the capital release trigger at 33% for the interim regime and have updated our guidance to reflect this. We believe that setting the capital release trigger at this level will help encourage a thriving and competitive superfund market while maintaining member protection.
2. Safeguards: Minimum period
Consistent with the DWP, to avoid capital being released due to short-term market movements, we proposed including at least a six-month minimum period before capital can be released after it reached the trigger.
We asked
- Do you agree with this?
- Please provide your reasoning if you feel that it should be a shorter or longer period.
You said
Minimum period
Most respondents were supportive of a minimum period and agreed this would safeguard members’ benefits against release based on volatility, rather than genuine outperformance.
There was no clear consensus on the length of any minimum period. Suggestions ranged from three months to more than six months. Some respondents identified that the minimum period may be longer in practice because the processes involved in the capital release calculation takes time.
Suggestions on mechanisms for minimum period
Suggestions provided to support a minimum period included the use of averages and measurements being taken at the end of each quarter. Respondents believed that this should ensure a robust assessment without making the test more onerous than intended.
Some respondents suggested adopting an insurance methodology involving the trigger being measured at a particular date to ascertain whether capital could be released. If it is concluded that capital could be released, a further check would be done against the trigger when the capital is to be released, ensuring the trigger is still met.
Our response
To reduce the likelihood that capital released is from surplus as a result of short-term market movements, and to avoid superfunds cherry-picking favourable dates, we expect superfunds to nominate capital release calculation dates at the outset, look back from those dates over the preceding month-ends and take an average. The period over which the average is to be taken is six months. We consider six months to be long enough to smooth the surplus calculation over a reasonable period and a number of market data points. It also allows superfunds two opportunities annually, six months apart, to release capital.
If the trigger is met on the capital release calculation date, and for the average of the preceding six months, surplus capital may be released.
Other safeguards
To align with our capital adequacy expectations, we don’t think capital release will significantly increase investment risk. We expect trustees to monitor surplus development and submit a statement to TPR one month before release. This statement should explain how the release aligns with the expectations set out in our guidance.
3. Safeguards: Minimum period including scheme year end
We asked
- Do you agree that the minimum period should include the scheme year-end valuation date?
- If not, please provide your reasoning and outline how the assets might otherwise be valued and how the risks of value being extracted, based on unaudited asset valuations, might be mitigated.
You said
Views on including year-end in the minimum period were evenly split. The rationale for favouring inclusion was that some assets, for example certain illiquids, are not valued more frequently than at year-end. Those who were less supportive of including year-end valuations believed that doing so is restrictive and could have the effect of extending the minimum period. It was also noted that most audited values can be provided at other times, and suggested that other evidence could be provided where asset valuations are not readily available.
Most were in favour of using audited asset values. Those who appreciate the utility of audited asset values also acknowledge potential downsides including difficulties valuing illiquid assets, reporting lags, cost implications and a potential challenge with syncing audited accounts and the minimum period. Some respondents suggested requiring at least one audited valuation within the minimum period.
Our response
We have decided not to specify that the scheme year-end valuation date must be used to demonstrate that the capital release trigger has been met. This is because we accept that audited values can be obtained outside of the year-end.
During the six-month lookback, superfunds will be expected to use one set of audited asset values. We acknowledge that obtaining audited asset values can take some time but, as they have been subject to third-party scrutiny, they are necessary to help ensure:
- that it is appropriate to release capital, and
- where capital is released, the correct amount is taken.
This strikes a balance between commercial interests and savers’ security.
We acknowledge that month-end valuations may not always be available, for example for some illiquid/private-market assets. In these circumstances we would accept estimated month-end fund valuations, which should be prepared by independent third parties in line with standard industry practices.
4. Reflecting discount rate changes
We asked
- Do you think any additional requirements on profit extraction should be imposed where, for example, the discount rate is expected to reduce following a review which overlaps with the minimum period?
You said
There was widespread agreement that changes in the discount rate should be reflected. Some respondents suggested that a change in discount rate should extend or restart the minimum period. Others favoured any changes being accounted for at the end of the minimum period, before capital is released. Responses indicated that superfunds should have short/medium-term capital projections, enabling them to understand the impact of known or expected future changes.
Our response
We are implementing ‘X% above a minimum level of funding on the superfund TPs basis’. However, as we now expect a ‘look-back’ period to apply rather than a forward-looking holding period, it seems reasonable for the discount rate at the end of the look-back period to apply. Therefore, we are proposing that the discount rate at the end of that ‘look-back’ period should be applied for the calculation of whether the trigger has been met, on average, during that period.
5. Sectionalised superfunds
Aligned with the DWP, we proposed not to introduce an additional test for capital release in a sectionalised superfund. Not introducing such an additional test would, in principle, allow capital to be released from sections above the trigger level, even when the superfund has other sections below the trigger.
We asked
- Do you agree? If you feel that an additional test in these circumstances is necessary, please provide your reasoning.
You said
Most indicated that additional tests should not be imposed on sectionalised superfunds. A few respondents mentioned concerns about poorly funded sections, and this was the driver for the minority who believed that there should be a holistic assessment of a sectionalised superfund’s assumptions, assets and liabilities before allowing capital release. Some respondents expressed concerns about the risk of a failing section falling into the Pension Protection Fund (PPF).
Other comments encouraged us to consider the potential effect on the market. For example, if there is no additional test, providers may favour sectionalised arrangements as they may have more opportunity to release capital.
Our response
We do not intend to introduce any additional capital release tests for sectionalised superfunds.
We note concerns about failing sections falling into the PPF but consider this unlikely due to the wind-up trigger. We remain mindful of the effect our guidance has on the market and do not intend to favour any particular superfund structure.
6. Amendment of the ‘standalone’ principle
The previous version of our guidance (2020) set out a standalone principle where we expected all transfers to a superfund to meet our capital requirements on a ‘standalone’ basis. This was to prevent surplus being used to fund new transfers in. Given that we are now expecting capital to be released, subject to meeting certain expectations and before benefits are bought out, we propose removing the ‘standalone’ principle. This is on the basis that the funding level in the superfund is above the capital release trigger level at the time of the transfer into a superfund. Where the funding is not above this trigger, then the ‘standalone’ principle remains in place.
We asked
- Do you agree with this approach?
- Do you foresee any potential issues and risks? If so, please explain.
You said
Respondents unanimously agreed that this proposal is reasonable.
Our response
Our capital release threshold has been set at a level of 33% with an acceptance of the additional level of risk that capital release introduces to member benefits. Having considered this, and taken into account the responses, we have updated the guidance to confirm that the ‘standalone’ principle falls away as long as after the transfer the funding level in the superfund is above the capital release trigger level. Where the funding level is not above this trigger, then the ‘standalone’ principle applies. Overall, by allowing capital release earlier than benefits being bought out and doing away with this test along the lines described, this will mean that superfunds will be able to release capital earlier, while retaining appropriate protection for members.
7. Investment Principle 3 – investment in private market assets
In our 2023 guidance update, we added some flexibility to Investment Principle 3 (Recognisable maximum allocations) to enable superfunds to deviate from the maximum allocations if supported by appropriate independent investment advice.
We asked
- Do you believe that this principle unreasonably limits private market investment?
- Do you believe that there should be changes to this principle?
- If yes, what would you suggest and why?
You said
All but one respondent agreed with the current investment principle.
Generally, respondents thought the restrictions were suitable and welcomed the additional flexibility provided by the 2023 guidance update. Two respondents thought new superfunds might find the investment restrictions limiting until they gained asset scale but that these difficulties would reduce as the superfund grows.
Our response
We note that, on the whole, stakeholders do not find Investment Principle 3 unduly restrictive. Having considered this issue, including the responses, we will not be making any changes to this principle in the interim regime, aside from additional reference to insurance risk transfers.
We acknowledge the observations made about the limits being potentially more restrictive on providers who have not achieved scale. However, Investment Principle 2 (Scheme Assets should be managed in line with asset scale), pre-empts over-investment issues arising with such schemes. This is to ensure that concentration risks due to over-investment, relative to asset scale, do not arise.
8. Market risk element of capital buffer
Our superfunds guidance requires that the market risk element of the capital buffer is at such a level that, when added to the scheme assets, there is a 99% probability of being funded at or above the minimum TPs in five years. The DWP’s superfund consultation response of July 2023 assumed an annual risk of failure based on 1-in-100 Value at Risk (VaR).
We asked
We are considering moving to this one-year test rather than our current five-year test to better align with the DWP’s stated direction.
- Do you feel, in light of the DWP’s response, that we should review the basis of the market risk element of the capital buffer under the current interim regime?
- Do you think we should also consider making allowance for operational risks? How might we best do this in a simplified way for this period ahead of legislation?
You said
Of those expressing a definitive view, a small majority were in favour of the change, agreeing that there is a benefit to alignment with the DWP and that it could increase transparency or ease the comparison between superfunds and insurers. Those not in favour believed that changing the interim regime is disproportionate and potentially costly. They advocated waiting for the legislative regime.
Some considered the solvency requirements stringent enough to negate the need for an operational risk allowance and also noted that insurers tend not to have operational risk allowances as the capital they hold is adequate to absorb the risk.
Our response
We acknowledge the benefits of ensuring the closest alignment with the DWP and increasing comparability between superfunds and insurance. We also note respondents’ suggestions that the change to a one-year Value-at-Risk (VaR) could reduce entry prices to superfunds, and we agree that this may be true in some cases.
We have also carefully considered the modelling undertaken by Mercer, which looked at the probability of meeting members’ benefits (POMBs) and found that for higher-risk investment strategies a one-year test would impact member security significantly. Additionally, it found that for some lower-risk strategies, this would increase capital requirements, with implications for entry prices compared with insurance buy-out.
Having considered this issue carefully, including the modelling and engagement responses, we will be maintaining the ‘99% probability over five years’. We are permitting capital release, with the trigger for that at 33% (see question 1), and note that, even with retaining the five-year test, some more risk-taking investment approaches could result in POMBs below 99%. We believe this change is a strong indication of our support for further development of the superfund market, while maintaining adequate protection for members.
9. Expectations on residual risks
We asked
Whether we should add detail on our expectations around residual risks to the trustee and employer guidance, to:
- be able to explain the due diligence undertaken to assess and mitigate the potential for residual risks within the scheme
- demonstrate how any residual risks have been mitigated and managed, for example through insurance or indemnities, or data cleansing exercises
- include an additional capital reserve in some circumstances, for example where concerns around data quality or benefit integrity limit their ability to mitigate residual risks through insurance or indemnities
You said
Responses were finely balanced. Those against additional guidance said we do not provide it in respect of insurance transactions, despite the risks being similar. Those in favour agreed that there should be an explanation of the due diligence undertaken to assess and mitigate the potential for residual risks within the scheme. They also agreed that there should be an ability to demonstrate how residual risks have been mitigated and managed. Several respondents stated that this was a commercial matter, but some still supported extra content as long it was no more onerous for superfund transactions than insurance transactions.
Our response
Having considered this issue, we have decided not to materially amend this area of the guidance as we accept that residual risk is a commercial matter to be settled between the parties.
We do however clarify our position in guidance. In summary, ceding trustees should:
- explain the due diligence undertaken to assess and mitigate the potential for residual risks within the scheme, and
- demonstrate how any residual risks have been mitigated and managed, for example through the use of insurance or indemnities, or data cleansing exercises
Where mitigations are limited (for example, where concerns around data quality or benefit integrity persist), we expect parties to consider including an additional capital reserve where insurance or indemnities are unavailable or would not suffice. These are not additional expectations, but an illustration of how we’d expect trustees to approach this particular scenario, in view of their existing duties.
10. Any other feedback?
You said
Capital release
Respondents:
- suggested that we should be aware of the impact of any changes on completed transactions or those pending at the time of change
- noted that broader consideration was needed as there are possible links between the proposals for superfunds and capital-backed arrangements (CBAs) or employers looking to extract surplus from pension schemes
- noted that our guidance will be relevant to the PRA’s statutory objectives if a superfund is established within an insurer
- suggested retiring the ‘profit extraction’ terminology to avoid negative connotations
Other matters
Respondents:
- suggested that we reconsider our gateway tests, and instead implement principles akin to the material detriment test when asking whether entry to a superfund or capital release is appropriate. This would help reduce barriers to members achieving full benefits.
- suggested that the wind-up trigger be recalibrated to 102.5% of the section 179 liabilities to align with the DWP proposals and prevent wind-ups from occurring when it may be contrary to members’ interests.
- felt that the long-term rate of mortality improvement should be set by a superfund’s trustees upon receipt of advice from the scheme actuary. Linked to this, the longevity reserve should be defined as an increase in liabilities with the ability to use market pricing, rather than actuarial assumptions.
- wished to see greater alignment between the interim regime and the ideas expressed in the Mansion House announcement and suggested extensive revisions to our investment principles.
Our response
We have noted and considered the additional comments but we will not be introducing these suggestions in the interim regime.
Having considered the mortality point, we do not believe it needs amending at this time. We are not aware that it is having an impact on superfunds being able to offer a competitive price. However, we may consider this issue further in the future.
Relaxation of capital adequacy requirements following employer insolvency (February 2024 engagement)
We saw scope to potentially introduce flexibility in capital adequacy expectations for schemes where the employer has become insolvent. In February 2024, we sought views on how this could be done.
We have considered whether the superfund market, alongside other CBAs such as capital-backed journey plans, could better assist schemes whose employer has become insolvent and is unable to afford to buy out full benefits, or enter an arrangement operating under the current superfund guidance level of capital. Currently, such schemes would likely move to a “PPF+ buy-out” under which members would suffer a benefit haircut and therefore lose the potential for better outcomes via a superfund.
Below we summarise the responses to this engagement:
1. Capital adequacy relaxation
We asked
- Do you think that this relaxation would be appropriate and help improve member outcomes?
You said
Most respondents were supportive of this relaxation for insolvency situations as it could improve expected outcomes for members. Some caveated they would only support the relaxation if it does not undermine or complicate the existing superfund regime, and if we could ensure capital adequacy requirements were not relaxed so much that it compromises the security of benefits accrued. Some also expressed concerns regarding the significant amount of scheme assets that could be used to explore these options.
Our response
We believe there is a case for allowing this relaxation for superfunds and CBAs.
To avoid undermining or complicating the interim regime, we will not be introducing a parallel regime to monitor transactions under this relaxation. Following the insolvency of the sponsoring employer, we have accepted that trustees may decide that a CBA or entry to a superfund would be appropriate even if the provider was unable initially to meet our capital adequacy expectations.
We will expect trustees to satisfy themselves that they have a robust rationale for wanting to enter into the arrangement. We expect them to be able to evidence that the transaction on lower capital adequacy terms would be in members’ interests and that there is a high level of certainty that members will not end up with lower benefits than with an immediate PPF+ buy-out. The latter should prevent compromise of the security of benefits accrued.
We have also laid out some expectations about intervention triggers and capital release for the case of CBAs. We would emphasise that costs relating to innovative structures and methodologies for entering these options should not be taken out of scheme assets.
2. Further capital adequacy expectations
Suggestions varied and included:
- introducing an investment risk requirement
- a minimum capital requirement or reduction of capital being proportional to the funding position of the scheme at the outset
- capping trustee/PPF costs at 0.5% of TPs
- a trigger to automatically place a scheme into the PPF assessment if it appears to be inappropriate
- the provider should cover, at least in part, due diligence costs
Several respondents advocated this should be a trustee decision but expressed concerns about whether trustees have the appropriate resources and abilities to make this decision.
Our response
Our intention is not to steer trustees towards running-on rather than buying-out, but to clarify that we would consider it to be an option in post-insolvency situations.
We believe we can address the concerns expressed by setting out some expectations we would like trustees to follow in these transactions. For example, we are setting out an expectation for there to be a mechanism akin to the low-risk trigger for CBAs and any additional mechanism that trustees may judge appropriate to have a say when funding deteriorates.
With regards to CBAs, we expect there to be a wind-up trigger in line with our guidance (by default, at 105% of s179), and for any capital release mechanism to be consistent with the one introduced in this update.
As an additional expectation for circumstances where parties agree there is to be capital released, we would expect there to be alignment between the capital release threshold and the scheme’s funding position as it progresses through the milestones. This should mitigate the risk that capital release is detrimental to members by undermining the agreed journey plan.
We do not intend to introduce any new investment expectations.
We note the issue of which parties bear what costs, and do not intend to change the principles in our guidance for prospective ceding trustees and employers. However, we would not expect the costs of exploring innovative solutions involving superfunds or CBAs to be met from scheme assets. As with any transaction, we would encourage trustees to consider potential costs at an early stage and to have clear agreements with other parties as to cost allocation. We can see that CBAs could be put in place for the shell employer to take over the scheme if insolvency happens at a later point. Appendix A of our guidance for ceding trustees provides further detail for CBAs in this situation.
3. Role of intervention triggers
We asked
- While we would retain the PPF wind-up trigger, how would you see the role of a low-risk trigger in these circumstances?
You said
Most supported the low-risk trigger being kept and recommended the parameters should be reduced to reflect the lower funding position from the offset. Some commented that a pre-agreed formula or a specified single level for this trigger would not be helpful or practical in these situations. Instead, trustees should negotiate a low-risk funding trigger.
A few responses suggested the low-risk trigger should be removed altogether to mitigate the concern that it would be unattractive to providers if the trigger was set too high and was breached early on.
Our response
We agree with the general view that there should be a mechanism akin to the low-risk funding trigger. The guidance sets out this expectation, and that additionally trustees may want to consider whether it is necessary to introduce any other mechanisms to ensure they have a say when the funding of the scheme under this arrangement approaches the agreed level of the low-risk trigger.
While we are not prescriptive about the levels (as these will need to reflect the capital relaxation under which these transactions take place), we expect trustees to consider whether these intervention mechanisms are appropriate to ensure that members’ benefits are protected from an uncomfortable level of risk.
4. Evidence to enter into relaxed capital adequacy transactions
We asked
- Do you have any suggestions about how trustees should proportionately evidence where there are insufficient scheme assets to enter into a superfund on full capital adequacy terms?
You said
Most respondents agreed that trustees should provide evidence that they cannot afford to enter a superfund with full capital adequacy requirements, and that this should be evidenced by providing a quotation from a superfund.
There were some concerns around the reliability of these quotations and conflict of interest issues due to the limited size of the superfund market. Suggestions about how trustees could mitigate this by proportionately evidencing insufficient scheme assets varied greatly.
Our response
In principle, we agree that trustees should provide us with evidence that demonstrates they are unable to afford to enter into a superfund on full capital adequacy terms. We take on board the concerns around the reliability of quotations, and potential conflict issues We favour taking a proportionate approach, noting the potential time and cost impacts. . However, this would be an important decision for trustees, with significant potential impact on members. We will therefore expect the trustees of the scheme to set out to us how they have satisfied themselves that the transaction on lower capital adequacy terms would be in members’ interests, and the basis for their conclusion that there is sufficient protection for members against the risk of members ending up with lower benefits than with an immediate PPF+ buy-out.
5. Role of the shell company in capital backed arrangements
We asked
- What governance role do you see for the shell company in these relationships, and how are they distinguished from a traditional employer?
You said
Respondents mainly said governance should always be trustee-led, while a few responses stated that trustees should negotiate this role with the provider of the CBA to ensure they are content with the control they have over key aspects of the arrangements and what powers are being transferred to the shell company.
Our response
We believe it is key that trustees retain an appropriate level of control over the scheme when the shell employer takes over the role of the employer under these arrangements. We expect trustees to consider what level of control can be ceded carefully before entering into any agreement, particularly on key points such as the power to appoint new trustees. We also expect parties to consider if there are circumstances where full control of the shell company should be ceded to the trustees.
6. Any other comments
You said
Several respondents felt we should provide more detailed guidance around relaxing the capital requirements more generally, including:
- due diligence for ceding trustees to help them determine what suitable capital requirements would look like
- how insolvency is defined before allowing entry, especially for overseas employers
There was also the suggestion of potentially offering it to employers who are at risk of insolvency in the next 12 months. Finally, it was noted that schemes should be mindful of how the PPF levy may impact these types of transactions.
Our response
We have considered these issues carefully, and note that there are risks and challenges in taking this approach, but also potential benefits to members. In particular, members may have the potential to receive higher benefits than if the scheme bought out at PPF+ assessment levels. We have added high-level content to our guidance to signpost issues trustees should consider, but have sought to avoid creating a parallel regime.
We do not anticipate a large number of schemes that will seek to access a superfund or a CBA at a lower capital requirement, as the relaxation only applies if the employer has already become insolvent. We also do not believe it is appropriate for the interim regime to extend the relaxation further to schemes where the employer is at risk of insolvency within the following 12 months.