When a sponsor and trustee agree to take the active decision to run-on a defined benefit (DB) pension scheme, understanding the associated risks and considering ways to mitigate those risks is paramount. For trustees who can already afford to fully insure their scheme, likely that the biggest concern about the decision to run-on instead, is whether members could end up with less than full benefits.

It is common for many schemes to focus on investment risk when running-on but covenant risk is as important, if not more so. Ensuring adequate covenant protection is therefore key to an effective run-on strategy and a key part of Aon’s Active Solution to Run On (ASTRO). Some sponsors are already very secure. Others may need some enhancement to their security. A surety bond is just one way to deliver this but one that it is relatively easy to procure, and widely available.

What is a surety bond and where is the benefit?

The circumstance of members not receiving all of their benefits would arise if a scheme is underfunded versus an insurer’s pricing assumptions (buyout basis), at the same time as the sponsor defaults. Other options may be available, such as commercial consolidators, but I have omitted them from this article as they have so far only been used when insurance has not been deemed financially viable in the near term.

A surety bond is an insurance policy from an independent A-AA rated insurer, set-up to make a payment quickly when a sponsor defaults. For example, for a scheme that is fully-funded on a buyout basis and with a surety bond covering 5 percent of assets, the following scenarios illustrate where the value of surety bond comes in:

  • If the employer becomes insolvent but the funding level remains strong, the scheme can afford to insure full benefits and there is no payment needed form the insurer;
  • If the assets lose value relative to liabilities, but the sponsor remains solvent, then the sponsor can support the scheme back to full funding. The surety coverage can also be increased to cover any new deficit; or
  • If there is a simultaneous insolvency and a significant fall in the scheme’s asset value, the insurer would pay out up to 5 percent of assets to top up the scheme to then fully insure member benefits.

Surety bonds are temporary in nature and require periodic renewal. These renewals need careful management to ensure coverage is maintained at an appropriate level. Renewals can also be timed with a periodic review of whether to continue running-on.

Bringing it to life

To test the effect of adding the surety bond covenant overlay, we conducted some extensive research. In simple terms, we looked at:

  • Taking a scheme 100 percent funded on a buyout basis today supported by a BBB rated sponsoring employer
  • Modelling the position of the scheme’s funding level stochastically over the long term (20 years) and the solvency status of the sponsor in 5,000 scenarios
  • The scheme investing to generate returns of up to Gilts + 1.5 percent p.a. – one which generates stable returns from a portfolio offering low volatility relative to insurers’ pricing
  • Returning any excess assets above 103 percent to the sponsor and members (e.g. through DC benefit enhancement) regularly over time

We’re primarily concerned with benefit outcomes for members, compared as a percentage of the original pensions promised, which we’ve tested with and without a surety bond overlay. First, regardless of the surety bond, there was a very low probability of failure. In terms of average benefit outcomes, there was an average of 99.9 percent of the original benefits promised to members paid to members.

Digging deeper though, our analysis highlighted the value of the surety bond in that:

  • Without the surety bond, there were around 2.1 percent* of scenarios where members didn’t receive the full value of benefits they were promised
  • The equivalent percentage when the surety bond was introduced was 0.6 percent* (i.e. less than one time in 150)
  • In other words, the proportion of scenarios where there was an adverse outcome from a member perspective, was reduced considerably - 70 percent* in this case study. Hence, the surety bond can be very effective at supporting in cases where there is a fairly sudden failure of the sponsor, and when the additional financial support pays out to the scheme. While all of these scenarios are often considered ‘the tail’, this remains an important consideration and reducing this possibility in a cost-effective way is the core business case for the surety bond.

*Based on Aon ASTRO modelling using 5,000 simulations, allowing for expected market volatility and an allowance for movements in expected insurer pricing.

Of course, there is still risk associated. Here, the majority of that risk is from either:

  • The maximum agreed surety bond being insufficient to meet the funding shortfall – i.e. a severe fall in funding level in a short space of time; or
  • Where there has been a gradual deterioration in the employer beyond the point of expiry (beyond the triennial period), and at the point when the scheme is underfunded on a buyout basis.

Along with illustrating the possible value from the surety bond overlay, the analysis emphasises the need for careful structuring of the framework (e.g. expanding the level of surety cover to manage down the risk above), to understand the risks of making the decision to actively run-on.

Doesn’t the cost weigh on expected value in future?

The price of surety bonds is based on the credit worthiness of the sponsoring employer. For employers with a stronger covenant, the surety cost can comfortably be absorbed within the targeted additional value being created - potentially around 2 percent p.a. (targeted asset returns as well as natural maturing of the plan) of the total asset value. By definition, active run-on is typically for those with a stronger covenant, therefore fitting naturally with the surety markets preference for providing cover to entities deemed more credit worthy. Overall, the relative cost of surety bonds is not a barrier if there is broader agreement for run-on, because the effect of expected overall returns is relatively minimal. A small price to pay for security.

 

Paul Heaney
Associate Partner