Behold I stand!

This is a record of a conversation had between me and my colleagues Hilary Salt, Rob Hammond and Derek Benstead, there were other parties to the conversation , I won’t name them, but they were interested and interesting.

Essay question

Is the way that defined benefits pensions are valued, encourage undue prudence and cramp a sponsoring company’s room for manoeuvre?

Funding strategy

The received idea is that pension schemes should be funded using a gilts based discount rate. For instance our largest funded DB scheme (Universities Superannuation Scheme) is proposing a discount rate of 0.5% above the gilt rate in its valuation negotiations.

Getting the scheme funded on this basis is extremely expensive to an employer but there is virtually no risk to the trustees that the member’s benefits aren’t getting paid. The problem  for the Universities , is that the cost has to be passed on either in a lower service to students or a higher price (the university fee cap is set to rise above to over £9,000 pa).

Michael O’Higgins , a former chair of the PPF has forcibly argued that trustees and employers agreeing a recklessly conservative funding strategy could be mis-allocating capital that might better be used to fulfil the social purpose of the sponsoring enterprise.

The principal driver for this rush to de-risk is the volatility that a pension scheme presents to an organisations balance sheet. Enterprises wishing the freedom to merge, acquire or even pay dividends are supposed to seek clearance from the Pensions Regulator unless the pension scheme’s funding isn’t at risk. Since this rule has come into force, the number of clearance applications has fallen from 263 to 9. The recent report by the DWP Select Committee, sees this evidence of weak regulation, but it might better be seen as a result of de-risking.

But this freedom for corporates has been bought at a high price. We have seen the various de-risking measures force up pension funding rates to 40-50% of pensionable salaries; the pension funds themselves cannot invest productively, investing in debt that becomes increasingly devalued as demand exceeds supply; finally the capacity for companies to meet future obligations from increased productivity is diminished as cash flow has gone to the pensions and equity markets have dried up as a source of capital. This is the vicious circle created by an unbalanced approach to risk

Accounting standards

There can be little doubt that the reason that Finance Directors have sanctioned expensive de-risking programs has been to avoid the volatility in the annual reporting of its pension scheme against the International Reporting Standard IAS 19. But this reporting is theoretical and creates a mis-alignment between the corporate position and the trustee’s position.

As an example, a company might be concerned about the Value at Risk from a fractional movement in interest rates (PV01= the impact of a 0.01% change in interest rate expectations!). Measures such as PV01 are very important for the finance director but of little interest to the trustee or the member as PV01 is barely touching the business of meeting  cash-flow obligations decades hence.

IAS 19 focusses minds on the here and now, trustees think for the future. It is clear that the here and now is winning the argument at the present, but at a cost.

Pandering to the short-term interest

Say it quietly, but finance directors not only sponsor pension funds, but they pay the bills of those who manage them . Consultants, professional trustees, lawyers and other advisers may act for the member but they are paid by the FD.

This may partially account for what we see as a herd instinct towards de-risking. Not only are professional trustees answerable to their pay-masters, but they are answerable to their insurers (those to whom they pay PI premiums).

The consultants are similarly stuck. At great expense they (we) have created financial models to answer questions about VAR and to model assets against liabilities. These models are based on a “gilts+” approach being “right”. There is very little modelling being done on how cash flows might best be met through a scheme investing for long-term growth.

Pension schemes provide income, the asset value of the pension scheme is a secondary matter. Virtually no monitoring is going on of the volatility of income, all attention is paid to the volatility of assets. The long-term measures of good health are being ignored and the long term assessment of a fund’s vitality are ignored.

The role of the Regulator

It could be argued that there is not much we can do about International Accounting Standards (though Brexit may loosen their hold). But the negative impact of a gilts + mentality is something that Government (through its Pensions Regulator) could be talking about. Alternatively (and perhaps preferably), the Pensions Regulator could promote the choice that exists for trustees to invest using a “best estimate” funding approach.

Recently, this has started to happen. As if we were in latter-day  Narnia, case workers have moved away from “frozen pensions” towards a vivid optimism that assumes pension schemes are an employee benefit as well as a balance sheet liability.

The role of the PPF

The Pension Protection Fund has not shown any signs of thawing. It is still invested as if it were an insurance company, with the  majority of its assets in bonds. But the PPF is not an insurance company. It was set up because it was thought there was insufficient capacity in the insurance market to buy-out failing pension schemes. It is a sponsored occupational pension scheme with an (extremely expensive) levy which it charges across the 6000 schemes not within its purlieu.

So why is it investing as if it was an insurance company and what is this telling other occupational pension schemes? One impact of investing like an insurance company is high demands through the levy. A second is a natural propensity to build up a reserve within itself that is economically unproductive. The PPF is currently 130% funded against its own measure of funding (s179). We are currently looking at what this measure would be on a best estimates basis (the Fab Index approach). It is likely to be well in excess of 130%.

Not only is the PPF replicating the problems outlined earlier in this article, it is setting the tone for this approach to continue. The PPF is not an insurer of last resort, it has recourse to occupational pension schemes and ultimately it can call upon the Government. But its behaviour sets an inflexible example to all the other stakeholders (including the Pensions Regulator).

The PPF is now a (small) sovereign wealth fund with some £24bn of assets, it is time that it started behaving in the national interest rather than the inward-focussed way it currently manages its investment. The PPF could invest more productively and if it did, perhaps the Regulator and the large pension schemes would follow. Richard Harrington asks why the infrastructure assets in his Watford constituency are being bought by the Ontario Pension Fund – he might well ask where were the PPF!

Over insuring

When you buy fire insurance for your house, it is so that you can have an open fire to roast your chestnuts. When you set up the PPF, it is so pension funds can invest for the future knowing there is a fire insurance in place.

But our occupational pension schemes are trying to be self-sufficient with minimum risk and this is akin to double insurance. Not only is this inefficient, it creates new risks. The premiums companies pay to their insurance like occupational pension schemes are supplemented by premiums to their insurance like PPF. The aggregate premium is putting a strain on employers (especially small employers) which ironically may put the employer at risk.

Do we need more Regulation?

The answer that Frank Field and the DWP Select Committee has come up with, is to give the Pensions Regulator the nuclear option of fining sponsors hugely for not meeting trustee demands.

This Field calls the nuclear option, but – as Paul Lewis has joke- pressing the nuclear option wouldn’t do much for anyone.

The Pensions Regulator can do much without a change to any existing regulation. It is within the powers of the Pension Protection Fund to make itself more productive.

If “Big” Government was to adopt a different approach to the problem, we would be able to see what happened at BHS , not as a disaster, but as a limited success. The  majority of those BHS pensioners will be protected to at least 90% of their initial pension and though they may lose some rights in payment, they are a lot better off than in previous times. The PPF should be setting its horizons on reducing the overall haircut to its pensioners (reckoned to be 27%) in total , rather than upping levies and de-risking for “self-sufficiency”. Wouldn’t it be good to see instead the PPF looking to reduce the haircut to 20% of less?

Why no cry of pain from employers?

Any DB pension sponsoring employer reading the DWP Select Committee’s report would be forgiven for crying “no more we have suffered enough.

Why are employers so quiet about the demands placed upon them. This is the subject for a separate (shorter) article. I suspect that having put their pension schemes into lock-down with LDI, many are giving up on them and awaiting the glorious day of buy-out. But this is only a proportion of schemes, many cannot afford LDI and are too small to be bought out.

A big government issue

The truth is they have no voice. Here is cry from the heart of a Director of a medium sized scheme

Henry – just read the piece on the Select Cmt paper. what can those of us with experience of looking after company schemes – those of us in the real world and not politicians – do to stop the madness? Those bodies who purport to be our conduit into the debate don’t seem to be succeeding.

This is a big government problem; it is more than an issue for the DWP or Treasury, it is an issue for our country to deal with, as part of our fundamental review of the way we govern ourselves. This is a task for 2017 and I hope this Government is up to it!

Maybe a cat’s chance?