Con Keating- the author

The idea that DB pension schemes should be self-sufficient, funded to such a level that they are capable of paying all pensions when due from their own resources is now rather popular. It is also completely idiotic, as the limit to such things makes obvious.

In the limit the fund must hold cash equal in amount to the total projected values of all future pension payments. And then of course, as these may have been mis-estimated, some additional sums are needed to cover that possible eventuality.

It is worth recalling that the total pension payments promised for a year of service are multiples of the contribution made. Investment income is the source of the majority of pension finances, over 90% for many schemes. The cost of this full funding to an employer might easily be higher than the employee’s annual salary.

While this may be considered as being simply the limit of a zero interest or discount rate, it is also compression of time. A member may take all of their pension in transfer immediately. A fully funded scheme, in this limit, has no use or need for investment as this would entail risk to the scheme. A member, having transferred funds out, might, if risk averse, similarly take no risk in the new fund, or if risk-seeking, look to make further gains, either speculative or investment.

Indeed, the scheme, rather than being a source of capital formation and productive investment, is now a drain on the capital of the employer firm. Such a scheme would also be a drain on public finances, through the tax concessions. If the funding is arrived at by normal employer contributions, there is full deductibility and if by way of special deficit repair contributions deduction spread over four years.

This limit exposition serves to illuminate many of the follies we see in practice, such as the de-risking of asset portfolios as scheme funding status improves.

It is also clear that the priority status of the pension fund is unique; it now has super-secured priority status above all other stakeholders; a situation which is clearly inequitable among creditors.

The precise origins of this self-sufficiency concept are difficult to determine. It is not a direct consequence of any of the reams of new pension and trust regulation introduced in the wake of the Maxwell affair in the early 1990s, though the Pensions Regulator and PPF have undoubtedly served to promote the idea. The strongest candidate for this seminal role seems to be a 1987 actuarial paper by McLeish and Stewart: ‘Objectives and Methods of Funding Defined Benefit Pension Schemes’.

However, this paper is a very weak foundation; merely a simple assertion, lacking any supporting evidence or even argument. Following recognition that the employer may cease to exist, the authors, McLeish and Stewart, assert: “It seems to us to follow, therefore, that the prime purpose of funding an occupational scheme must be to secure the accrued benefits, whatever they might be, in the event of the sponsor being unable or unwilling to pay at some time in the future.“

They continue with: “To that end, the contributions would have to be sufficient both the pay the benefits as they fell due for as long as the scheme continued, and also to establish and maintain a fund which would be sufficient to secure the accrued benefits in the event of contributions ceasing and the scheme being discontinued, whenever that might occur.“

It is clear that, in this view, the role of the pension fund has changed. It is now seeking to provide pensions independently of the sponsor rather than offsetting the employer’s cost of production of the pension.

“Secure the accrued benefits” needs unpacking. It is one thing for scheme assets to secure the accrued amount of the sponsor’s contractual promises at the date of insolvency, but quite another to extend this to accruals occurring after the date of insolvency. There is a significant difference here between the trustee’s duty to secure benefits and its common misstatement as: the primary duty of the trustee is to ensure that there are sufficient funds available to pay the pensions promised, as they fall due.

Trustees have many duties, including collecting contributions, holding and investing assets and paying benefits, all in accordance with the terms of the trust. Self-sufficiency is not one of their duties and in a lifetime of dealing with pension trusts, I have never seen one where this was introduced by the scheme rules.

Given the centrality of pensions to most members’ financial health, it is reasonable to afford them secured status with respect to vested benefits accrued to the date of insolvency. However, this may or may not be sufficient to allow them to buy replacement pensions from other suppliers at that time. In this they are in the same position as other secured creditors of the sponsor firm, which may include DC pension funds.

Some perspective is advisable. With the sponsor business trading as an ongoing concern, funding at the level of technical provisions is more than sufficient to secure the obligations to members. Actuarial practice, guidance from the Pensions Regulator and trust law all support the introduction of prudence into these valuations; that is to say they are conservatively biased, with liabilities being overstated. It is more likely than not that a scheme funded to the level of technical provisions will proceed to pay all pensions in full and on time.

Of course, the ongoing business may fail; but the cost of this risk for the scheme is small. A scheme such as USS might have an insolvency likelihood of 0.25% and a loss of 50% of benefits after failure – this is 0.12 percent of scheme outcomes. Prudential margins, which are typically of the order of ten or twenty percent of scheme value, swamp these concerns.

The excess funding needed to cope with the uncertainty faced by a stand-alone self-sufficient pension scheme is substantial; it is directly analogous to the capital required to be held by an insurance company writing pensions policies.

Investment consultants have adopted the more opaque practice of describing this in terms of a likelihood of paying all pensions when due, say 95% or 99%, rather than as a sum of money, and expressing this as a gilt spread discount rate – gilts plus 25 basis points is the most common formula.

We should remember that the discount rate is the implicit rate of return on contributions to the scheme member. I wonder how many would be content to make long-term investments at such rates if this point were made expressly transparent to them>

There is a further, collective problem. If all schemes were to follow this self-sufficiency ambition, the aggregate level of scheme funding would be quite close to the cost of full buyout – around £800 billion more than the current funding of £1,341 billion – an economic folly of unprecedented dimension.

The solution to such low probability high consequence problems is well known; it is insurance, as is well-known and practiced in some other countries.

By contrast, self-sufficiency requires scheme funding sufficient that it may continue after the demise of its sponsor, with the ongoing purpose of discharging the pensions as originally promised by the sponsor employer. This is an expensive course of action.