Elements of Truth – and Complete Misunderstandings (Con Keating and the DB Green Paper).



This is an era of fake news, half-truths and outright lies. Spin and distortion have become the fabric of a false DB pension narrative; their unjustified ruination. Some “fact checking” is appropriate.

We hear again and again that DB pensions are deferred pay[i]. This may be true of the employer contribution, but it clearly isn’t for employee contributions; they are an investment, plain and simple – a deferred annuity. The overwhelming majority of the pension associated with the employer’s participation comes not from the contribution but from the investment returns promised and realised on that.

The investment return promised on the employee’s contribution is implicit in the terms of the pension contract; the pensions payable in consideration of the contribution(s) made uniquely determine this. The return implicit on the employer’s contribution is (usually) the same; this is the contractual investment accrual rate. It is a cost of the sponsor employer.

Suppose the sponsor company decides to issue deferred annuities to investors and prices these at this same rate. For convenience and security, in common with many corporate bonds, this issue has a trustee, with responsibility for monitoring and enforcing employer performance of the deferred annuity contract. Let us further suppose that the credit standing of the sponsor company is such that it needs to secure these securities in order to sell them. The question for the trustee then becomes: what is the appropriate amount of security required at any time during their existence.

The answer is that this should be the principal amount initially advanced (contribution) together with the accrual, from issuance to date, at this rate. DB pensions are, in principle, no different.

There is no consideration by the trustee of any future state of the world, no consideration of the future development of the sponsor company’s “covenant”. This is based entirely on historical fact; what risks may have been faced previously has eventuated, or not. Nor should there be with DB pensions. The DB pension trustee’s duty is to secure the members’ benefits, at a point in time; no more, no less.

The Pension Regulator has invented other views. Their Code of Practice[ii], Funding Defined Benefits, states: “Paying the promised benefits is the key objective for scheme trustees.” It is most interesting that the Regulator’s more extensive descriptions of Trustee duties[iii] do not include this objective. It has been seized upon by many advisors and “gold-plated”; used to promote elaborate, expensive and unnecessary management strategies. Unless this is written into scheme rules, this objective isn’t a duty or even desirable.

If followed it would constitute very poor corporate governance, favouring one stakeholder group above all others. It suffers the further problem that scheme funding can never fully assure that outcome. If the role of the scheme and its fund would have shifted, the occupational link been broken.

But it gets worse. The Regulator’s Code introduces a “Principle”: “Managing risk: Trustees should implement an approach which integrates the management of employer covenant, investment and funding risks; identifying, assessing, monitoring and addressing those risks effectively.” The shift is now total, though entirely unsupported in any of the many Pensions Acts.

The scheme is now to be considered as a stand-alone entity; its assets primarily responsible for generating the returns to pay pensions. It is now an insurance company in all but name. The economic and financial inefficiency of creating almost six thousand insurance companies is self-evident.

Doubtless, the Regulator sees this approach as fulfilling its objective: “to reduce the risk of situations arising which may lead to compensation being payable from the Pension Protection Fund (PPF)”. As these situations can only arise from either or both sponsor and scheme insolvency, the wording of this objective is unfortunate. The lack of political will for systematic involvement in the financial affairs of private sector business leaves only schemes and their funds available to the Regulator. The problem with the wording is that it precludes allowing the correct, and lower, level of (contractual) funding; it encourages excess funding in schemes. The minutiae of these rules go far further, constraining their asset allocations and management strategies, fostering complexity. The Regulator appears to believe that the increasingly complex financial arrangements, which include leverage, of schemes have made them more resilient, when the lesson of the financial crisis is that the opposite turned out to be true.

The splendidly misleadingly titled 2005 Occupational Pension Schemes (Scheme Funding) Regulations are not helpful; they specify scheme valuation techniques. “…the rates of interest used to discount future payments of benefits future payments of benefits must be chosen prudently, taking into account either or both –

  1. the yield on assets held by the scheme to fund future benefits and the anticipated future investment returns, and
  2. the market redemption yields on government or other high-quality bonds…”

Unfortunately, both methods are incorrect for sound valuation. The first, the expected return on scheme assets, would inform us as to the sufficiency of those assets for the purpose of paying benefits, if the expectations prove correct, but that may be a very big if indeed. The second is appropriate if we were an insurance company considering the price we might demand to assume those liabilities at the time of valuation, given our investment constraints.

Both result in time-inconsistent valuations, making them unsound as a basis for management action. Only the contractual accrual rate is time consistent; the valuations arrived by accrual (of the past actions which have occurred) and by discounting (the future obligations contracted) are the same. Along with the IFRS accounting standard, the scheme funding rules introduce both bias and volatility into valuations; a serious problem for corporate and pension management.

The greater problem is that actions based this view and these figures may bring with them real costs. The list of these costly actions is already long, and it appears that we may shortly be introduced to yet more in the form of DB scheme “consolidation”.


[i]             This description, though, does provide an interesting test for DC “pensions”, where no pay is deferred.

[ii] Code of Practice No 3, dated July 2014

[iii] See: The Trustees Duties and Powers: http://www.thepensionsregulator.gov.uk/guidance/guidance-for-trustees.aspx#s1542

Con Keating is well known to readers of this blog, Con is currently a member of the steering committee of the financial econometrics research centre at the University of Warwick and of the Société Universitaire Européenne de Recherches en Finance. As a research fellow of the Finance Development Centre he published widely on the regulation of financial institutions and pension systems, and also developed new statistical tools for the analysis of financial data, such as Omega functions and metrics.

From 1994 to 2001, Con was chairman of the committee on methods and measures of the European Federation of Financial Analysts Societies and currently is a member of their Market Structure Commission. Con has also served as an advisor and consultant to the OECD’s private pensions committee and a number of other international institutions.

In a career spanning more than forty years, Con has worked as an infrastructure project financier, corporate advisor, investment manager and research analyst in Europe, Asia and the United States. He has served on the boards of a number of educational and charitable foundations and as a trustee of several pension schemes. He is currently Head of Research for the BrightonRock insurance group.


This article is also published in Portfolio Institutional.


About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
This entry was posted in pensions and tagged , , , , . Bookmark the permalink.

Leave a Reply