a case for consolidation

The PLSA paper “The case for consolidation” begs an important question; one far broader than it addresses. The Pensions Regulator and DWP have concluded that DB pensions do not suffer from a problem of systemic risk, but the PLSA Taskforce Chair, Ashok Gupta, while agreeing with this, goes further and is concerned by the cuts to benefits imposed by the PPF on members of schemes.

This is the epitome of the school of belief that DB pension funds exist to pay pensions in full and on time. The precise origins of this self-sufficiency concept are difficult to determine. It is not a consequence of any of the reams of new pension and trust regulation introduced since the Maxwell affair in the early 1990s. This is now a commonly held view and finds expression in many ways in different places. This is scarcely surprising when the Pensions Regulator actively promotes the view. It is seductive view, clothed in benevolent intention; though in the case of the Regulator it may be no more than pursuit of its statutory objective to protect the Pension Protection Fund.

Its origins are shrouded in the mists of time, but the earliest express articulation of it appears to be a 1986/87 Institute of Actuaries paper[1]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.”

If this had been the view and intent of Parliament, then surely the legislation would have made it a statutory requirement in one or other of the myriad of pension acts. Indeed, such an obligation, enacted in law, would have rendered the creation of the Pension Protection Fund entirely redundant.

This view is a reaction to the possibility of sponsor insolvency, and the desire to ensure due performance of this particular class of corporate liability. Obviously, elimination of the possibility of corporate insolvency is not a desirable objective; this is Schumpeter’s creative destruction at work. The problems of ‘zombie’ companies and the resulting misallocations of capital are well known.

Insolvency is a problem faced by all holders of claims on a company, not just pension scheme members. When rescue and recovery are not viable, the solution is immediate liquidation of the accrued claim to date. In addition to the triggering corporate deficiency, the costs of liquidation will usually mean that creditors receive only a fraction of their claim. For this reason, many debt claims are secured on assets which are not available generally to creditors; the pension trust is such a security arrangement with assets ring-fenced for the benefit of members.

The amount of a claim, and equivalently the security warranted, is based upon the performance due from origination of the claim to the date of commencement of insolvency protection. In the case of a conventional bond, it is the sum advanced plus any accrued but unpaid coupons; in the case of a zero-coupon bond, the amount advanced and the accrual on that to date, at the rate promised under the terms of the original contract. In the absence of over-riding legislation, there is no reason for DB pension claims to be treated differently, and many good arguments, based upon the legal concept of equity, why there should not be any such over-riding legislation.

There is no promise, implicit or otherwise, that the amount receivable would be sufficient to buy a replacement security offering equivalent terms, no matter whether the claim was secured or not. There is a separate issue as to whether this situation is satisfactory from a public policy standpoint, particularly given the importance of DB pensions in the wealth and wellbeing of so many individuals.

The US municipal bond market had long had many individual investors holding its securities. Issuer insolvencies and reorganisations prompted concerns for retail investor wellbeing. The solution introduced was insurance of performance of the obligations embodied in the bonds; payment of coupons and principal, fully, when due – technically, the exercise of a right of subrogation[2].

The most elementary point is that performance of an obligation after the insolvency of an obligor, a form of corporate death, requires there to be some third-party institution with the resources to undertake this. Two obvious institutional forms are available: the pension fund itself and independent insurance companies. Both remove the occupational linkage of DB pensions.

Insurance is by far the more efficient form of solution to the problem. It exists in a number of other jurisdictions. We should note, though, that the Pension Protection Fund is a mutual compensation scheme, not an insurer, and that it reduces member benefits. Indeed, it is this reduction that motivates the PLSA “consolidation” paper.

Funding in order to make a scheme self-sufficient, to be able to continue as stand-alone entity which exists to pay the pensions, is expensive. The cost of full buy-out gives an indication of just how expensive. Of course, a stand-alone survivor scheme would not need quite as much funding as buy-out, since it would not have to provide for a profit margin, or other costs such as marketing expenditures, or have the restrictions on investments faced by an insurance company. But it would need the majority of that excess cost.

Funding to stand-alone levels also creates a further issue. If the scheme is funded to, say, the 99.5% probability level, members are extremely secure. Indeed, in 99.5% of outcomes it would have excessive funding, creating a problem of ‘orphan’ assets, which are rightly the property of unsatisfied creditors and perhaps even former shareholders of the sponsor company. The amount may be very substantial indeed, many billions of pounds; on average, it would be equal to the difference between the buy-out level and the best estimate value of liabilities. Restitution of these assets to their rightful owners, twenty, forty or more years after the liquidation is simply not feasible.

Funding to stand-alone levels can also be expected to raise the cost of debt and other capital for the sponsor company, since it lowers the strength of the sponsor balance sheet. Section 75 values, inflation of the proper claim, are also problematic in this regard.

There are further issues in a stand-alone situation – the solvency constraint is binding, deficits would require the scheme to liquidate. This introduces a degree of short-termism into investment policy and practice not present in the corporate-supported arrangement; markedly so when the accounting and regulation are ‘market-consistent’.

[1] Journal of the Institute of Actuaries 114 (1987)

[2] It is interesting to note that the problems of the municipal bond insurers which arose during the financial crisis were not rooted in their municipal bond insurance exposure written in this (subrogation) way but rather in the extension of their activities into financial guarantee more broadly. One of the principles on which the guarantee market operates is that the insurer pays the claim as a lump sum immediately on notification of the trigger event, and any disputes are resolved later.