This is an abbreviated version of Long Finance’s response to the DWP’s DB Green Paper. Long Finance are a group of Financial Analysts, led by Con Keating. They are not ivory tower academics but long experienced market practitioners.
In finance, a long position in a financial instrument, means the holder of the position owns a positive amount of the instrument. It is contrasted with going short.
Long Finance’s original response is too long for this blog, the length of the response was driven by their desire to demonstrate there are other narratives to that promoted by the Regulator; indeed – in their opinion – a number of these fit the facts better than the Regulator’s version.
The article makes good reading not just for DB specialists, ,but for those speculating on the advatages of “cashing out” – their or their client’s DB pension rights.
Insolvency of the sponsor employer is the principal risk to occupational DB pension schemes. Though such events are rare, they now dominate the management of scheme funds. Misconceptions abound: schemes do not have longer expected lives than their sponsor companies. Companies may change ownership more frequently than in previous times, but insolvency averages around 0.4% pa of the population, and that figure is inflated by the high rates of insolvency among young companies, which do not have DB pension schemes.
In essence, there are two views of the purpose of a scheme and fund. In the first, the scheme and fund exist to provide security for member’s accrued benefits and defray the employer’s cost of pension provision. One sponsor-centric justification for the use of funded arrangements is that this mitigates the risks associated with the scheme growing large relative to the sponsor’s labour force. In the second, the scheme is an entity capable of delivering the pensions of members before and after sponsor insolvency – effectively an independent insurance company. Prior to insolvency, recourse to the sponsor substitutes for paid-in equity capital.
Neither the historical record nor legislation provide unambiguous direction. History tends to favour the former interpretation, and regulatory “guidance” the latter. The picture is inconsistent and specific situations often anomalous. By way of illustration, the authorities resisted European plans to introduce Solvency 2 methods, which were derived for insurance companies, for UK schemes, but now the Regulator requires schemes to consider their sponsor covenant and adopt “integrated risk management”. A public debate is clearly necessary.
In this gap. the authorities have developed and promoted a particular narrative; this is the framework within which the six multi-part questions posed in the DWP’s DB green paper are situated. In order to respond in a coherent and consistent manner, we first deconstructed that narrative.
This deconstruction, an unpacking of the narrative shows that many of the issues are products of the legislation and narrative. The narrative is also incomplete. For example, it is much concerned by the growth in dividend payments, which has been accompanied by calls for deficit repair contributions to take priority, but there is no discussion about contributions being part of a firm’s labour costs, and such contribution payments would carry implications for productivity, competitiveness and the Exchequer’s corporation tax receipts.
Consolidation is another prime example – it arises from the ‘hair-cuts’ applied (unjustifiably) by the Pension Protection Fund to the pensions of members – who are third party victims of sponsor insolvency. This motivates the recommendation for the PPF to pay full benefits. Indeed, such full pension indemnity insurance is a far superior resolution than funding to the problem of continuity after sponsor failure. It is materially cheaper and does not introduce the spectre of vast amounts of orphan (tax privileged) assets. This motivates the call for the PPF to be privatised and opened to competition.
Other examples are errors of analysis – pre-pack insolvency is not a problem of moral hazard, but of perverse incentives arising from legislation, notably the Section 75 (PA 1995) value. It is a self-serving mischaracterisation that permits blame-shifting and demonisation of a company’s management. Mixed messages are also evident here: the debt remains a general unsecured obligation but its amount is grossly inflated.
Yet more examples arise from interpretations and emphasis, such as the conflicted objectives of the Regulator. The objective ‘to reduce the risk of situations arising which may lead to compensation being payable from the Pension Protection Fund’ is routinely described as being ‘to protect the PPF’.
The long-running debate on scheme valuation is relevant here. The existing methods are appropriate for the pricing of new business, and a failed scheme is new business for the PPF, but the valuation of a scheme is a question of a book of business in force, and for that, different methods are appropriate. The methods specified in legislation are counterfactuals to the business in force valuation. They address the question: what might this set of liabilities cost under this discount rate assumption. These are replacement cost rather than going-concern valuations. It is interesting but it isn’t a true and fair view of the status quo, and that is a requirement of both UK and European law.
These values are qualitatively different from the claims of other creditors. Professor Sir Roy Goode made the point that a surplus may only be determined after all liabilities have been fully discharged – the unstated corollary is that these are estimates also of limited likelihood.
Ordinarily, problems in measurement over time resolve themselves with the passage of time, but that is not the case here. There are direct and explicit costs resulting from this mismeasurement – deficit repair contributions and the costs of cash equivalent transfers are examples. There are also indirect costs, among which the distorted asset allocations and portfolio hedging strategies figure large. Costs are further inflated by the compliance requirements of current practice. The greatest cost is unmeasured; it is the cost of inferior provision to current and future generations.
There is much in the Green Paper with which we agree, but with problems and scheme closures on all fronts, it really is time to question the narrative. Funded occupational DB schemes are by far the most efficient form of pension provision ever devised. Their collective risk-pooling, risk-sharing and risk mitigation lower the cost of pension provision materially. The matters are and should be of central concern in social welfare policy, and that motivates our call for a Royal Commission to investigate, consider and hopefully resolve these issues.
The full response is freely available at: http://www.longfinance.net/publications.html
