Con Keating; the purpose of a pension scheme

Con 8

This article is published with the kind permissions of Dr Keating and Professional Pensions (in which it first appeared).

Given its length and subject matter, Iain Clacher, Andrew Slater and I were surprised, and flattered, by the number of downloads – over one thousand – of our response to the DWP Green Paper, DB Pension Schemes: Security and Sustainability. Less satisfyingly, the majority of the comments, criticisms and questions we have received have concerned our first, and principal recommendation, which is that the precise role of defined benefit (DB) pension schemes, and their funds, be debated and determined. It was felt that our description of the issues of concern surrounding the purpose of a scheme and fund were just too sparse and scanty.

The truth is that the original version of the paper was one third longer than that finally submitted and published, which was itself longer than the consultation. Much of the material excised was concerned with an elaboration of some of these issues and their consequences. In this article, we shall attempt to precis some of the less well-trodden, but nonetheless important aspects.

It is a fundamental feature of English law, and many other legal systems, that a person’s debts and obligations cease to accrue on death. This holds for both natural and juridical persons. The obligations do not transfer to heirs and successors. This is often misleadingly, and incorrectly stated as ‘your debts die with you’, when in fact they crystallize and become payable, as the value accrued to date. It is self-evident that the person cannot perform the future actions promised; consideration of what might have been is clearly futile.

In other words, it is not the proper purpose of a company to make provision for events occurring after its insolvency. It is as misguided for a company to over-provide security for its pensions promises as it would be to the company to create and fund a trust for the payment of dividends to shareholders to take place after the company’s insolvency.

There is also an issue of equity among stakeholders to be considered. Favouring one class, pension beneficiaries, above all others, is inequitable. This holds true even if insolvency does not occur.

This raises some fundamental questions for both regulation and current practice. The specific questions arising range far and wide, from the trivial to the profound. They include valuation procedures taking present values of projected cash flows that arise after sponsor insolvency, to concepts such as the “self-sufficiency” of the scheme. The central regulatory themes of protecting beneficiary members and funding to reduce Pension Protection Fund exposure are deeply suspect, though well-intentioned.

A company should rightly be concerned with actions that continue or enhance its sustainability, which serves to the advantage of all stakeholders. As part of this process, honouring the due performance of its existing contracts and commitments is paramount. But not more.

The establishment of a trust to administer[1] the scheme raises further issues. The beneficiaries of an occupational pension scheme, current and past employees, are not the only members of the scheme. The employer sponsor is usually[2] the residual claimant to assets remaining after the discharge of all pension liabilities, and in this sense, it is also a member of the scheme having an interest in it, albeit of a different class. This means that the management objective of the trustees is compound. It is not simply to look after the interests of one class of member. In many regards, this is analogous to the standard situation of corporate finance, where creditors have fixed claims and the equity owners are the residual claimants. The most remote claimants, the equity owners have the most control.

The analogy is also helpful inasmuch as, analogously with stakeholders and the assets of a firm, members have an interest in the trust, not in its assets. In this regard, the strategy of transferring and encashing DB pensions enabled by so-called pension freedoms can be seen as a gross error of judgement. How could a company operate if its long-term creditors or equity holders could help themselves to the company’s assets at any point in time, at the sole discretion of those stakeholders?

There is an implicit return promised on the contributions made by both the employer and employees, which is defined and determined by the projected benefits payable. We refer to this as the contractual accrual rate. This is arguably the main occupational link. The employer underwrites any shortfalls from this rate. By equal part, as the residual claimant, it gains from returns on assets in excess of this rate. In all too much of the discussion around the risks of shortfalls, this fact gets scarcely a mention.

The sponsor is the bearer of the risk associated with the liability. The manner in which the asset portfolio is managed is the primary contributor to the sponsor’s risk exposure. It is only proper that it should therefore determine the asset allocation strategy of the fund, which contrasts sharply with the current legal position.

It is also worth distinguishing between real risks, that is to say the factors which increase the pensions ultimately payable and those arising from the measure used to reduce those liabilities to a present value. The former include longevity, and wage and price inflation, and the latter market interest rates. Changes to the expectations of the former alter the true cost of provision, the contractual accrual rate.

By contrast, changes in the valuation discount rate do not in and of themselves have to have cost implications. It is only when interim actions are based upon those valuations that this becomes the case. Unfortunately, solvency regulation, with its requirements for deficit repair contributions, operates in just such a manner. This is also true of cash equivalent transfer values – pensions freedoms have granted an attractive option to scheme members, which is integrally linked to the (actuarially utilised) discount rate. This is extremely costly to schemes in the current environment.

However, the true risk exposure of the sponsor is determined at the point of execution of the pension contract. In this regard, it is analogous to the fixing of a coupon at issuance for a debt instrument. Any actions by the sponsor to limit or modify this risk subsequently may only be properly done at the sponsor’s expense. Correctly, such actions should be conducted by and within the sponsor company, not the scheme.

A sponsor company may validly decide that it no longer wishes to bear the risk associated with its underwriting of the scheme, but in doing so, the costs incurred should be for its account, not members, not the scheme. Moreover, as these costs arise from a change in corporate risk preference or tolerance, they should not be classified as pensions or even labour costs.

It is disappointing to see some trustees accepting broad limitations on deficit repair contributions. Indeed, the idea that a sponsor may limit its exposure in absolute terms is anathema to the very root of a DB scheme. Once restricted, this is a defined contribution arrangement. In particular, it is inappropriate for the terms of new awards to contain elements of deficit repair; this would constitute subsidy of the sponsor’s cost liability by members.

The setting of extremely low expected return rates in the pricing of new award contributions is one, perhaps subtle, way of doing this. The risk exposure of the sponsor is relative to this rate and the use of a low expected return both limits the sponsor’s downside and increases their upside, to the detriment of beneficiary members.

There is a relation between the contractual accrual rate (and its scheme equivalent, the weighted average accrual rate) and the required rate of return on assets held necessary to meet all obligations as they fall due; it is the limiting case. This immediately gives rise to a measure of the performance of the sponsor. When the contractual accrual is above the required rate of return on assets held, the sponsor is outperforming its contractual obligations and when below, the sponsor is delinquent.

Why are we so concerned about these aspects of DB pensions when ‘everyone knows they are both unaffordable and dying. The future is DC’. The reasons are simple and many. The risk sharing and risk pooling of open ongoing DB schemes are powerful; depending upon the precise elements present, the efficiency of DB relative to DC lies between 30% and 100% above DC. Moreover, survey work shows that DB characteristics, not DC, are what individuals actually want in their pension. This preference for a predictable lifetime income is independent of the age of survey respondents. Contrary to the received wisdom, it is the younger cohorts who are most willing to pay more for a stable predictable lifetime income.

This is a sketch of some of the issues, omitted from our Green Paper response, which we believe need an open and frank debate. We would welcome it beginning.

Con Keating is head of research at Brighton Rock Group

[1] It has become common practice to use the existence of trustees to delegate to them responsibility for certain discretions regarding the pension obligation, for example pension increases, as specified in the governing documentation. But the trustees do not, in any sense, own the resultant obligation.

[2] This is the norm, but not universal. There will be some pension arrangements where it is not specified in governing documentation that the sponsor is a beneficiary of residual assets. But it is grey, as there is legislation which provides for a refund to the sponsor if the assets are considerably greater than the value placed on the pension obligation, although that legislation been reviewed or revised for quite some time.

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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4 Responses to Con Keating; the purpose of a pension scheme

  1. Peter Tompkins says:

    I’m not sure this piece places enough importance on the concept that pensions are deferred pay. Their promise is part of the cost of the goods and services provided by the entity. Of course they should rank with the creditors who need paying for the widgets they supplied. But a business should not be predicated on not paying either the future pensioners or the creditors.

    DC need not be greatly more expensive to administer particularly if DC holders use cheap “buy and hold” strategies for individual stock purchases rather than spending a fortune on dubious investment management fees.

  2. Con Keating says:

    Pensions are indeed deferred pay. The open question is how much is deferred pay. We might argue that this is no more than the initial employer contribution. This is actually the amount of pay foregone. Certainly it is difficult to argue that a member’s contribution is deferred pay either at contribution or in payment. If we want to argue that it is the income in retirement that is deferred pay, then there are real difficulties as it is obvious that most is in fact an investment accrual. I am not sure that the deferred pay arguments carry that much weight when you consider that employees only get a maximum of £800 in insolvency and then are general unsecured creditors in any excess balance.
    There are some interesting considerations as to whether new contributions can validly be used to offset past underperformance of investments (a sponsor alone obligation in most situations) and it goes on to consideration of the circumstances in which members might have a claim on residual assets – with some glorious complications where member benefits have been varied over time. Iain (Clacher) is writing these aspects up as a separate paper.

  3. henry tapper says:

    By happy coincidence, the Labour Party have endorsed CDC as part of policy today, this can be a very efficient way of converting contributions into a wage in later life.

  4. Con Keating says:

    Peter I would agree with you that a business should not be predicated on not paying its creditors -that would be a basic breach of good faith. What I am saying is that it should not in general be making provisions today for future events. There is an exception to this generality. A company would be protected by the business judgement rule in making such provisions, for example hedging or eliminating particular risks, but only if there is a business case for this action – in such a case, there would need to be no harm to other stakeholders.
    One of the important aspects of what we are saying is that it eliminates the various approaches I have heard which claim that we should be using a covenant adjusted discount rate for liabilities.

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