Derek Benstead

On Monday night, I attended an actuarial sessional in Staples Inn. This may sound dangerously close to masonry. It was a worthy use of two hours- though it is actuaries only and I suffered (I kept my mouth shut and my head down). Much was said and little understood – at least by me. The meeting was discussing a paper put before the Institute and Faculty of Actuaries by Charles Cowling. You can’t read it here unless you are an actuary but I can tell you it was about funding DB schemes and IRM (Integrated Risk Management).

After Charles and his team had explained their ideas, a number of people stood up and presented their responses.

One person spoke with an authority that stood out. It was my friend and colleague Derek Benstead and this is what he said.

What does a successful pension scheme look like?

A successful pension scheme is one which is open to new entrants. An open scheme has a funding and investment strategy and an employer’s share of the cost which the employer is happy with. An open scheme provides benefits for future generations as it has for past generations, thus minimising inter-generational differences of provision.

Therefore, first decide on the design for benefits, funding and investment which an employer would willingly sponsor for future service, and let that be the guide for the funding plan of the scheme.

Let us demonstrate that we are experts in provision of pensions by providing pensions. We do not demonstrate our expertise by shutting pension schemes to new entrants and to future accrual. We demonstrate it by showing where the successful compromise of benefits, contribution and risk lies. We should be modifying schemes towards successful compromises, not shutting them.

After the meeting, Derek provided me with this further commentary on the paper:

In today’s environment of bond yields, most trust schemes are not fully solvent on a buy-out basis the near equivalent of self-sufficiency in gilts. Such a scheme will provide a smaller benefit after employer insolvency than it did before.

If the scheme’s benefits were set at a level which could be insured in full, and the scheme is invested in matching assets, then the outcome is benefits before employer insolvency which are as small as they are after insolvency.

It is of no advantage to members if, to solve the problem of benefits being smaller after employer insolvency, we make the benefits equally small before insolvency. The likely response of an employer to an invitation to sponsor accrual on buy out funding and matching assets basis is to be to decline to sponsor accrual at all, on grounds of the extreme cost inefficiency, and this would be a failure of design.

If the defined scheme’s benefits are set at a level which can be insured in full, and the scheme is invested in more rewarding assets, then to the extent that the assets perform well, discretionary additional benefits may be awarded. Then before employer insolvency, there is a combination of defined and discretionary benefits. After insolvency, the discretionary benefits mostly disappear and the defined benefits are fully insured.

This approach to benefit design may make it more transparent to members which part of their benefits may be delivered after employer insolvency and which part may be mostly lost. It also has the merit of making the scheme more manageable while the employer is solvent. Manipulation of the discretionary benefit can be used as a level of funding control, as well as or in replacement of manipulation of the employer’s contribution rate.

That benefits are smaller after an employer’s insolvency is the inevitable consequence of changing from more cost efficient to less cost efficient pension provision. The same quantity of assets is bound to provide smaller benefits if spent less cost efficiently. There is no merit in resolving this by making benefit provision before employer insolvency as cost inefficient as it is after employer insolvency, by funding and investing on a self-sufficiency in gilts basis.

The government recognised this when it reformed the statutory funding requirements. It noticed the high cost of solvency funding which results in either unaffordable costs before employer insolvency or benefit reductions after employer insolvency. It solved the problem by inventing the Pension Protection Fund.

Constitutionally, the PPF is not an insurance company. Neither should it behave like an insurance company, because to do so would recreate the problem which the PPF was set up to solve. The PPF is a pension scheme sponsored, ultimately, by employers, through the levy system. Now, whether the employer is solvent or not, its benefit promises can be provided by an employer sponsored pension scheme, minimising the change in cost efficiency otherwise triggered by employer insolvency.

If we are not satisfied with PPF compensation as a minimum post insolvency benefit, then let’s improve the PPF until we are. Lifting the cap on compensation to cover all pension accrued within the rules for tax approved pension provision, and introducing pension increases for pension from pre-1997 service if a scheme provided any increases on pre-1997 pension would be two good improvements to make.

Investment risk is not the leading risk criterion in a pension scheme and returns on gilts and gilt yields are not the yardsticks by which everything else must be judged. I propose that three good risk criteria for making judgements in a pension scheme are:

• Does an action raise the probability of paying the benefits in full?

• Does an action raise the probability of the employer’s share of the cost falling within what it is able to pay?

• And within what it is willing to pay?

If an employer is financially weak and contributing at its limit of affordability, actions should be judged by whether they raise the likelihood of paying the benefits in full.The Pensions Regulator, and this paper, uses the phrase “The employer underwrites the investment strategy.” This is not a helpful formulation. The employer underwrites the benefits, not the investment strategy. Alongside the contributions, the purpose of the investment strategy is to provide for the benefits. The investment strategy which is most likely to pay the benefits is the one to choose in cash constrained circumstances.The discussion of the paper touched on the disclosure of funding levels to members, the meaninglessness of reporting the technical provisions funding level without also explaining the TPs target, and the danger of reporting the buy out solvency level with wording alongside suggesting it is not important. I suggest that the first two things to explain to members are, one, that their defined benefits are payable in full for as long as the sponsoring employer remains solvent, and, two, if their sponsoring employer becomes insolvent the minimum benefit which will be paid is Pension Protection Fund compensation. This is most of what members need to know, the funding levels are of much less importance than these two statements.Three leading risk criteria are:

To conclude, the major objective of a pension scheme is not the minimisation of funding and investment risk, but the provision of benefits and the minimisation of risk to the provision of benefits. If we close schemes to new entrants and to accrual, we have failed in the most basic objective of all, to provide pensions to the future generations who cannot join.

The Pension Regulator’s formulation suggests funding can be to a lower level while an employer is strong, but if an employer becomes weak it should then fund to a higher standard, and the scheme should invest more in bonds. It is no surprise that TPR’s formulation is not observed in practice. Weak employers cannot afford it. It would make more sense for better off employers to contribute more while they are stronger, in the reverse of TPR’s formulation. It would make more sense still to recognise that the importance of the employer’s covenant is not that it should affect the funding target or the investment strategy in the manner TPR would have it, but that it should affect the judgement of the contributions payable and the design of the benefits to be provided.

In cash constrained circumstances, with less than 100% funding on a gilt yield basis, it is not benefit risk reducing to invest more in gilts. Investing wholly in gilts may make it certain that the benefits cannot be paid, not certain that they can. Investing in a combination of growth assets and short dated bonds to cover net outgo for a number of years may have a high probability of paying the benefits in full.

These three criteria go to together. Members’ benefits are payable in full while the employer is solvent. If the package of benefits, funding and investment strategy has a cost falling within the employer’s ability to pay, members get their benefits in full. If the cost falls within the employer’s willingness to pay, the scheme stays open to accrual and inter-generational differences are minimised.

• Does an action raise the probability of paying the benefits in full?

• Does an action raise the probability of the employer’s share of the cost falling within what it is able to pay?

• And within what it is willing to pay?

At which point – I wanted to go up and shake Derek Benstead by the hand. For I now understand how actuarial science works for pensions and I am very glad I was allowed into the actuarial hall to hear this man speak.

I recommend that we first decide on the design for benefits, funding and investment which an employer would willingly sponsor for future service, and let that be the guide for the funding plan of the scheme.