Or equivalently: how much risk to members’ pensions is there in mutually offered funded pension?

The setting is the DB type pension (Cdb) of some fixed proportion of, say, final salary. Typically, for mature schemes these represent amounts which are normally in the range 3% – 5% of scheme assets. Obviously if scheme assets fully cover proportionally the equitable interest of pensioners, then no cuts are necessary. This is clearly a “going concern”, in good health.

We would also note that balance sheet insolvency is not a binding constraint (nor is it illegal to operate a balance sheet insolvent company), but the inability to meet a payment due, cash flow insolvency is binding.

If the assets of the scheme do not fully cover the equitable interest, then the pension payment would be at risk, but at this point, a risk sharing agreement comes into play. The pension payment is made in full – the top-up being provided from the assets attributable to other non-pensioner members of the scheme. In any year, the amounts of this top-up are quite modest. To illustrate this let us consider a scheme which is 80% funded, the equitable interests of pensioners are 40% of the scheme total and pensions amount to 5% of the value of assets. As earlier, the top-up, or transfer among members, is just 1% of the total equitable interest, or 1.25% of scheme assets. Even if the deficit or shortfall is 50%, the transfers only amount to 2.5% and 3.13% respectively. As was noted earlier, this transfer of assets triggers a reciprocal and compensating increase in the equitable interests of non-pensioner members.

Now the first problem that needs to be addressed by trustees concerns the cause of the deficit which led to the insufficiency. Has this arisen from a fundamental misestimation of the implicit investment returns available or is it simply the result of the transient “animal spirits” of markets, and likely to self-correct. Clarification of these issues gives rise to the need for a forbearance period, during which the risk-sharing mechanism will operate. Clearly that mechanism needs to be related to both the magnitude of the deficit and the resultant support transfer.

The straw man offered is that a 10% deficit should admit a ten-year forbearance period, a 20% deficit five years, and 50% just two. Some further rules are needed to allow for sequences of deficits. Increasing deficits shortens the forbearance period, so a 20% deficit has a five-year forbearance period and if this increases in year one to 50% the forbearance period shortens to just two years from that date. Some clarification of the rules are needed to accommodate partial recoveries; suppose that the 50% deficit shrinks to just 20% in the first year, then the forbearance period is now five years, but the clock started the year previously, leaving just four years of ongoing forbearance.

If a scheme is still in deficit at the end of this forbearance period, then the pension payable is simply the funded level of the pensioner members’ equitable interests. To avoid an actual cut, the pensioner may choose to borrow against, or bring forward, some of his or her residual equitable interest. If and when the asset coverage of the scheme recovers, the cuts imposed will be restored, but doubtless some members may have died in that interim.

There is also the issue of the amount of their equitable interest that non-pensioner members might be happy to risk in support of pensioners. This is constrained also by the possibility that excessive support would reduce the asset pool to a level from which recovery is not possible. A level of 10% of the non-pensioner members’ equitable interest seems plausible, particularly when it is understood that this is a maximum exposure. Figure 1 below examines the support payments for a scheme paying 5% of (initial) assets in annual pensions. The scheme has a contractual accrual rate (CAR) or expected investment return on assets of 5.5% pa.  The evolution of asset portfolio is shown for the period 1999 – 2013. This period captures the worst experience of the 1899 -2015 period – it is an all equity UK index portfolio with high volatility. In fact, the likelihood of a sequence as poor as that observed, between 2000 and 2002, is less that one in a thousand. The asset coverage level is arbitrarily set to 1 in 1999. The asset coverage of the total equitable interest falls to a low of 63%, implying that significant cuts would otherwise be appropriate.

The largest level of support in any year amounts to 1.83% out of the total 5% payable. The cumulative support over the five years of deficits reaches a maximum of 4.87%. This is 8.1 % of the non-pensioners’ equitable interest, when these members account for 60% of the scheme.

Put another way, in this the worst experience of any period since 1899, it was unnecessary to cut pensions in payment.

Figure 1: funding coverage, annual and cumulative pension support

More sophisticated analysis, allowing for the reciprocal increases in non-pensioner equitable interests, and the modified shortfalls arising from that, increases the cumulative support to 5.42%, which is 8.38% of the non-pensioner interests.

By supporting pensioners over this period when scheme asset coverage would not otherwise merit this, non-pensioner members have increased their equitable interest, their pension “entitlement” by a total of 9.67%.

Extensive simulation of the scheme and this 10% support for pensioners indicates that it only becomes necessary to cut pensions in payment in less than one case in a thousand. In no case, does this level of support result in an irrecoverable “death spiral”.

The presentation to scheme members is simple. If you place at risk of partial loss, 10% of your equitable interest in the scheme in support of pensioners, you may expect to enhance your own pension outcomes by a similar or larger amount.

Con Keating – author of this blog