Con Keating and Iain Clacher
Amazon commenced trading in 1995. It has proved a remarkable success; its market capitalisation is now around $1.5 trillion. That year also marked the debut of the modern era of DB pensions regulation with the Pensions Act 1995 (PA95) as its keystone; it was informed by the earlier Goode Review at a time when DB arrangements were the dominant form of occupational pension, and taxation of surpluses was an issue. Unlike the performance of Amazon, the success of DB pensions regulation in the UK is highly questionable looking back at the consequences of the past 25 years.
The years since have seen a welter of further regulation motivated by the shortcomings of the last piece of regulation; a trend that had continued unabated. These successive pieces of regulation have proved inordinately costly to corporate sponsors. In the period since 2009, for which consistent statistics are available[i], some £160 billion in special contributions alone have been paid into deficit recovery, with no discernible impacts on deficits or member security. Taxpayers have borne about £30 billion of this cost (See Box 1) and occupational DB provision is now marginal.
The over-arching and all-consuming concern of government has been the security of member pensions. The cost of the regulation to “protect” members has resulted in the closure of DB schemes to new members and future accrual on a grand scale. The principal concerns that drove this regulatory tsunami were abandonment of the scheme by an employer and sponsor insolvency.
Of course, the presentation of this regulation as enhancement to pensioner security could be relied upon to find parliamentary support – pensioners vote. Scheme abandonment was precluded, effectively, by the 2003 debt on employer legislation and the valuation (in wind-up) of liabilities for solvent employers was raised to the level of buy-out.
Section 75 of PA1995, which deals with deficiencies on winding-up is a particularly good indicator of how legislation has moved the goal posts over time. In its original form, it is innocuous. It precludes pension debts from having priority over other general unsecured creditors and requires liability values to be calculated in the prescribed manner, and that prescription was contained in the associated minimum funding legislation, and the Actuarial guidance notes 19 and 27. These notes specify the selection of discount rates and include different rates for pensioner liabilities to those for other members. We have previously criticised prescribed methods extensively in a range of commentaries and publications, and describe out in Box 2, what is the correct discount rate for the estimation of the present value of DB liabilities.
The Pensions Act 2004 (PA04)
Since the introduction of PA04, its subsequent scheme funding regulations, provided a new regulatory architecture, creating a new Pensions Regulator and the Pension Protection Fund (PPF). Under this regime, section 75 liabilities became full buy-out for both solvent and insolvent companies at wind-up, and with that, any pretence of equitable treatment of the other creditors of an insolvent firm was no more.
The scheme funding requirement is based on “technical provisions”, which are upwardly biased estimates of liabilities, and are erroneously heavily dependent upon market yields and asset prices. The result is that as interest rates have fallen, liability valuations, but not pensions themselves, have exploded, and schemes have progressively followed defensive asset allocation strategies. More importantly, in the context of the retirement outcomes of future generations, schemes closed to new members and future accrual in droves, replacing some level of security in retirement with what was at the time lacklustre DC.
Throughout this period, the Regulator’s emphasis has been one of ever more funding, motivated in part by its statutory requirement to protect the PPF. The missing objective[ii] for the Pensions Regulator is the absence of any requirement to promote the ongoing provision of high-quality affordable occupational pensions (and this did not have to be DB).
In looking at the history of how we arrived here, we could be criticized as having a rear-view mirror to pick holes in what was well meaning regulation. And who could have predicted the outrageous largesse of central banks to encourage moral hazard, maintain property prices, and keep zombie companies afloat. However, the game of discount rates was clearly identified in the Myners Review in 2001 in relation to the Minimum Funding Requirement:
“For that reason, it does not agree with proposals for a standardised test, even if it were only applied to some portion of the benefits. This would still create artificial incentives to match the assets used to generate the discount rate for the liabilities.”[iii]
In looking at The Regulator’s proposed new DB Funding Code, we now have foresight from before the 2004 Act that identified the gaming of incorrect discount rates; we have the hindsight of the past 15 years or so and the significant economic consequences of not understanding discount rate game; and today we have foresight as to what will most definitely come under the new Code.
Simply put, the new Funding Code is all concerned with management of the ’end-game’; a world where DB is dead in all but a few places. Self-sufficiency, the elimination of dependency upon the sponsor employer, is the new objective. It will require further funding on a massive scale. The PPF currently reports a total deficit[iv] (for schemes in deficit) to the section 179 value of £290 billion, and that is likely an under-estimate of complete self-sufficiency. Further funding on this scale would be an economic and fiscal disaster. Perhaps, the least of this would be the loss of £60 billion in corporate tax revenues.
A New Hope
However, there is now hope that the worm has finally turned. Baroness Bowles of Berkhamsted introduced an amendment, which was adopted, to the current pensions Bill, which would require:
(a) schemes that are expected to remain open to new members, either indefinitely or for a significant period of time, are treated differently from schemes that are not;
(b) scheme liquidity is balanced with scheme maturity;
(c) there is a correlation between appropriate investment risk and scheme maturity;
(d) affordability of contributions to employers is maintained;
(e) affordability of contributions to members is maintained;
(f) the closure of schemes that are expected to remain open to new members, either indefinitely or for a significant period of time, is not accelerated; and
(g) trustees retain sufficient discretion to be able to comply with their duty to act in the best interests of their beneficiaries.
Hope springs eternal.
[i] The Pensions Regulator has compiled deficit repair contribution aggregates only since 2009. The ONS reports a closely related statistic, total special contributions. They are closely related. The principal difference would arise from sponsor contributions to scheme annuitisation in buy-out or buy-in transactions. From the ONS figures, it appears that deficit repair contributions from 2004 to 2009 may have totalled some £40 billion.
[ii] The Pensions Act 2014 did introduce a requirement for the Regulator to minimise, for funding purposes, any adverse impact on the sustainable growth of the employer. It has had little obvious effect.
[iii] See, Paragraph 67, Page 12, of Institutional Investment in the United Kingdom: A Review, 2001.
[iv] Analysis by the Regulator of the latest tranche of valuations suggests that had they all been conducted as at the end of period, March, date, sharp rises in deficit repair contributions would have been warranted,
The idea of a contractual accrual rate of return implies no change whatsoever in the terms of financing of the pension promise. This flies in the face of the reality that investment returns and values and opportunities are always altering. Future pensioners will not be well served by ignoring the markets and just hoping that things will improve to where you had hoped to reach.
I would have more sympathy for your warning, Peter, if as an actuary you would address the Keating/Clacher criticisms of your profession’s methodology for estimating pensions liabilities and current funding requirements.
Yes, investment returns are “always altering” if you will measure them hourly, daily, monthly, quarterly. But assumptions about longer-term investment returns, prudent averaging, should surely be far less volatile if only tested annually or triennially?
One problem with your profession’s mark-to-market, everything’s gilts-relative approach is it seems to change the nature and values of what are supposed to be longer-term assumptions on a daily or monthly basis. We need stability in our financing assumptions, not measurement volatility which at times borders on the farcical.
Well said Con and Iain. Old people vote, and by on large they make the regulations too – to see anyone at a Pensions forum or conference who is not a grey haired white male, is a rarity. That generation have devised for themselves a set of Rules that over allocates a share of the national wealth, and as you say the next step in this is to seek to further increase and lock in that excess share through ‘self sufficiency’, distancing themselves from single employer risk, without consideration of the aggregate. They are blinded by their own greed and fears, and worship at the alter of false gods of de-risking’ as the damage to the economy from the enormous misallocation of capital, poor returns, and the burden of extra taxation they are loading on the next generations, will weaken not strengthen their pensions. Ultimately the young will revolt against the economic malaise and excess taxation, nationalising and eroding the value of their DB jewels. I fear however it’s far easier to view investment and allocation of wealth through the simplicity and sense of (false) security of spreadsheets the actuaries are so fond of, rather than the intellectually honest approach about investment and sharing of risk inherent in Con and Iain’s articles, but I applaude their efforts and determination to keep this critical debate alive.
Taken from the blog……..“However, there is now hope that the worm has finally turned. Baroness Bowles of Berkhamsted introduced an amendment, which was adopted, to the current pensions Bill”
With regards to the amendment which has been introduced by Baroness Bowles of Berkhamsted, I assume that some of its requirements wouldn’t apply to those DB Pension Schemes that have already closed to new members and future accrual e.g. The British Steel Pension Scheme (BSPS2)?
A future buy-out of this Scheme is looking very likely and as a deferred member (non-pensioner) I have some concerns which I have read about…….
(a) On 31 March 2020, BSPS2 membership was 74,342 comprising 14,812 deferred pensioners and 59,530 members whose benefits were currently in payment. As deferred pensioners are in the minority, in the event of a buy-out they could lose out compared to those members whose benefits are currently in payment?
(b) A buy-out will produce annuity type pensions for all of the members and if you wish to make provision for a spouse’s pension, your annuity will be reduced? (this is unlike BSPS2 which provides a spouse’s pension at no detriment to the member).
Do you think my concerns have any food for thought?
Robert, the buy-out of BSPS2 will suit the insurers and the consultants but I doubt it will add much to the sum of steel men’s happiness. The peculiar de-risking of the scheme involved it shedding £3.5bn of liabilities through transfers paid with an actuarial reduction. It is a sorry state of affairs that a once great scheme has reduced its ambition that it now regards the buy-out as a success.
Yes, I doubt it Henry.
The British Steel Pension Scheme has been around for decades and many of its members (me included) are somewhat wary of a buy-out.
As you know, the Scheme is not the only one going down this route but hopefully it’ll all be sorted out one way or another within the next few years?
The Barnett-Waddingham website says this on the subject……
“For many sponsors, the cost of running a defined benefit (DB) pension scheme has increased dramatically over the last decade; mainly due to poor investment returns, increasing life expectancy and additional layers of compliance introduced by new regulatory regimes.”
“As a result, many sponsors have switched to offering defined contribution (DC) arrangements for their employees, as they are typically cheaper and do not expose the employer to the risks they are exposed to with a DB scheme. However the sponsor is still responsible for the legacy defined benefit scheme which, even though few or no current employees are members, could still represent a significant cost and potential risk far into the future.”
“To remove the risk of further rising costs, sponsors are increasingly looking to insure some or all of their pension scheme obligations with a specialist insurance company. A premium is paid to the insurer to complete such a transaction. These types of transactions are known as bulk annuity policies and can be structured in two ways: through either a buy-out or a buy-in.”
Peter
The value (in the sense of amount) of a liability is, in general, independent of the way in which it is financed. If I owe you £100, I owe you £100, regardless of whether I finance that payment from wages, investment income, or even theft. The exception to that generality would be a liability explicitly linked to the performance of some asset, for example, a financial asset. However, DB pensions have no such linkage; they are linked to wages, longevity and inflation, but there is certainly no financial market dependence.
You introduce a spurious dependence in the present value of the liability when you use gilts or some other financial variable such as the expected returns on scheme assets as the discount rate.
Jnamdoc
Let me suggest a little caution here. Overfunding does not increase the wealth of oensioners. It is best viewed as prepayment of funding due in the future. It has a tax cost now rather than in the future. Of course, it raises the cost of provision to the sponsor and with that likely reduces new investment and productivity growth. The deadweight costs of regulation and its implementation stimulate the current economic activity. I don’t think that you can get to an exacerbation of intergenerational inequality from this.
Robert
The amendment needs some work, for example, an anti-abuse clause but as it stands and should, it would not apply to schemes closed to new members and future accrual. I think your concern that pensioners in payment will have priority is malfounded. The duty to treat all members equally is a central obligation for trustees.
Thanks Con.
After doing some more research on buy-outs and members being treated equally, I found this……
“With a buy-out, the scheme’s liabilities are transferred to the insurer and the sponsor’s obligation to the members is extinguished. The terms of the insurance policy are required to precisely match the form of the members’ benefits under the scheme. Securing such a policy arrangement can be a long, protracted process. A buy-out normally precedes a wind-up of a scheme and involves the entire scheme membership being covered by the policy. A buy-out of only part of the membership is rare due to the fact that the scheme’s trustees could be seen to be favouring one group of members by providing them with increased security (i.e. those covered by the bulk annuity policy) over the remaining members.”
https://www.barnett-waddingham.co.uk/finance-directors-guide/liability-management-risk-reduction/buy-outs-and-buy-ins/
With regards to my concern (b) on annuities and a spouse’s pension i.e……“A buy-out will produce annuity type pensions for all of the members and if you wish to make provision for a spouse’s pension, your annuity will be reduced? (this is unlike BSPS2 which provides a spouse’s pension at no detriment to the member).”, the moneyadviceservice.org.uk says this about joint-life annuities……
“You decide on the proportion that will be paid when buying the annuity. It could, for example, be 100%, two-thirds or half of your retirement income at the time of your death. However, the higher the proportion you choose, the lower your retirement income will be.”
https://www.moneyadviceservice.org.uk/en/articles/individual-or-joint-annuities
As the BSPS2 spouse’s pension is 50% of that of the member, I wonder if this would be incorporated in the terms of a buy-out, with no detrimental effect to the member’s annuity type policy?
Thanks Con.
After doing some more research on buy-outs and members being treated equally, I found this…….
“With a buy-out, the scheme’s liabilities are transferred to the insurer and the sponsor’s obligation to the members is extinguished. The terms of the insurance policy are required to precisely match the form of the members’ benefits under the scheme. Securing such a policy arrangement can be a long, protracted process. A buy-out normally precedes a wind-up of a scheme and involves the entire scheme membership being covered by the policy. A buy-out of only part of the membership is rare due to the fact that the scheme’s trustees could be seen to be favouring one group of members by providing them with increased security (i.e. those covered by the bulk annuity policy) over the remaining members.”
https://www.barnett-waddingham.co.uk/finance-directors-guide/liability-management-risk-reduction/buy-outs-and-buy-ins/
With regards to my concern (b) on annuities and a spouse’s pension i.e. “A buy-out will produce annuity type pensions for all of the members and if you wish to make provision for a spouse’s pension, your annuity will be reduced? (this is unlike BSPS2 which provides a spouse’s pension at no detriment to the member).”, the moneyadviceservice.org.uk says this about joint-life annuities…….
“You decide on the proportion that will be paid when buying the annuity. It could, for example, be 100%, two-thirds or half of your retirement income at the time of your death. However, the higher the proportion you choose, the lower your retirement income will be.
https://www.moneyadviceservice.org.uk/en/articles/individual-or-joint-annuities
As the BSPS2 spouse pension is 50% of that of the member’s, I wonder if this would be incorporated in the terms of a buy-out, with no detrimental effect to the member’s annuity type policy?
IRobert
If a scheme covers only part of the membership, this is a buy-in and the policy is an asset of the scheme. Payments under it are not hypothecated to that group of members. If the scheme offers spouses’ benefits, then in buy-in or buy-out it must buy this joint life cover. This will be more expensive than single life, but that cost is borne by the scheme, not the member. It is the member’s marital status at the time of the annuity policy being written – if you were single and marry afterwards, your spouse will not normally be covered.
There’s some fascinating cases of US civil war pensions still being paid in 2002 and 2004 because the pensioner married a very young woman in his older age.
Con..
Con, thanks for this information.
I am living with my partner (female) but we aren’t yet married. Perhaps I should think about this before a buy-out of the BSPS2 in order to benefit from the joint-life annuity cover?
As you say, if I was single and marry afterwards, my spouse will not normally be covered.
There again, I did read a while ago that upon buy-out, BSPS2 members may get ‘enhanced annuities’. I wonder what this would entail?