Iain Clacher and Con Keating explain the headwinds faced by pension schemes over the past 30 years. They explain how we have been systematically stripped of our pensions.
In this, our second article on DB pensions history, we begin with the Maxwell affair of the early 1990s.
This made pensions the stuff of headlines; all too often alarmist and exaggerated. The Mirror Group schemes had been well funded before Maxwell’s ravages – and it is worth stating, Maxwell was theft and fraud, nothing else, it was not about guarantees, or promises, future returns, discount rates or anything else – this was a criminal act. But it is this that set the tone, and ever since, member protection and security became the ‘only game in town’. Put succinctly, the British version of the old Chinese curse came into play – “May you come to the attention of Parliamentarians”[i].
What’s yours is mine and mine’s my own
1993 saw the first incursion into the dividend tax credit arrangement known as ACT; it was completed in 1997 as one of the first acts of the new Labour Chancellor (an instance of Clacher’s Law[ii]). It was a classic tax grab by stealth, in that few would understand it
At the time we estimated its capital value to be £65 billion which was 10% of scheme assets . HMT produced a slightly higher estimate of £75 billion. Estimates of the annual yield to the Treasury are of the order of 20% of pensions paid, a total of approximately £160 billion since 1997. This has had a material effect on the solvency of pension schemes, by constraining asset growth.
Prior to the 1997 ACT tax credit removal, the more or less universal valuation methodology for UK pension funds undertaken by almost all of the actuarial firms was to value the assets by discounting the expected future dividend yield on those assets (if equities), with corresponding adjustments for other asset classes. In this case, the return on the asset, in the case of equities, was based on its projected dividend growth over time from the current market yield and the discount rate was based on the expected long term nominal annual yield.
Prior to 1997, if a UK tax approved pension fund received a dividend from a UK company of £80 it could reclaim a tax credit of £20. Once the ability to reclaim the £20 was removed in 1997, the logical consequence should have been:
- that the value of the pension fund assets invested in UK equities should have been reduced by 20%
- that the present value of the future pension payment obligations should have been increased by a corresponding amount.
However, the actuaries observed that market values were high in the run up to the dotcom boom peak in 2000. So, they changed the asset valuation methodology to use market values as the discounted cash flow models showed values for assets that were significantly below market prices. This shift in methodology was, however, rather convenient, because it meant that employer contributions did not need to increase as a result of the tax changes, when, logically, there should have been a very substantial increase to reflect the loss of the tax credit.
Changes to the treatment of deferred members
The 1993 Pension Schemes Act completed[iii] the earlier marginal requirement for deferred pensions with rights now to be revalued in line with prices[iv], capped at 5% for service to 5 April 2009, and at 2.5% for service thereafter. The Pensions Act 1995 (PA95) then introduced limited price inflation increases, capped at 5%, for pensions in payment, effective from 1997, although this was lowered to 2.5% in 2005.
The reference index was changed from RPI to CPI in 2011, although some schemes had RPI hard wired into their Trust Deed & Rules. For those schemes not already paying inflation increases these were extremely expensive changes.
For a 45-year-old early leaver[v], the starting pension at age 65 would be 265% of its uninflated value, if the 5% cap applied throughout. The total cost of a 22-year pension[vi] rises by 83% if the 5% cap applies throughout. Fortunately, these extreme scenarios have not been realised over the ensuing years: annual retail price inflation has averaged 2.7% and wages just 2.9%. These changes add materially to the costs of providing DB pensions.
It is also worth noting that this treatment of deferred members differs from the treatment in other jurisdictions; it Is not required at all in the US; it is conditional on funding levels in the Netherlands; and was dependent on the profitability of the employer in Germany until 2018.
The 1995 Pensions Act is notable in several other regards. Section 67 prohibits changes to members’ accrued benefits without their consent – another example of the focus on member’s accrued rights and security. However, this has the effect of precluding the solution, adopted by the Dutch, to the problem of an absence of recourse the employer. The Dutch chose adjustment of member benefits for schemes in deficit, while the UK subsequently chose statutory imposition on employers of the obligation. By many metrics, such as the ongoing provision and levels of retirement incomes, the Dutch outcomes have been superior to the UK experience.
Imposing funding requirements
In earlier blogs (see below) we have discussed the imposition of funding requirements by PA95 and the associated minimum funding legislation (MFR). Here we wish to draw attention to the response to these changes in terms of asset allocation strategies.
The 1950s and 1960s had seen a radical revision of asset allocation in funds, away from the pre-war gilts and insurance policies into equities and diversified portfolios as pioneered by George Ross-Goobey at the Imperial Tobacco pension fund. It had served schemes well, weathering the equity market storms of 1969, 1974, 1987, and 1991/92, and still delivering strong returns (the well-established compensation of the equity risk premium over the long-term). The response induced by the MFR discount rates formulation was, however, to start the movement to buy more gilts and other bonds. Coupled with the move towards FRS 17 and its international version IAS 19, the liability driven investment management industry (LDI) was born.
There is a seductive ’logic’ to the idea of matching assets to liabilities when those assets must deliver the returns to discharge those liabilities. However, it is flawed as it fails to recognise that the ultimate liabilities, the pensions payable and their projections, are independent of the way in which they are financed or measured. LDI in practice is hedging of the risk of the measure (a discount rate) rather than the risk of the liabilities themselves.
Even if we could buy a portfolio of default-free bonds (or derivatives) which exactly matched the projected benefits cash flows payable (a technique known as dedication) we would find that their cost varied wildly from the contributions actually made. The contributions and projected benefits define a rate, which we have referred to as the contractual accrual rate, which is the rate at which contributions should be accrued or benefits discounted.
In practice, LDI utilises a technique known as immunisation; the matching of the modified durations of assets and liabilities. Modified duration is a measure of the local sensitivity of price to small changes in the level of interest rates; hedges will therefore be effective only for similarly small changes in interest rates. Large and sustained declines in rates will result in a requirement for more funds to be committed to the hedging strategy. Empirically we have seen progressively more funds committed to LDI; higher shares of scheme assets, accounting recently for over 40% of total assets[vii] in large schemes.
We illustrate, in table 1, the effect of declining discount rates on a representative open DB scheme, with past service liabilities stretching 70 years into the future. We use the rates prevailing in 1990, 2000 and 2020. We assume unchanged liabilities for each valuation, enabling comparison of the stand-alone discount rate effect. The row, % Pensions, shows the proportion of the total of pension cash flows ultimately payable represented by the present value. The row, Multiple, shows the growth of these present values as a proportion of the 11.7% case. The years covered row is an alternate presentation; the present value expressed in terms of the number of years of projected pension cash flows that this present value represents.
A scheme funded to these levels would, with no further income, be sufficient to pay these numbers of years of pensions; it is a measure of the degree of prefunding of liabilities. The number of years pre-funded in these valuations[viii] rises from 9 to 35 years. These rows may be considered as instantaneous changes in the discount rate.
The bottom row, the required rate, is most informative. It shows the rate of return required to be earned by the assets of the scheme fully funded in 1990 to achieve full funding at the new rates in 2000 and 2020, with the liabilities themselves unchanged. At over 20% p.a. for the decade to 2000, and almost 17% p.a. for the three decades to 2020,it is scarcely surprising that recurrent deficits should have arisen even with £200 bn or more of deficit repair contributions being made.
A final illustration to complete this analysis.
If we consider the cash flows for 2020 and beyond as projected in 1990 with those same liability projections in 2020, we see a small decline in the total amount of these (1.7%). This decline is the net result of lower than assumed price and wage inflation and an increase of four years in life expectancy. Notwithstanding this decline, the shift in the discount rate from 11.7% to 0.7% results in a near doubling of the present value (up 92%).
The paradox of liability (present) values separating from actual pension values is an artefact of the discount rate. The cost of paying pensions in terms of the contractual obligations of the firm is largely no different to what they were 30 years ago. The apparent cost increase is a mirage; the product of misconceived discount rate methods.
The next steps in changing the nature or the obligation
Returning to the regulatory chronology, 1997 saw the introduction of a statutory override to scheme priority rules for schemes winding up in deficit. Its inequity resulted in a campaign by the former employees of Allied Steel and Wire which was highly visible – who can forget protesters standing naked behind a strategically placed banner on Brighton beach in front of the 2002 Labour Party conference venue?
The Compensation Board which existed at that time, another creation of PA95, covered only deficits arising from acts of dishonesty (a result of Maxwell). The campaign was ultimately successful, with government announcing in 2007 a settlement of 90% of members’ benefits[ix].
In 2002, a statutory debt on the employer was created, effective from 2003 and limited to the MFR value – the target was scheme abandonment. 2002 also saw the publication of a National Audit Office report: ”Opra: Tackling the risks to pension scheme members.” It is something of a curate’s egg, listing the risks as:
A: Misappropriation of scheme assets
B: Funds are insufficient to provide scheme members with the benefits they could reasonably expect
C: Incorrect benefits accrue to scheme members in due course
D: Scheme members lose track of pension schemes or vice versa.
However, its comments on insolvency and abandonment were sparse:
“There is little, however, that any regulator could do directly about one of the biggest risks to pension scheme members receiving the pension they expect, that of the employer going out of business or closing the scheme,” and footnoted: ”If the employer closes the scheme, it is still liable to fund for pension rights already accrued. If an employer becomes insolvent, then insufficient funds may mean that all members may suffer – pensioners and, more probably, employees (future pensioners).”
That footnote also contained:
“The risks to members once a scheme is closed relate to pension rights that an employee would have expected to gain in the future”
Unfortunately, this caution seems to have been missed or ignored by successive governments and the legislation and regulation to follow, and under which we still operate. This will be the subject of our next article.
[i] The original version of this curse is: May you come to the attention of those in authority.
[ii] Clacher’s Law is based on a suggestion made at a conference. It states that the pensions industry could design a workable system of pensions provision in a few days, but within a few decades, it will be destroyed by the government of the day regardless of political persuasion. As successive governments have shown, the attractions of large pools of savings as sources of tax revenue are simply too great. (this will also apply to DC in the future). If destruction does not come about by taxation, then it will occur through measures pandering to the electorate at the expense of those providing pensions.
[iii] The legislation that brought in the first batch of revaluation changes was the Social Security Act 1985 (only applicable to future pensionable service accruing from 1st January 1984 for leavers after 31st December 1984). It was the Social Security Act 1990 which brought in the retroactive element (i.e. guaranteed statutory revaluation for all pensionable service accrued before 1st January 1984) for the benefit of leavers after 31st December 1990.
[iv] As measured using the National Average Earnings Index. It should be noted that this is a poor proxy for those following executive careers or in positions with promotional scales.
[v] If the cap pf 2.5% applied throughout, the uplift would be 163%
[vi] If the cap of 2.5% applied throughout, the increase would be 34.5%.
[vii] ClearGlass analysis
[viii] These coverage periods may be considered informative with respect to the term of deficit repair schedules,
[ix] Although agreed in 2007, the actual payment of pensions was a very drawn-out affair and some members remain in dispute to this day.