How regulation suffocated DB pensions (Pt 3) – Clacher and Keating

Ian con

Iain Clacher and Con Keating

 This is the third of a trilogy chronicling how we’ve messed up our defined benefit pension framework. It brings us from the Pension Act 2004 to date

And suddenly you are doing the impossible (but only if you want to)

Our two previous articles considered the development of occupational DB pensions from the early post-war period until the eve, in 2004, of the regime under which we currently operate. There were over that period many changes introduced and these interventions, sought to increase the quality of the defined benefit pension being offered.

However, this situation has changed to member security and been far from benign. The costs of DB have soared unceasingly, through deficit recovery and much more, with no commensurate increase in pensions.

Moreover, in what can only be the most depressing of ironies,  much of the population  has been left without the comfort of a DB pension and all the benefits of risk sharing that go with it.

The most significant change that led to schemes closing to new members and future accrual was the imposition of the debt on employer legislation. This changed the obligation of the employer from being simply to pay a contribution, to being to pay the contribution and to guarantee the return needed on that contribution to generate the benefits promised.

In turn, this change altered the role and purpose of the pension fund from the stand-alone ‘to pay the pensions as and when due’ to being ‘to secure the accrued rights of scheme members, and to defray the employer’s cost of provision’. Unfortunately, little, if any, of the subsequent legislation and guidance has recognised the effect of this change, with very predictable consequences.

The Pensions Act 2004 introduced a new body, The Pensions Regulator (TPR) and a mutually organised compensation fund, the Pension Protection Fund (PPF). Unlike its predecessor, OPRA, TPR was given a statutory set of objectives.

The first of these objectives

to protect members’ benefits

sets the direction and objectives of its operations but it is somewhat surprising given that the Act was also creating the Pension Protection Fund. At the inception of the PPF, members’ benefits could only be at risk to the extent that the PPF cover was lower[1] than the amount of the member’s benefits[2].

The second objective is ambiguous

to reduce the risk of calls on the Pension Protection Fund

and ambiguity in a statutory objective is never good. As such, TPR has often interpreted and described this as being to protect the PPF. It is worth noting there are institutions, with similar purpose to the PPF, in many other jurisdictions, both publicly and privately organised, and none has need of, or has such a guardian angel.

The payment of only partial benefits to members by the PPF is an important defect in its design. There is no justification for this; there is no moral hazard involving members. It is certainly feasible to pay full benefits, indeed it is the practice in other jurisdictions, such as Sweden. It does, of course, leave TPR with some benefits to protect. It cannot be argued that the coverage of full benefits would be unaffordable. Their excess reserves far exceed the benefit reductions of schemes admitted or in assessment.

By expressing this duty in terms of risk, it opens the door for the Regulator to focus on the pension fund rather than the sustainability of the sponsor employer, as the risk to members is employer insolvency, and exposure to deficits at the time of failure. In Part 3 of the Pensions Act 2004, the Pensions Regulator is simply told  that the valuation assumptions etc. are to be prudent (as determined, usually, by the Trustee and the employer).

However, if the Pensions Regulator does not consider the assumptions to be prudent or the recovery plan to be prudent, the Pensions Regulator has power to substitute its own basis. To the best of our knowledge, this is something the Regulator has so far avoided.

Discipline and Punish (French edition).jpg

The absence of such interventions is not an abrogation of its duties, rather, it seems that this is an exercise in good old Foucauldian disciplinary power. The Pensions Regulator has essentially created the Panopticon for pensions through the publication of distributions of assumptions.


Jeremy Bentham’s Panopticon

As such, professional advisors know ‘what will be accepted by the Regulator’ and so the aim is not be visible lest the wrath of the Regulator be visited upon them, and so employers and trustees dutifully comply. Employers have essentially lost control and been alienated from their schemes.

The funding emphasis has also been embedded in legislation as the scheme’s claim in sponsor insolvency is now the amount of any deficit of assets relative to the cost of buying out the benefits with an insurance company. Of course, this is inequitable to other stakeholders. This inequity has had negative effects on sponsor employers, for example, many venture capital and private equity firms will simply not entertain investing in companies with even closed legacy DB schemes.

A buyout funding requirement is a very poor idea. It provides an incentive for sponsors to lower the quality of the pension offered, since that will have a lower replacement cost[i]. Even if minimum quality standards are introduced, the ultimate end point of this spiral is the cessation of provision.

We should not forget that employers voluntarily choose to offer DB pensions. The emphasis on scheme funding continues to this day. Objectives such as funding to levels of self-sufficiency or buy-out are expressly trying to reduce or eliminate any dependence on the sponsor employer. It is incredibly inefficient. It is the equivalent of putting aside savings to pay for the full rebuilding costs of our homes rather than simply insuring them.

An odd omission when regulating pensions

There is a missing but obvious objective for the Pensions Regulator – to promote high-quality pension provision. This is not a new idea. It was actively lobbied for in the wake of the global financial crisis.  The government did respond, but all that was offered was a consultation.

An additional objective for the regulator requiring it to consider the affordability of deficit recovery plans for sponsoring employers was proposed, but not the stronger objective requested by NAPF, to promote good pension provision and to ensure the health and longevity of schemes.[ii]

As noted earlier, the introduction of the debt on the employer also changed the purpose of the fund; it now serves as collateral to secure members’ accrued benefits. It is the current market value of those assets which should be of interest to members, not their performance over either the short or long term. The scheme member should be concerned solely with the sustainability of the sponsor employer, and for most active members the continuance of their employment is the greater concern.

The presence of the PPF greatly mitigates the exposure of scheme members, and it could, if extended, eliminate it entirely. All of the risk management, scenario analysis and long-term objective formation, promoted by the Regulator, for the scheme to conduct would then be redundant, with unnecessary compliance costs.

The sponsor employer should be concerned with the performance of the fund as it serves to defray the rate of return embedded within the pensions awards outstanding, which it is now guaranteeing. It is concerned with the level of the portfolio returns and their covariance with their earnings.

A hedging strategy such as LDI, which is concerned with the elimination of portfolio variability, is most unlikely to be optimal, particularly so given its short-term nature. Notwithstanding this, in 2019 the Pensions Regulator[iii] was advising trustees to

understand and quantify the liability valuation risks you are running

and to consider mitigating those risks

by investing in assets that move in a similar way to the value placed on the liabilities as market conditions change”.

A belief has recently gained currency that the tails of the distributions of pension projections of closed schemes are, in some sense, riskier and more difficult to manage than a less mature scheme. This is simply not true. Negative cash flows are only a potential problem when the fund is viewed as the sole source of pension service. There is no net gain to the company from contributions.

The cash flows of tails decline exponentially, and the total risk exposure, the residual value of the scheme declines hyper-exponentially, and with this the potential debt service load on the employer. On these grounds the covenant of the employer will tend to improve as time passes as the potential service cost diminishes.

This negative cashflow misunderstanding appears to have driven, at least in part, the Regulator’s desire for a new, separate regime for schemes in run-off. The resistance reported to the Bowles amendment is misplaced. Inclusion of open DB schemes within that proposed framework will certainly lead to their closure.


Michael O’Higgins (then TPR Chair) said in a speech in 2012:

There will be occasions when the right thing to do for the employer and the scheme will be to invest in the growth of the sponsoring company rather than making higher pension contributions.”

We wonder if it has ever happened.


[1] For completeness, it should be noted that the PPF can adopt measures to “balance its books” by reducing the level of revaluation and indexation and, ultimately, the compensation percentage – albeit with a floor of 50% of the member’s pension each year from that which would have been payable from that member’s scheme before it went into the PPF.

[2] Recent judgements in the ECJ and in the High Court have modified this original position and removed some of the iniquity of the original structure of PPF compensation.

[i] Until the late 1990s schemes commencing winding up were often sufficiently well-funded that they could buy-out the liabilities with an insurance company. This was partly due to the higher gilt yields then prevailing but also to the fact that it was the basic pension with no allowance for discretionary increases which was bought.

[ii] This is an edited quotation from an excellent paper, which we recommend should be read in full:

Deborah Mabbett (2020): Reckless prudence: financialization in UK pension scheme governance after the crisis, Review of International Political Economy, DOI: 10.1080/09692290.2020.1758187

[iii] TPR. (2019). Investment guidance for defined benefit pension schemes.

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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