We have been asked what impact the Funding Code would have on open schemes by a number of correspondents. This blog illustrates why the new funding code is the biggest risk that open scheme members face . Simply put, this threat is the staggering increases in cost of provision under the proposals.
All of our previously published estimates of the total cost of the proposed Code have been limited to the cost of the transition to de-risked low sponsor dependent schemes. Those costs run into hundreds of billions of pounds for all schemes. The absence of any cost benefit or impact analysis in the consultation raises some serious questions. How can the Regulator have developed these proposals without some estimate of the costs of the status quo and set out a clear economic rationale for change being necessary? This is not difficult to estimate; it is the total of the reductions in pensions payments made by the Pension Protection Fund. It is a small number in the context of the overall DB universe, perhaps £3 billion over 15 years.
Let’s walk through one simple estimate of the total cost. TPR estimated the cost of buy-out as £720 billion. The concept of low sponsor dependency is closely related to buy-out; that is the limit of no dependency. Low dependency, or self sufficiency would not be as costly as this. We can reduce the buy-out figure by an allowance for insurer profits, say 15%, which leaves the figure as £612 billion. We can estimate the reduced liabilities, say, 15 years in the future, of the pensions universe as schemes mature as, say, 80% of those prevailing today – the figure then becomes £490 billion. We may even say that consolidators and self-sufficient investment strategies can be expected to deliver a further 20% of savings relative to buy-out, but that still leaves the cost estimate at £391 billion.
This is clearly out of all proportion to potential member harm. It prompts the question: Cui Bono? Who profits? It can only be the Pension Protection Fund. It will gain materially since schemes funded to self-sufficiency will be funded at better than PPF benefits but less than buy-out costs. Indeed, if schemes failing represent windfall gains to the PPF, there is a perverse circularity here. The disproportionate costs of the proposed regime will push firms to the brink of insolvency through excessive demands for funding, increasing the chances schemes falling into the PPF.
It was disappointing to see the Regulator challenging an estimate of £100 billion as being too high. It seems to us that the greater challenge would really be to get total cost estimates down to that level. Even if our calculations are out by 100%, then the cost is just under £200bn, the magnitude of error to get below £100bn is therefore considerable.
Our estimates are for all schemes, but a crucial and important distinction that both current and proposed regulation fail to appropriately recognise, is that open schemes do not mature and run-off in the manner of closed schemes; new members join each year creating further liabilities. This is where the existential threat to open schemes comes about. Extrapolating a few scheme estimates of their increases in future service costs to all open schemes, we arrive at an increase of around £10 billion annually. If we capitalise this figure as a real perpetuity, the increase is actually much higher than the full buy-out cost, around £1 trillion (real). It should be borne in mind that, unlike the earlier buy-out based estimate, these costs will be borne by the far smaller number of schemes which remain open.
This is the source of the existential threat to the sponsors of these schemes and the schemes themselves. The cost for open schemes is at least twice that for closed, and unlike closed schemes, these costs are increasing through time.
Shared cost schemes are highly represented among open schemes; USS and RailPen are obvious, large examples. Members pay a fixed proportion of the total contribution, say 35% or 40%. It is difficult to believe that their members will choose to remain rather than leave, to pay the inflated contributions that the code would bring about, given their extremely poor value for money.
We think that members of open schemes would do well to make their case now. The House of Commons Public Bill Committee on the Pension Schemes Bill [House of Lords] 2019-21 is taking evidence until November 3.
For the biggest risk faced by a scheme and its members to be caused by the Regulator would be funny if the consequences were not so devastating.