Con Keating as a young man

Very early in my career, in order to learn to understand and speak Japanese, it was necessary to comprehend the circumlocutions and etiquette of that culture. ‘Yes, but….’ means ‘NO!’ was an early revelation.  Responses to regulatory consultations similarly have their own etiquette, particularly so when the regulator has a reputation among some trustees for being petty and vindictive. Advisors and independent trustees are unlikely to express objections forcefully – ongoing commercial concerns will be dominant. The description of independent trustees, who are now much promoted by the regulator, as “regulators in residence” has more than a grain of truth to it.

The centrality of pension codes to the regulation of UK DB pensions.

To quote the abstract of a recent but as yet unpublished, academic paper: “At the heart of UK pension fund regulation are quasi-compulsory codes of practices and tests of pension fund trustees’ competence. This regime of ‘soft’ regulation focuses upon the ‘performance’ of governance and is intrusive in terms of expected behaviour and board decision-making.  … The UK pension regime has hit a dead-end being neither fit-for-purpose in a world of technological disruption and financial turmoil nor capable of empowering those funds willing and able to innovate in the best interests of participants.”

Though the advice that a code is “not a statement of the law” is usually present as boilerplate, the pensions regulator usually also states that any deviation from a code may result in penalties being applied if that variation cannot be justified to their satisfaction. In doing so, tPR waves the stick that the codes of practice would be taken into account in any judicial determination process. Notwithstanding the threat of the stick, the “voluntary” nature of the code offers the regulator cover against trustee litigation. Unlike Boris, tPR can have their cake and eat it.

Trustees report that the Pension Regulator’s policies and procedures for variation are cumbersome and opaque, and that obtaining a dispensation is difficult and time-consuming.

It is surprising that the consultation responses have not been made publicly available alongside the interim response. We have obtained and read 47 (of 127) responses and find ourselves most surprised by some of the statements in the interim response, such as “Overall, there was general support for the principles and regulatory approach proposed in the consultation”. Some of the responses, such as that from the Association of Pensions Lawyers, were excoriating, and not one supported the proposals unequivocally. Yes, BUT!  It may be that my sample is unrepresentative of all responses, but that is unlikely.

The response lists, as bullet points, six concerns expressed in submissions. It would be logical that these were the most important, or at least most frequently cited objections. Three of these do not even make the top ten in our sample by either metric. These are:

• “Potential loss of flexibility (eg through benchmarking the Bespoke route against Fast Track).”

Loss of flexibility is not an adequate description for the many objections I have read on the inappropriateness of using a Fast Track benchmark for schemes using Bespoke methods

• “The Bespoke route may be perceived as being ‘second-best’.”

This simply did not appear at all in any of the responses I have read. In any event, why should perceptions matter here?

• “Reliance on covenant being watered down and what a greater trustee focus on covenant visibility would mean for schemes’ ability to rely on covenant beyond the medium term.”

Not one submission that I have read expressed concern that reliance on the sponsor would be “watered down”. However, many expressed concern that the covenant of the sponsor would be adversely affected by the higher funding requirements associated with low dependency. The role of the sponsor employer as underwriter of the scheme, and scheme recourse to it, is unaffected by any of the terms of the new Pensions Bill.

The assurance that “We will consider all comments carefully and with an open mind.” rings hollow when, immediately following in ‘Next steps and timings’, the response states: “We need to … develop Fast Track guidelines … “.

Target End States

It is clear that the proposed Code will bring substantial new expense to DB schemes. This is made explicitly clear in the Institute and Faculty of Actuaries “Report of the target end states for defined benefit pension schemes working party”. “Target end states” (TES) are an actuarial simile for low dependency schemes.

That report sees the proposed new world as a full employment charter for actuaries. Quote: “The role of the actuary should change: Rather than be a technical specialist, actuaries have the opportunity to move into a strategic advisory role which will be needed to help clients properly. Many actuaries already have. Broad generalist skills are vital, and deep, technical precision is replaced by more agile, rounded thinking: the ability to facilitate multi-disciplinary collaboration, quickly weigh up options, and play out alternative scenarios. New skills include:

Strategist;

Contingency planner;

Decision making coach; and

Cross-disciplinary facilitator (bringing the strands together).

And states: “A team of expert advisers (investment, actuarial, covenant) working closely together with the trustees and the company will help the smooth running of a low-dependency TES.” Before adding: “Fees, expenses and charges will likely consume a greater share of the excess returns than for a growth-focused portfolio.”

We should note that just one third of the responses to the consultation came from those directly affected, schemes and their employer sponsors; for the rest, the spectre of commercial opportunity overshadows their responses, much like the ‘need’ to change the role of the actuary. In response to questions as to the supine nature of trustees, we received the following comments:” Some consultants tell us that the majority of trustees (by number, but not necessarily by value) will tend to comply with TPR because (a) none of their advisers (and the actuary is probably the main culprit, although covenant and legal advisers are often not far behind) encourage them to challenge TPR (despite “challenge” being stressed by almost everyone, including TPR ironically, as a quality to be desired in a diverse, trustee board); (b) similar “don’t rock the boat” compliance is increasingly the norm for employers after they have closed their DB schemes and essentially then think in terms of wanting rid of them; and (c) the vast majority of so-called independent and/or professional trustees, who could act as a form of amicus curiae, instead advocate compliance, which maybe is not surprising since they tend to come to trusteeship as a “twilight career” after serving as a consultant or other business service provider.”

The interim response references a previous blog from the Regulator, which addressed, in part, the issues for open schemes. But, that blog also contained the following: “As the White Paper and our consultation set out, as schemes mature, their ability to deal with volatile and poor investment outcomes is limited and the impacts this could have on the sponsor could be significant. There is consensus that it makes sense for trustees to plan to reach a position of higher resilience to risk and less reliance on the employer when their scheme is very mature.” The White Paper contained just three references to mature schemes, and none of these references make an evidential or even theoretical basis for the subsequent argument expressed here. The consultation similarly fails to make the case for mature schemes to have higher resilience to risk or less reliance on the employer. If there is such a  consensus, it is erroneous.

Sine Qua Non

There are two precursors to the sound regulation of DB pensions:

• sound valuation of the employer obligation, and
• recognition of the true nature of the pension promise.

Though these are expressed somewhat inchoately, it seems that the actuaries have, at long last, come around to recognising concerns over liability valuations as is evident from the IFoA report: “An employer’s  view  on investment  strategy  and journey  plan  is  sometimes  driven  by the  impact on the  employer’s  financial  statements  and this  in turn can be driven by accounting standards. This  can lead to sub-optimal  decision  making and  sub-optimal Member  Outcomes.  We recommend TPR considers  how  it  can identify  and assist  trustees  in the situations  in  which the employer’s  GAAP  approach is  most  likely  to  lead to distorted management  of  scheme liabilities. The actuarial  profession could  help here by  preparing analysis  that  highlights  the  features  in financial  statements  that  typically  lead to a  disconnect to how  a trustee board may manage scheme liabilities.”

With others, I have repeatedly made the point that the terms of award of a DB pension determine the discount rate which should be used for the accrual over time of the liability. We have referred to this as the contractual accrual rate; it is the rate of return on the contribution implicit in the contract. It changes only if experience varies from the assumptions made in projections of future pension cash flows. This is not some radical invention. IFRS16 mandates the use of the rate embedded in the contract for the valuation of long-term operating leases. For the recognition of profit over the life of a long-term insurance contract, IFRS17 holds fixed the initial discount rate and changes this only if experience differs from that assumed. With scheme assets and liabilities accruing at this rate, pensions will be paid on time and in full.

This liability or rather its asset equivalent may or may not be sufficient to buy out in a market at a point in time during its life. However, if the liability is funded to this contractual level, the sponsor employer has discharged its contractual liability.

Why pensions have been singled out for special treatment in a way that ignores basic economics and contract law is a fundamental flaw in the regulation of DB in the UK.

The idea that a scheme should be funded to such an extent that it may buy-out or run-off liabilities at any point time without a sponsor standing behind is a pernicious misconception of occupational pensions. It is the mistake at the heart of the regulator’s proposed regime of low-dependency schemes and the propose new Code – the cost of which, as proposed, will be ruinous to UK plc.