The Pensions Regulator is fixated upon scheme funding. Its proposed DB funding code has, as its principal objective, funding to a level which reduces a scheme’s dependence on the employer sponsor to irrelevance. Part of its motivation appears to be the rather strange idea that the PPF needs protection, when the evidence is that the PPF has been charging levies at levels approaching twice those appropriate for the level of risk it has experienced. Its most recent accounts, for the year 2020/2021, report a funding ratio of 127.3%, a £9 billion surplus. Those accounts report that 41.5%  of their funding arises from the funding of failing schemes and 11.5% from assets recovered from insolvent employers.

While there has been some cursory discussion of the likelihood of insolvency of sponsor employers and a crude credit classification is in use, there has been action only when the sponsor appears to be in its death throes. This should be surprising as it is insolvency which takes precedence and is the determinant of any risk crystallisation.

Funding as a solution to the problem arising from sponsor insolvency is highly inefficient; the extent of this may be judged from the case of the Universities Superannuation Scheme, who report that funding to self-sufficiency requires assets of £111 billion versus their best estimate value of the liabilities at £56 billion, almost twice as much. Funding to open-market buy-out levels would lie above this. The best estimate level is, of course, that which the employer sponsors contracted for when making the pension awards.

The problem was correctly diagnosed long ago as being best covered by insurance, which led to the creation of the Pension Protection Fund, but somewhere in the interim that seems to have gone terribly wrong. There are bodies insuring the obligations of pension schemes in many countries, of which there are two of particular note, the German Pensions-Sicherungs-Verein (PSV) and the Swedish, PRI-Pensionsgaranti (PRI-PG).

Both of these insurers offer superior benefits to the members of schemes whose sponsors have failed than those provided by the PPF. Both buy annuities on sponsor insolvency to cover the pension liabilities – from a syndicate led by Allianz in the case of PSV and from Alecta in the case of PRI-PG. These are supplied to them on commercial terms meaning  that it might be argued it would be more efficient for PSV and PRI-PG to write those annuities themselves to avoid incurring the costs of the annuity providers, which of course include their profit margin.

The particular characteristic of these companies is that the majority of the sponsors insured have DB schemes which are unfunded, or book-reserve. Over 90,000 schemes in the case of PSV and almost all of the 1700 PRI-PG schemes. These schemes have no assets other than trivial amounts for operating purposes. The claims of PSV and PRI-PG are on the insolvent estates of the sponsor employers. Over the decades, these insurers have managed to charge very small premiums, in the range 0.3% – 0.4% of scheme liabilities.

In Germany, these book-reserves became the largest source of finance for the Mittelstand and are credited by many with enabling the post-war Wirtschaftswunder.  They explicitly align the interests of employees and management and contribute to good industrial relations. Moreover, they are attractive to companies as a known and predictable source of finance (the notional contributions) whose ultimate redemption is through relatively small sums paid over lifetimes in retirement. No cliff edge debt securities maturities. The increases in provisions from year-to-year for prior awards are also predictable and effectively set at the initial award; they represent the true cost to the sponsor of providing the pension. The absence of funding also makes them efficient as there are no investment consultants or fund managers to feed. And of course, there is no dependence on external market prices or expectations of returns for their valuation. In a UK context, that would use the effective interest method laid down by HMRC[i]. “The effective interest rate is the rate of return that provides a level yield on a financial asset through to maturity date (or the next re-pricing date). To look at it another way, it is the rate that exactly discounts the cash flows associated with the financial instrument through to maturity (or the next re-pricing date) to the net carrying amount at initial recognition, i.e., a constant rate on the carrying amount.”

The DWP cannot be said to be unaware  as the creation of an insurer to write precisely this form of business was discussed with them, and the most forgotten Pensions Minister, Mike O’Brien, in 2007/2008. They discouraged it, wanting to protect the Pension Protection Fund. Let’s not compound that mistake by  introducing the new DB Funding Code.

[i]  See: HMRC:  CFM21640-60