This is the first in a series of blogs covering our responses to the questions posed in the Funding Regulations consultation paper, which closes on October 17, 2022. As there are 25 questions and we wish to keep our blogs short and readable, we shall cover them in small groups. We use blue italics for quotations from the DWP documents and indicate where we have added emphasis in bold type.
We shall limit our comments to just two sentences in the Ministerial foreword, though much more might be said. The first of these is:
“With millions of people still relying on defined benefit pensions, it is important that we get the right balance between ensuring those pensions are secure for members over the longer term and keeping them affordable for sponsoring employers.” [Emphasis added.]
Unfortunately, the funding approach does not do this. It would be far more efficient and effective to use pension indemnity assurance – and alongside private insurers, the PPF could easily be modified to offer that.
“Those schemes that are maturing will be required to manage their risks carefully, taking proper account of the extent to which those risks remain supportable as they move towards run-off, or securing members’ benefits”
The proposed approach fails to recognise that as schemes mature their liabilities decline, as many pensions have been discharged, on time and in full. In other words, for closed schemes, the sponsor’s liability exposure peaks and then declines with the passage of time. It is only if the sponsor’s ability to pay declines at a faster rate than the pension liabilities that the ability to support these liabilities is impaired. (And this would be the exception rather than the rule for the sponsors of DB schemes.) The proposed approach uses a sledgehammer to crack a very small nut. The 2021 Purple Book reports an average failure rate in the PPF universe of 0.62%. In recent years, just 25 to 30 schemes have entered the PPF, annually. With their most recent liabilities reported at £9.4 billion, the loss risk to members (at 15% of liabilities) is less than £1.5 billion – this is less than one tenth of one percent of all scheme liabilities or assets.
The Consultation Questions
Draft regulation 4(1)(b) provides that a scheme reaches significant maturity on the date it reaches the duration of liabilities in years specified by the Pensions Regulator’s revised Defined Benefit Funding Code of Practice.
- i) Do you think that it would be better for the duration of liabilities at which the scheme reaches significant maturity to be set out in the Regulations rather than the Code of Practice?
Response: If we accept a need for this funding approach, then the point of significant maturity must be specified in an Act of Parliament, not in any Code of Practice. In any event, it should not be expressed as a duration for the reasons set out later in this blog.
A Code of Practice is produced by an unelected Pensions Regulator, which is then rubber stamped by Parliament to give the illusion of accountability. In practice, it is never scrutinised by Parliament.
As a reminder of the legal status of a Code of Practice Pensions Act 2004, Section 90 says:
“(4) A failure on the part of any person to observe any provision of a code of practice issued under this section does not of itself render that person liable to any legal proceedings.
This is subject to section 13(3)(a) and (8) (power for improvement notice to direct that person complies with code of practice and civil penalties for failure to comply).
(5) A code of practice issued under this section is admissible in evidence in any legal proceedings and, if any provision of such a code appears to the court or tribunal concerned to be relevant to any question arising in the proceedings, it must be taken into account in determining that question.
Such a profound extension of the powers of the Pensions Regulator as proposed in the current consultation would require extensive discussion and authorisation by Parliament and explicit changes to the Regulator’s constitutional standing and accountability. We should also remember that there is a very significant cost to the Exchequer and tax-payer in all of this (because employer contributions are tax deductible when calculating the profits of a business on which corporation tax is assessed).
- ii) If you think that the point of significant maturity should be specified in Regulations, do you agree that a duration of 12 years is an appropriate duration at which schemes reach significant maturity?
Response: Simply put, no. Duration is sensitive to the levels of discount rates applied to cashflows; as rates rise so the term as measured by duration falls (and vice versa). As, or perhaps more, importantly, duration is a measure of all cash flows, a complex average of all of them. By contrast, the maturity of a pension scheme is a function of the relative importance of pensions in payment within a scheme; duration simply does not address this. Increasing the projected liabilities of a scheme, through say revisions to inflation or longevity, clearly increases the risk exposure to the sponsor that the scheme represents, but the effect on duration is ambiguous. The duration of the scheme may increase, decrease, or remain unchanged, depending upon both the membership mix of deferreds and pensioners, and the discount rate(s) applied.
Duration, in its modified form, is most often used as a metric by an investor in looking at the sensitivity of the market value of a bond to a change in interest rates – see here: https://corporatefinanceinstitute.com/resources/knowledge/finance/duration/ .
In its effective duration form, duration may take account of some forms of uncertainty in future cash flows, such as those that arise from the exercise of call options, but in all other forms all future cash flows are considered known with certainty. This is simply untrue of projected pension amounts. The use of duration in this context is quite simply wrong, with significant economic consequences for members, sponsors, and the Exchequer.
If the feedback to this blog from readers warrants it, we shall provide examples which illustrate that this is a metric that has no utility.
It is far simpler and more reliable to use simple sums of projected liabilities. We would suggest that a scheme is considered mature when some proportion, say 75%, of its total projected liabilities are the liabilities to pensioners in payment.
Low dependency investment allocation
“Do you think that the definition of low dependency investment allocation provided by draft regulation 5 is appropriate and will it be effective?
Draft regulation 5 provides that for the purposes of these draft Regulations, a low dependency investment allocation, in relation to the investment of the assets of a scheme, means that:
the assets of the scheme are invested in such a way that the cash flow from the investments is broadly matched with the payment of pensions and other benefits under the scheme; and
the assets of the scheme are invested in such a way that the value of the assets relative to the value of the scheme’s liabilities is highly resilient to short-term adverse changes in market conditions,
in a way that complies with an objective that further employer contributions are not expected to be required to make provision for accrued rights to pensions and other benefits under the scheme.”
Response: We do not believe that this is either appropriate or will be effective. We believe that the riskiness of a scheme’s asset portfolio should be determined by the risk appetite and capabilities of the sponsor employer. The asset allocation of a scheme is the prime determinant of the cost of provision of a scheme to sponsors. Let us remember that these sponsoring employers voluntarily created these schemes for the benefit of employees. Imposing costs arbitrarily on sponsor employers breaches natural justice.
The technique of matching assets to liabilities as proposed is known to financial analysts in other contexts, such as the defeasement of corporate debt liabilities. The technique has a name: dedication. It is known to be the most expensive way in which to discharge liabilities.
In these defeasement situations the future cash flows are known with certainty. For example,they might be the payments of coupons and principal outstanding on corporate debt issues. This means that they may be matched with precision and known expense. However, pension liabilities are not known with certainty and there are no instruments or securities which provide cover for the causes of that uncertainty, such as future inflation or member longevity. Index-linked gilts as hedges for inflation are particularly pernicious – this year they have been both the worst performing asset category and the most volatile (more so even than equity).
The strategy envisaged by this legislation would inevitably involve the purchase of large amount of conventional and index-linked gilts. They are very volatile relative to the projected liability amounts. The costs introduced by this strategy are twofold – First, the lower returns offered on these securities, which we would estimate at around 2% per annum, and second, the costs of rebalancing the portfolio to reflect adverse experience of the pension risk factors. (This is likely to have a cost of 0.25% – 0.5% pa.) Imposing these costs on sponsor employers will of course harm the quality of their covenant.
These costs can be expected to lower business investment and with that engender slower productivity growth and lower economic output. The elimination of a minor potential harm for a small minority will create a significantly greater harm for the overall population. There is cost to the tax-payer. We estimate that, based on the current proposal, the cost to the public purse to be between £38 and £40 billion. At a time of very considerable pressure on public finances, and long after the time when the UK stopped gold plating EU Directives when transposing them, it seems that gold plating is alive and well in the DWP and the Pensions Regulator.
The consultation and associated documents provide no estimate of the cost of additional funding to sponsor employers. We are expected to wait for any estimates until the Pensions Regulator publishes its revised Code. This is simply not acceptable when the imposition of such a major burden is being proposed. Our modelling indicates that this will be of the order of £180 – £200 billion, which is similar in magnitude to current total UK annual business investment.
As the modelling of these proposals is fraught with uncertainties, we will describe our analysis in detail in later blogs.
One of the problems here is that the approach is fundamentally short-term in nature, as is evident from the objective for the portfolio to be: “highly resilient to short-term adverse changes in market conditions,”. This strategy suffers the elementary problem of liability-driven investment: that a scheme may be in balance or improving in terms of actuarial valuations, while actually suffering a lowering of the coverage of the projected liabilities. We can illustrate this issue very simply. Take a scheme which, at the preliminary draft valuation in January this year, had total projected liabilities of £120 million, the present value of which was £75 million. It had £60 million of assets, a funding ratio of 93%. The movement in interest rates and securities prices in the period to the scheme’s end-of-June final valuation saw the present value of liabilities fall to £59 million, while the asset portfolio fell by 14.3% to £60 million, and the funding ratio improved to 1.02%. However, the coverage of ultimate liabilities, that is the total projected liabilities of £120m, fell from 58% to 50%.
It also illustrates the cognitive dissonance between this proposal and the challenge to pension funds laid down by the current Prime Minister and the former Chancellor of the Exchequer on 4th August, 2021 (just over a year ago):
“ Whether you are a trustee or manager of a DC or DB pension fund, running an insurance company or advising investors on their investment strategy, we are challenging you this summer to begin to invest more in long-term UK assets, giving pension savers access to better returns and enabling them to see their funds support an innovative, healthier, greener future for their country. We know that this will require a change in mindset for many investors that won’t happen overnight, but that is why this change needs to start now.”
The final clause
“that further employer contributions are not expected to be required”
is ambiguous. A scheme, funded and in balance with liabilities, valued on a best estimate basis using the expected rate of return on assets as its discount rate does not expect to require further employer contributions; they are as likely as not to require future contributions. What is actually being sought is funding to some very high level; values such as using a gilts plus 0.5% discount rate or the 95th percentile of the future liability distribution have been discussed elsewhere. The problem with funding to the 95th percentile is simply that in 95% of outcomes the scheme will be overfunded and resources, which rightly belong to the sponsor employer, will be, in part or entirely, unavailable to it.
As well as this, there is a considerable burden being placed on the taxpayer, which as mentioned above, we estimate at only £38 – £40 billion!
Low dependency funding basis
Question 3: Do you think that the definition of low dependency funding basis provided by draft regulation 6 is appropriate and will it be effective?
We recommend reading the full text of this section of the consultation but for brevity, we reproduce here only part of it.
“3.16. … A low dependency funding basis refers to actuarial assumptions consistent with low dependency on the employer. When choosing their assumptions, trustees or managers should work on the basis that further employer contributions will not be required under reasonable, foreseeable circumstances.
3.17. Draft regulation 6 provides that, for the purposes of these draft Regulations, the liabilities of a scheme are calculated on a low dependency funding basis. This is where they are calculated using actuarial assumptions which comply with the requirement that further employer contributions would not be expected to be required to make provision for accrued rights to pension benefits, if the following presumptions were satisfied:
(a) the funding level of the scheme is 1:1, on a calculation of the liabilities which uses those actuarial assumptions; and
(b) the assets of the scheme are invested in accordance with a low dependency investment allocation.”
Response: We do not believe that this definition is either appropriate or will be effective. Consider section 3.16 “reasonable, foreseeable circumstances”: this runs counter to the overarching objective of this legislation, which is making substantial provision for adverse unforeseen, and unforeseeable developments. It is also framed in terms of the immediate valuation of liabilities, not the long-term development of actual pension liabilities or their projections.
It is also worth stating explicitly: there is no such thing as a “low dependency investment allocation.” unless that expression simply refers to cash.
The aggregate effect of these regulations will simply be to increase the total amount of funding required of sponsors and, in consequence, perversely weaken the employer covenant, and when aggregated to a country level, will have severely weakened the resilience of UK plc. Moreover, sponsor employers will then have an increased dependence on financial market performance, creating greater procyclicality in the economy.
Finally, the funding basis proposed is higher than that of the Pension Protection Fund (PPF), which rather renders that body redundant in its current form. It is both telling and extremely surprising that the Consultation Paper makes no mention at all of the PPF, and no mention of the significant cost to the taxpayer both of which seem fundamental in any discussion, appraisal and consultation response
  Letter dated 4th August, 2021 from Boris Johnson and Rishi Sunak: https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1008814/A_Challenge_Letter_from_the_Prime_Minister_and_Chancellor_to_institution__1_.pdf