This is the third in our series of blogs addressing the questions posed in the DWP’s Funding Regulations consultation. The previous blogs may be seen firstly here and secondly here. We follow the same conventions as in previous blogs.

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Industry comment to date

We had a flurry of questions after our second blog was published. This was not surprising as there were several other press articles released around the same time on the significant problems of the Funding Regulations. To recap some of the principal points quoted in those:

Mercer says the draft DB funding regulations would “force” the sale of £500 billion of return-seeking assets, the majority being required before 2040.

“This could see around £200bn of liabilities added to the balance sheets of employers with DB schemes over the next 10-15 years”.”

And from Mercer again: “The regulations would significantly accelerate the buy-out of DB pension liabilities, such that we might expect to see the demand for the settlement of up to £200bn of liabilities each year for the next 15 years.”

This is far more than the present capitalisation of the bulk annuity insurers can support, leaving us wondering where the necessary new capital would come from.

LCP’s analysis suggests that around 5% of schemes (c. 200 to 250 in number) could face insolvency as a result of the new funding demands imposed upon them.

Our analysis is broadly in agreement with these figures, though we were unable, due to a lack of data, to produce any reliable estimates of the numbers of insolvencies arising.

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Resuming the blog  and moving to the next questions posed in the consultation:

Question 5:

Does it work in practice to set a minimum requirement for the relevant date to be no later than the end of the scheme year that the scheme is estimated to reach significant maturity?

 As long as significant maturity is defined in terms of duration and a low dependence portfolio (for which we read dominated by gilts and linkers) this is not practical. As we have shown in previous blogs the date of ‘maturity’ is very dependent upon the discount rate applied. It is the discount rate associated with this low-dependence portfolio at the future date which would determine whether or not the distribution of projected scheme liabilities at that date had reached a duration of 12 years.

There are a number of distinct problems to be considered.

First, increases in expected longevity and increases in inflation will tend to increase the duration of the liabilities, which would set the Regulation up to be gamed. Increases in both could be presented as ‘prudent’ behaviour by trustees.

Second, there are problems of transition from a growth portfolio to its low dependence equivalent. The expected return of the low-dependence portfolio, of course, varies over time. It does so in ways which may vary from the expected returns of growth portfolios. Conservatism in the estimation of the low-dependence portfolio returns will extend the duration and at the same time raise the immediate cost of the projected liabilities.

These issues may be avoided by setting this as: The end of the scheme year in which the scheme has reached significant maturity.

These issues do not arise if the date of significant maturity is derived from the undiscounted cash flow projections of pensioners and deferreds, as explained in our previous blogs.

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Question 6:

Does your scheme already have a long-term date and how is it calculated?

We do not manage any scheme. We are familiar with several schemes which have set long-term dates. All are closed schemes. For some it is a date in the future when they believe they will be able to buy out scheme liabilities, although as recent shifts in interest rates, inflation, and investments have shown, this is something of a moving feast and as such a highly subjective and arbitrary guesstimate. For others, it is the date at which they expect to be funded sufficiently to have achieved self-sufficiency (a bizarre concept in and of itself as we have noted previously). There is very little science in the determination of these dates.

We are also familiar with several open schemes – for which the concept of significant maturity is devoid of meaning. The introduction of new members, with their contributions and new liabilities, increases the overall duration of portfolio liabilities, and indeed these schemes are not maturing, but rather, growing ‘younger’. Any attempt to estimate significant maturity – even using the proportion of the total liabilities metric – would require some heroic assumptions about the size, age distribution and pay levels of the future labour force.

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Question 7:

Where the funding and investment strategy is being reviewed out of cycle with the actuarial valuation, would it be more helpful to require it to align with the most recent actuarial report?

No. In general, it is a very poor idea to align such reviews with the most recent actuarial report. That report may have taken place in unusual circumstances. The March 2020 valuation of USS is a notorious example. It should also be remembered that the most recent actuarial valuation may be close to three years old.

Of course, reviews conducted at the time of an actuarial valuation should be consistent with that valuation.

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Actuarial Methods

Questions 8 & 9 relate to actuarial methods and assumptions for purposes of funding level and encompass subsections relating to consistency of assumptions and to schedule 1, which covers the detail of the regulatory requirements for determining or revising the scheme’s funding and investment strategy. These are regulations 9, 10 and 11.

The only regulation here which we would (almost) unconditionally endorse is Regulation 9 (3): “… it is for the trustees or managers of a scheme to determine which methods and assumptions are to be used in specifying the funding level they intend the scheme to have achieved as at the relevant date.”, though we would add that this must be done in agreement with the sponsor employer.

Regulation 10 states:  “Where, for the purposes of a determination or revision of a scheme’s funding and investment strategy, the trustees or managers of the scheme are required to use actuarial assumptions which are used in a calculation of the liabilities of a scheme on a low dependency funding basis, the trustees or managers must choose one set of such assumptions which must be used each time such assumptions are required for the purposes of that determination or revision of the strategy.” [Emphasis Added]

The consultation paper elaborates the purpose and effect of this Regulation as: “3.30. The requirement of draft regulation 10 means that, whilst different low dependency actuarial assumptions can be used for different occasions on which the funding and investment strategy is being determined or revised, on any occasion it is being determined or revised, the same set of low dependency actuarial assumptions must be used by the trustees or managers for all aspects of that particular determination or revision (for example, determining the funding level they are targeting at the relevant date).”

 The Explanatory Note accompanying the draft Regulations state: “Regulation 10 ensures that when, in determining or revising a scheme’s funding and investment strategy, the trustees or managers of a scheme are required to use actuarial assumptions used for the calculation of the liabilities of a scheme on a low dependency funding basis, a single set of such assumptions is used for the purposes of that determination or revision.”

 We find this as clear as mud. The Regulation seems to envisage multiple values for each assumption within a set of assumptions. It also appears to set in stone for all time the assumptions which may be used. The Regulation and its description in the Consultation and Explanatory Note are ironically not consistent. While we do believe that assumptions should be consistent in their application, we believe this Regulation needs to be redrafted and clear explanation given, with examples, as to what the intended purpose of the Regulation is. It looks as if the drafting instructions given were not sufficiently clear for the person drafting the Regulation to understand what was intended

We reproduce below the paragraphs of Schedule 1 which are relevant to our response to question 8.

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“Funding and investment strategy – matters and principles

Matters

1. In determining or revising a scheme’s funding and investment strategy, the trustees or managers of the scheme must take into account—

 (a) the actuary’s estimate of the date on which the scheme is expected to (or, if applicable, did) reach significant maturity, as set out in the actuarial valuation to which the funding and investment strategy relates; and

(b) the actuary’s estimate of the maturity of the scheme as at the effective date of the actuarial valuation to which the funding and investment strategy relates, as set out in that actuarial valuation.

 Principles

2. The trustees or managers of a scheme must, in determining or revising the scheme’s funding and investment strategy, follow the principles set out in paragraphs 3 to 6 of this Schedule.

 Minimum requirements on and after the relevant date

3.—(1) The principles set out in sub-paragraph (2) relate to minimum requirements that a scheme is subject to on and after the relevant date. (2) The principles are—

 (a) on and after the relevant date the scheme is subject to the requirement that it has sufficient and appropriate assets such that the funding level of the scheme calculated in accordance with the requirements in regulation 9(2)(a) and (b) is as a minimum 1:1; and

(b) on and after the relevant date the scheme is subject to the requirement that its assets must be invested in accordance with a low dependency investment allocation.”

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We now turn to question 8.

Question 8:

Do you think that these minimum requirements are sensible and will provide additional protection for the accrued pension rights of scheme members?

 These requirements raise the required amount of funding and as such will increase the protection of members’ rights but only marginally. However, they do so at a cost which is totally disproportionate to that improvement, and as such cannot be considered sensible. We will comment in a later blog on the cost impact assessment of the Regulations. We will also discuss proportionality on pensions management more fully in a later blog.

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In order to provide context for our response to question 9, we reproduce below the relevant sections of Schedule 1:

“Investment risk on journey plan

 (1) The principles set out in sub-paragraph (2) relate to the level of risk that can be taken by the trustees or managers of a scheme in relation to the investment of the assets of the scheme as it moves along its journey plan.

 (2) The principles are that the level of risk that can be taken—

 (a) is dependent on the strength of the employer covenant (so that more risk can be taken where the employer covenant is stronger and less risk can be taken where the employer covenant is weaker);

 (b) subject to sub-paragraph (a), depends on how near the scheme is to reaching the relevant date (so that, subject to the strength of the employer covenant, more risk can be taken where a scheme is a long way from reaching the relevant date and less risk can be taken where a scheme is near to reaching the relevant date).

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 Risk in relation to calculation of liabilities on journey plan

 5.—(1) The principles set out in sub-paragraph (2) relate to the level of risk that can be taken by the trustees or managers of a scheme in determining the actuarial assumptions used for the purposes of calculating the liabilities of the scheme as it moves along its journey plan.

  (2) The principles are that the level of risk that can be taken—

 (a) is dependent on the strength of the employer covenant (so that more risk can be taken where the employer covenant is stronger and less risk can be taken where the employer covenant is weaker);

 (b) subject to sub-paragraph (a), depends on how near the scheme is to reaching the relevant date (so that, subject to the strength of the employer covenant, more risk can be taken where a scheme is a long way from reaching the relevant date and less risk can be taken where a scheme is near to reaching the relevant date).”

The narrative preceding Question 9 in the Consultation, which we reproduce below, is misleading in that it fails to recognise that the Regulations and Schedule also operate on the risk profile of a scheme prior to the ‘maturity’ date. This is a massive further imposition on schemes, which we believe is entirely unwarranted. The Consultation narrative deals solely with requirements on or after the ‘maturity’ date.

3.32. The principles relating to the minimum requirements that a scheme is subject to on and after the relevant date under paragraph 3 of Schedule 1 are:

 a) the requirement to have sufficient and appropriate assets to have a funding level of at least 1:1 calculated on a low dependency funding basis; and

 b) the requirement for the assets of the scheme to be invested in accordance with a low dependency investment strategy.

 Whilst draft Regulations provide for schemes to stay at low dependency on their employer after significant maturity, we would like your views on whether some more risk taking could be permitted, provided this can be supported by high-quality contingent assets provided by another company within the group or a third party and is limited to, for example, five per cent of total liabilities. Contingent assets could include cash in an escrow account.

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Question 9:

 Should such limited additional risk at and after significant maturity be permitted, if supported by contingent assets? If so, to what percentage of total liabilities should this be limited?

 If supported by contingent assets there should be no limit on the total amount of risk permitted. This is a matter for the writers of those contingent contracts. We note that the phrasing of the 1:1 requirement of low dependency assets and liabilities implies that any deficit on an actual valuation date would be immediately due, and that there appear to be no deficit repair contribution schedules available to sponsor employers.

We believe that this latter solvency requirement will prove highly problematic, even with a low-dependency asset portfolio.

 What additional risks to members’ benefits might be posed as a result, and what safeguards should apply to protect members?

 The risks would be different rather than additional. In fact, as we show below, the traditional 60/40 equity/bond portfolio has materially outperformed a low-dependency portfolio. This low-dependency portfolio consists of a 12-year gilt strip and the 0.75% ILG due March 2036. The duration of this portfolio is slightly above 12 years. The traditional portfolio uses the 12-year gilt strip and the FTSE All-Share index. Figure 1 shows the performance of these two portfolios over the year from July 1, 2021 to June 30, 2022.

Figure 1:

Table 1 below reports some descriptive statistics for these two portfolios. The average prices are very similar, with a difference of just 0.5% in favour of the 60/40 portfolio.  The conventional lost 6.2%, some 5% less than the low-dependency portfolio at 11.2%. The difference in the range of portfolio prices is stark – 11% for the 60/40 and 21% for the low-dependency portfolio. The standard deviation of prices, a common measure of risk for the low-dependency portfolio, is twice that of conventional 60/40 portfolio.

Table 1: Descriptive Statistics of Conventional 60/40 Equity/Gilt Portfolio and Low-Dependency Portfolio July 1, 2021 – June 30, 2022

 

	60/40 Equity/Gilt	Low Dependency
Maximum	103%	107%
Minimum	92%	86%
Return	-6.2%	-11.2%
Average Price	100.1%	99.6%
Standard Deviation	2.32%	4.67%

Finally, Figure 2 examines the differences in the prices of these portfolios over time, which is worth doing.

Figure 2: Price Advantage Low Dependency minus 60/40

 

The low-dependency portfolio performance ranges from 6% better to 7.8% worse and underperforms by 0.5% on average.

This simple illustration shows that the concept of a low-dependency portfolio is imaginary. It may be extremely risky in both absolute and relative terms.

We may also examine effects of these different portfolios in a scheme setting using the same £120 million scheme as used in our previous blogs. We consider using these portfolio allocations for the first year after maturity has been reached. We assume the scheme is fully funded at that ‘maturity’ date. The coverage of total projected assets and the solvency ratio is reported for each portfolio. The discount rate used is gilts +50 basis points, rising from 1.47% to 2.95%, though we might consider this to be unjustified for the low-dependency portfolio, which is all gilt.

 Table 2: Liability Coverage After Maturity for a Conventional 60/40 Equity/Gilt Portfolio and a Low-Dependency Portfolio

 

		Projected Liabilities	Scheme Solvency
Initial		81.4%	100.0%
Final	Low Dependency	70.8%	103.7%
	60/40 Equity/Gilt	80.0%	117.2%

The Solvency ratio improves marginally for the low-dependency portfolio but extremely strongly for the traditional portfolio. However, the coverage of the projected liabilities falls by 10.6 percentage points for the low dependency against just 1.4 percentage points for the 60/40.

This provides a challenge to the requirement that a scheme “… must be fully funded, or in other words have a funding level (defined as the ratio of a scheme’s assets to its liabilities by section 221A(3)(a) of the Pensions Act 2004) of 1:1, on a low dependency funding basis”, as it shows that improving solvency coverage, which is based on the present value of liabilities, may be accompanied by an increase in dependence upon the sponsor employer, the reduction of which is the objective of this legislation.

In other words, the theoretical and analytical basis for the proposed regulations yet again demonstrates that it is not fit for purpose.