Iain Clacher & Con Keating
This is the fourth in our series of blogs addressing the questions posed in the DWP’s Funding Regulations consultation. Links to previous blogs may be found at the end of this blog. We follow the same conventions as in previous blogs.
Before moving to our responses to the next questions posed in the consultation, we shall address a question posed to us as to our view of the nature of the fundamental issues at play and their consequences.
The fundamental problem with the proposed Funding Regulations is that they are in search of certainty, a rational impossibility. If achieved, absolute certainty would be a very strange world of unchanging beliefs, no matter what evidence is presented to challenge them. The problem with this approach is that it impairs our ability to adapt to new, shifting, or unexpected events and perspectives.
A recent article in Psyche by Thomas Costello and Shauna Bowes provides an insight:
“The philosopher of science Karl Popper went so far as to argue that absolute certainty is the foundational component of totalitarianism: if one is sure that one’s political philosophy will lead to the best possible future for humankind, all manner of terrible acts become justifiable in service of the greater good.”
It seems that, in our pensions case, the Pensions Regulator is to be the instrument enforcing subservience to the authoritarian State. It is evident in the ever-wider range of powers and penalties sought by and granted to the Regulator. The result of this will be increasingly authoritarian statements of their ever-more intrusive expectations of trustees and their sponsor employers – Orwellian ‘guidance’.
Functionally, this is a shift of emphasis from supervision, the enforcement of democratically determined external principles, postulates and rules, to invasive regulation – the interpretation and creation of rules. With this, the need for genuine accountability assumes a critical importance.
The purpose and effect of these ‘guidance’ instructions is to lead to a particular conclusion in a particular way. This precludes rigorous thought, which would allow trustees to develop their own conclusions. It also both creates and embeds systemic risk. If all schemes “de-risk” in the same way, and over similar time periods, when the world changes then everyone fails together. While this may be politically expedient, it is economically catastrophic.
The recent statement on refinancing is a case in point.
“… we expect employers to provide meaningful and timely information on debt and refinancing proposals, including debt transactions, to trustees. In addition to the legal documents, this could include forecasts, scenario analysis and other information provided to the lender as part of the process, that trustees may find helpful as part of their analysis and monitoring.”[i]
Most would regard refinancing as an activity falling within the ordinary course of business. Perhaps the Regulator would care to set the prices of the goods and services offered by sponsor employers, after all they may affect the quality of the sponsor covenant.
All too much of the Regulation is phrased in abstract, indeterminate language; to model anything concretely requires an analyst to preface that work with caveats concerning the interpretations made. The absence of any meaningful impact assessment makes this all the more difficult. It also, of course, increases the reliance of the regulated on the Regulator, when, given their lack of accountability, many would be wary of this. It also permits the Regulator to adopt its own dogmatic stance.
It also brings into stark relief the Regulator’s weak and limited objective, “to minimise any adverse impact on the sustainable growth of an employer” to extend it to one similar to that to be imposed by the Financial Services and Markets Bill on the FCA and PRA “to facilitate growth and competitiveness”. A change to the Regulator’s objective to align it with the FCA and the PRA given the reach of the Regulator would be more than welcome at a time when the overriding need for economic growth has rarely been higher.
While such a change would require primary legislation, an additional objective of “to facilitate the continuance and growth of cost-effective defined benefit schemes” would help to emphasise that taxpayers, employees, and employers all have an interest in the highest level of pension at the lowest cost, commensurate with a prudent level of security. Reckless prudence, as was noted in our first blog, has a direct and significant cost to the taxpayer.
The proposed Regulations seem to mark a pronounced shift from the ‘comply or explain’ of the current guidance Code to one better described as ‘comply or else’.
The Impact Assessment, which will be the subject of a later blog, places this motivation as a central justification for the Act, the proposed Regulations, and the new powers to be awarded to the Pensions Regulator.
“The practical details and metrics will be provided by The Pensions Regulator (TPR) in a revised DB Funding Code of Practice. These changes are necessary to raise standards and to ensure all schemes plan for the long term and mitigate risks in a maturing DB landscape. They are also needed to support TPR’s scheme funding powers by making clearer what all DB schemes are required to do.”
It is most interesting that the Impact Assessment dismisses simply making the existing Code more enforceable in favour of the far more onerous, if opaque, imposition of requirements and duties on trustees, along of course with new and extremely wide powers for the Pensions Regulator. which will place huge costs on the taxpayer and the employer, creating job losses, not new jobs, and weaken the employer covenant.
The Consultation continues with question 10, which is concerned with Investment risk on the journey plan.
Do you think that the provisions of paragraph 4 of Schedule 1 will allow appropriate open schemes to continue to invest in growth assets as long as that risk is appropriately supported?
We reproduce that paragraph of Schedule 1 below.
Investment risk on journey plan
4.—(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—
- 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 consultation acknowledges that:
“During the passage of the Pension Schemes Act 2021 through Parliament in 2020, Ministers committed to ensuring that secondary legislation does not prevent appropriate open schemes from investing in riskier assets, where there are potentially higher returns as long as the risks being taken can be supported and members’ benefits protected.” [Emphasis Added]
We note first that the concept of a journey plan has been introduced for all schemes, and that the ‘journey plan is itself an invention of the Pensions Regulator. We would favour a ‘journey plan’, which may be expressed as: ‘We intend to pay all pensions in full, when due, and will take such actions as are prudent (but not recklessly prudent) to ensure this. These will be appropriate to the circumstances then prevailing and recognising the long-term nature of the pension obligations in our investment strategy.’
While the regulation is limited to investment risk, we note that in general risk is a very slippery, intangible concept, which, without prior definition, may be invoked to justify almost any action. It is undefined in these Regulations.
The relevant amount of investment risk faced by a scheme or sponsor depends upon the total amount or value of the assets held, or liabilities outstanding. Other than in times of rampant inflation, or (incredible) increases in longevity, the exposure is strictly decreasing with the passage of time for mature closed schemes.
For open schemes, the annual liabilities rise and only begin to decline after many years have elapsed. As shown in Figure 1 below, we illustrate the position for an open scheme with a steady membership size, showing also the effect of adding three years of new liabilities. These total approximately 5% of the projected scheme liabilities in each year.
Figure 1: Open scheme with three years of new liabilities written
The duration of this scheme at a 5% discount rate is 17.34 years. The duration of the scheme after addition of the new liabilities will be 17.62 years. The present value of the total liabilities is 34.6% immediately and 38.1% in 3 years time. The scheme would currently reach a duration of 12 years early in year 18. In 3 years time the scheme would then reach a 12-year duration at the beginning of year 19 (from that future date).
The annual liabilities of this scheme do not begin to decline until year 25. If it now closed, it would reach ‘maturity’ under the 12-year duration definition 7-years prior to that. At that point in time, the proportion of pensioners in the scheme would be approximately 55%.
Question 10:
Do you think that the provisions of paragraph 4 of Schedule 1 will allow appropriate open schemes to continue to invest in growth assets as long as that risk is appropriately supported?
These Regulations impose constraints on the asset allocation of all schemes prior to reaching the point of significant ‘maturity’. There is no ‘carve-out’ for open schemes. This imposition seems foolhardy for any government, particularly at a time when public finances are under very considerable pressure. It will increase the cost of providing the scheme benefits, increase employer (and for some schemes employee) contributions, which are (in general) tax deductible. This will reduce tax receipts for HM Treasury, increase the likelihood of employer insolvency (higher employer contributions reduce the amount of free cash of the employer available for investment) and, increase the number of members whose pensions are reduced, on employer insolvency, to the PPF compensation level.
The structure of these constraints is highly questionable. If a sponsor’s commercial prospects diminish, additional funding demands will be placed upon them. Weakening a company in these circumstances is not sound risk management practice. Moreover, this practice would be pro-cyclical, exacerbating and prolonging a general economic downturn. Such an approach, as has been set out in the consultation, is wholly inconsistent with HM Treasury’s desire for the regulation of financial services companies to promote growth and competition.
We have already noted that these Regulations will require substantial additional funding, which will of course increase the dependence of those sponsors on financial market performance.
The regulation proposes that schemes with ‘stronger’ covenants may be permitted to assume more investment risk, but that term is undefined and incalculable. If it is to be required, it is not something that should be left to a Regulatory Code.
We note the presence of the qualifying “appropriate” in the question posed. Without definition, this renders the statement devoid of meaning and provides no comfort or grounds for confidence in scheme trustees. It is notable by its absence from the draft Regulation. It also leaves open the question as to who defines “appropriate” without any prior statement. We suspect that the judgement of “appropriate” will be left to the discretion of the Regulator.
The regulation goes further, it requires diminishing exposure to growth assets with the passage of time. This will bring forward the costs of introducing a low-dependency portfolio. We have earlier observed that the date of “significant maturity” is itself a movable feast, when defined in terms of scheme duration. This will greatly complicate the task of trustees in assuming acceptable levels of investment risk. It will also remove a source of long-term patient capital that could be used to help finance investible projects to assist the UK in meeting its 2050 net zero target and exacerbate intergenerational unfairness by favouring the current older generations who have over-emitted carbon. We wonder how these regulations can be considered consistent with the UK’s obligations under the Climate Change Act (2008)?
Moving on:
Question 11:
Do you think that the principles in paragraphs 4 and 5 of Schedule 1, requiring funding risks and investment risks to be linked primarily to the strength of the employer covenant, are sensible?
Paragraph 5 of Schedule 1 is concerned with “risk” in relation to the calculation of liabilities on a journey plan.
It is word-for-word the same as Paragraph 4 though it applies 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.”
The idea of linking liability assumptions to the quality of the sponsor covenant is far from sensible. The task of the actuary is to arrive at best estimates for the assumptions driving the projected values of liabilities, and these are independent of the quality of the sponsor covenant. These best estimates are then adjusted by trustees to comply with the requirement that their funding assumptions should be ‘prudent’, that is to say, more likely than not to be realised or improved upon. Even here, there really is no reason to introduce a complex dependence upon the sponsor covenant.
As we have observed previously, variation of assumptions can be used to game a duration-based measure of liabilities. The proposed regulation would mean that two schemes having identical liabilities with identical expectations for the actuarial assumptions would report different values for those liabilities; the strong scheme would report lower values (and a shorter duration) than the weak scheme. As with investment risk, as we discussed in the previous response, these measures would be inimical and pro-cyclical with respect to the broader economy.
We also note that the Institute & Faculty of Actuaries believes that before advising on the assessment of a sponsor’s covenant in relation to actuarial advice, pensions actuaries should consider carefully whether they are competent to do so, and that the actuarial training and typical pensions actuary’s experience is unlikely by itself to provide an actuary with this competence.
Finally, we would note that applying the same criteria to both assets and liabilities would operate in a multiplicative manner when the quality of covenant improves or deteriorates. We feel that it is the absence of a definition of risk which gives rise to these anomalies.
Question 12: Do you think that the new liquidity principle set out in paragraph 6 of Schedule 1 is a sensible addition to the existing liquidity requirement of regulation 4(3) of the Occupational Pension Schemes (Investment) Regulations 2005?
Regulation 4 (3) states that:
The powers of investment, or the discretion, must be exercised in a manner calculated to ensure the security, quality, liquidity and profitability of the portfolio as a whole.
Note that this is concerned solely with investment.
Paragraph 6 states:
(1) The principle in sub-paragraph (2) relates to the liquidity of the assets of the scheme—
(a) as it moves along its journey plan; and
(b) on and after the relevant date.
(2) The assets of the scheme must be in investments with sufficient liquidity to enable the scheme to meet expected cash flow requirements and make reasonable allowance for unexpected cash flow requirements
The benefit payments of a scheme are known with high degrees of confidence and provision is normally made for them in the ordinary course of business, in compliance with Regulation 4(3).
Cash equivalent transfers for deferred members in the period prior to 12 months before the scheme’s normal retirement age can prove demanding if, for example, bad publicity surrounds the sponsor. These liquidity demands can be managed by the adjustment of transfer values to reflect the liquidity realisation costs. In practice, however, few trustees commission “insufficiency reports” from scheme actuaries.
Of far greater concern are the collateral maintenance requirements associated with derivatives positions such as interest rate swaps, together with the collateral calls arising from repo exposures. In the first six months of this year, with swaps estimated to cover 50% of nominal interest rate exposures, and twenty-year gilt yields rising from 1.22% to 2.72%, a 25% decline in price, these calls may be estimated to have totalled £430 billion of total assets of £1.7 trillion. In addition, with repo exposures at 15% of scheme assets, and assuming 20-year index linked gilts as the assets ‘repoed’, these would have resulted in further calls of the order of 23% of assets, amounting to £58.6 billion.
The total liquidity strain associated with these positions, £488 billion, approaches 29% of net total scheme assets. These sums are far in excess of the normal precautionary levels of liquidity held for collateral management. Many schemes have been distressed sellers of assets.
Holding cash collateral against changes of this order of magnitude is simply not practicable. The investment drag would be punitive, and this approach is simply unreasonable. A standby line of credit of say 10% -15% of scheme assets, from either a bank or the sponsor, where these are cash-rich, would be far more efficient. This would allow the time needed for an orderly liquidation of assets.
We would also suggest that these collateral calls make evident the fact that repo transactions are not true sales, but rather disguised borrowing, and most likely ultra vires for trustees. Enforcement of Regulation 5 of the Occupational Pension Schemes (Investment) Regulations 2005, which prohibits the borrowing of money other than for temporary liquidity purposes, seems now to be overdue.
As the effects of distressed sales of assets are captured in the value and volatility of the portfolio to which the covenant quality formula is applied, there simply is no justification for also relating the liquidity of the fund in the same way.
Question 13:
Will the matters and principles set out in Schedule 1 enable the scheme specific funding regime to continue to apply flexibly to the circumstances of different schemes and employers, including those schemes that remain open to new members?
We believe that these Regulations will severely restrict the flexibility of scheme specific funding. As there is no carve-out for open DB schemes, we believe they will also be affected. If the webinar presented by Neil Bull as TPR’s update on their new DB Funding Code is a fair guide, flexibility will be further reduced by that.
For the first time, these Regulations involve the authorities in the choice and management of scheme investment portfolios. We would draw attention to the fact that both conventional gilts and index-linked gilts are offering rates of return far lower than long-term rate of inflation expectations. Such ‘low dependency’ portfolios will inevitably raise the costs of provision of pensions.
The additional liquidity regulations directly conflict with government policy to encourage the acquisition of illiquid investments and to encourage schemes to help finance the investments needed to meet the UK’s net zero obligation.
We believe that the regime is not realistic in practical terms and cannot be effective in terms of costs and benefits. Even if we were to believe that a holistic balance sheet approach could be achieved (a very tall order), it is intellectually and practically unsound to apply the same sponsor covenant quality formula to assets, liabilities, and liquidity. What is even more telling is that even the more risk averse EU abandoned the holistic balance sheet approach as unworkable. In a post-Brexit world, these do not seem to be the regulatory freedoms that the UK was meant to benefit from.
Links to previous blogs
[i] Refinancing in the current economic climate: our expectations of trustees and sponsoring employers | The Pensions Regulator Blog
