Keating and Clacher take aim at DWP’s impact assessment

Tomorrow is the final day for responses to the DWP’s Draft Funding Regulations. This is the 8th blog from Con Keating and Iain Clacher on the inadequacy of these Regulations. In recent days we have seen a number of consultancies and pension schemes speaking out against the regulations including Willis Towers Watson who say that the Funding Regulations should be sent back to the drawing board. But I know of no other analysis of why the Regulations need to be changed that those that appear on these pages.

Iain Clacher and Con Keating

This blog considers the Impact Assessment which accompanies the draft Funding Regulations. It follows the same conventions and practices as the earlier blogs, which responded to questions posed in the Consultation on the proposed Funding Regulations. Links to the series of previous blogs are provided at the end of this blog.

We were surprised by these proposed Regulations; the Pension Schemes Act 2021 (PSA 2021) or its associated discussions and debates, simply did not prepare us for what is proposed. This is not some minor ‘mission creep’’ but a radical shift in DB scheme funding policy. The Impact Assessment would have us believe that these changes are extremely minor, verging on the apocryphal ‘free lunch’. The assessments are:

Total Net Present Social Value (in 2019 prices) (over ten-year period) £-2.4 m

Equivalent Annual Net Direct Cost to Business (EANDCB – in 2019 prices) (over 10-year period: £0.3 m)

“Social value refers to all of the impacts that an intervention, policy or project has on society and the value that these impacts have, both positive and negative. The social value of a project is the net value generated to society.^[1]”

We are unable to reconcile these figures with the narrative which follows. We note that the Impact Assessment accompanying PSA 2021 placed the costs of meeting only the requirements for Defined Benefit pension scheme trustee boards to appoint a Chair and to regularly prepare, review, and submit a statement on their scheme funding and investment strategy to TPR with their actuarial valuation as:

Total Net Present Social Value: £-148.9m

Business Net Present Value: £-148.9m

Net cost to business per year: £17.3m

These cost estimates are those of preparing and reviewing the statement, but the major expense is in deriving the scheme funding and investment strategy in the first place. The Impact Assessment does produce some estimates of the cost of trustee familiarisation with the legislation – a central estimate of £2.8 million with high/low estimates of £3.9 million to £1.7 million. These are simply not credible, for among other reasons, they omit any costs of consulting legal, investment or actuarial advisors.

Our assessment of the costs of full implementation is that this will be of the magnitude of £400 million to £600 million annually. To offer some perspective on this figure, it is an increase in total scheme administration costs of the order of 5% – 10%. We contested the annual net cost to business figure (£17.3 m) of this assessment at the time of its publication, as being too low, even in its limited setting.

In addition to which there is a funding contribution cost, which we and others have estimated to be of the order of £180 billion to £200 billion. We would estimate the initial familiarisation costs to be of similar magnitude to the annual service requirements. The investment, legal and actuarial consultants are in fact already marketing their services with respect to the proposed changes.

We accept that

“We will not be able to determine the full impacts and costs that are introduced by these legislative changes until the detail of all components of the regime are known – this includes the Pensions Regulator’s revised Defined Benefit Funding Code of practice which will contain more detailed guidance and specification on how to comply with legislative requirements in setting the Funding and Investment Strategy. …”

Means that this Impact Assessment is incomplete but it clearly does not conform to the later Impact Assessment statement:

“At this stage, we give a high-level assessment of possible business and other impacts.”

Nor is it consistent with the Consultation’s narrative:

6.4. At this stage, we give a high-level assessment of possible business and other impacts. The business impacts will mainly be for schemes whose technical provisions are currently weaker than that which would be required for them to achieve low dependency investment allocation and achieve full funding on a low dependency funding basis at significant maturity. We anticipate there to be minor familiarisation and implementation gross cost to business, partially offset by savings for schemes associated with improved clarity of the requirements.” [Emphasis Added]

For clarity, we shall reproduce here footnote 11 of the Impact Assessment:

”low dependency on the employer’ is defined as meaning that the scheme is not projected to rely on further employer contributions in respect of accrued rights. This means that the scheme must have sufficient low risk assets to provide for pension rights already accrued.”

We have discussed the feasibility, or rather impossibility, of this ambition in earlier blogs.

We find it completely unacceptable that Parliament should be asked to consider passing into law Regulations , which are as significant as this, when they have not even an elementary indication of its ultimate costs. If it is necessary to delay Parliamentary scrutiny until such time as the Pensions Regulator publishes it proposed new Code, and full estimates may be derived, so be it.

We turn next to the shape-shifting nature of the Regulations. The Impact Assessment accompanying PSA 2021 asks we consider (in thinking of the act)

“What are the policy objectives and the intended effects?

And concludes

These are to:

support good governance; improve trustee decision-making in relation to scheme funding by requiring trustees to explain their approach or how they are complying with legislative requirements;

support collaboration between the trustee board and the sponsor employer; and

enable TPR to enforce a stronger “comply or explain” regime for all Defined Benefits schemes in relation to scheme funding. [Emphasis Added]

Ultimately the intended effect is to enhance security of members’ pensions.”

This does not suggest anything like the radical changes being proposed by the new Funding Regulations. The shift in policy objective is evident from the introduction to the Consultation Impact Assessment:

“Policy Background – Issue – Rationale for Intervention – Intended Effects

Lack of long-term planning and poor risk management among some trustees in defined benefit (DB) occupational pension schemes presents the risk that their members will not receive the full benefits they have been promised.”

Trustees may have absolutely no long-term plans and truly terrible risk management capabilities, but unless the scheme sponsor fails, there is no risk to members. The risk to member benefits is limited in amount to the haircuts applied by the Pension Protection Fund, though there is a further risk, lying in the land of uncertainty rather than quantifiable risk, that the PPF will cut the benefits it pays – a power that rests as to future indexation with the Board of the PPF or for a cut to nominal accrued benefits with the Secretary of State (Pensions Act 2004, Schedule 7, paras 29 and 30).

The aggregate member risk for the universe of PPF member schemes summed over the future lives of all schemes, is small – £12.8 billion on central estimates, £25.6 billion on an extremely conservative basis. In fact, if all of the members of the scheme are pensioners who have reached their normal pension age[2], there is no risk of loss to members of their accrued nominal pension absent the remote possibility of the PPF having to cut benefits if the Secretary of State so determines, which seems unlikely given the political costs of such a move.

It is also perfectly possible for a scheme to consist entirely of pensioners in payment but not yet have reached its relevant date of significant maturity, where this is defined as a 12-year duration. Comparison of our estimated loss figures with the estimated increase in administrative expense suggests this proposed approach is grossly disproportionate; the administration costs are between 50% and 75% of the risk involved.

To reduce the risk to members the Pension Schemes Act 2021 requires trustees of DB pension schemes to determine a funding and investment strategy for ensuring that pensions benefits can be provided over the long term. [Emphasis Added]

PSA 2021 is silent on motivation. It is true that it requires trustees to determine a funding and investment strategy but that does not mean that it is necessarily the one now proposed by the DWP and the Pensions Regulator. We are concerned by such ex-post justifications, attributions of motivation, particularly when we read later:

“Through discussion with policy colleagues who have worked on the funding and investment strategy legalisation, the following assumptions have been made:”

Legalisation is defined by Wikipedia as the process of removing a legal prohibition against something which is currently not legal. Schemes are and always have been free to follow such funding and investment strategies as are proposed; it is the Regulations which seek to make these compulsory, along with a mechanism for enforcement. Absent such Regulations, it is this behaviour on the part of the Regulator that would be illegal.

The policy background continues with:

“The 2018 White Paper found that the scheme funding system was working well for the majority of (DB) pension schemes, but good practice was not universal. It proposed a package of measures to improve decision-making and governance for all schemes by delivering clearer more enforceable scheme funding standards, with a greater focus on risk management and longer-term planning.”

This is a very strange attempt at justification for a range of measures that will be imposed upon all schemes, when it is unnecessary for the majority of them. These Regulations impose standards which are far more onerous than previously, and it is far from clear that they are any clearer. It is interesting that the Impact Assessment invokes the 2018 White Paper, when the Regulations should be concerned with, and limited to implementation of the Pension Schemes Act 2021. It seems possible that this is tacit recognition that these Regulations go far beyond that and therefore need promotion, and that the Impact Assessment becomes a marketing instrument.

The Impact Assessment continues in this marketing mode:

“Some schemes were taking a short-term view of funding requirements and may not be effectively setting an investment strategy and managing the long-term obligations of the scheme and therefore inadequately anticipating or managing scheme funding risks. Severely underfunded schemes present a risk to members, the Pension Protection Fund (PPF) and ultimately other PPF levy payers. If the sponsoring employer of the scheme becomes insolvent then the scheme may have to enter the PPF, resulting in some members potentially losing 10% or more of their benefits.”

We would observe that it is the Pensions Act 2004 that imposes a short-term process upon schemes with the detail of statutory triennial scheme valuations and the Statutory Funding Objective (SFO). These Regulations maintain that incentive structure; it merely raises the level of the SFO. It also overstates its case and should read: Severely underfunded schemes may present a risk…

Then comes a remarkable and flawed leap of logic:

“Therefore, government intervention is necessary to ensure that schemes are making investment decisions in a way which results in the highest probability of members receiving their pensions in full. The draft regulations set out the key principles for setting and revising the funding and investment strategy and detail the evidence that must be provided in the statement of strategy.” [Emphasis Added]

It is far from obvious that the manner in which investment decisions are made can be influential with respect to the likelihood of members receiving their pensions on time and in full, when this is conditioned upon sponsor insolvency. it also raises a further question, which is that the payment of pensions on time and in full is and has been the trustees’ prime fiduciary responsibility all along. If some trustees have been in breach of their fiduciary duty, why have they not been prosecuted?

There then follows a

“Brief description of viable policy options considered (including alternatives to regulation)”

which states:

“We considered the following options:”

which are rather strangely numbered beginning with

“Option 0: Do Nothing”

The narrative for this option is:

“Leaving the system unchanged would not deliver improvements to the scheme funding regime. Funding standards would lack clarity, which would continue to lead to poor decision making by schemes, and TPR would continue to find them difficult to enforce. Although many schemes have a long term objective (LTO) in place, evidence suggests that a sizeable minority do not. As a result, members of these schemes would be at risk of poorer retirement outcomes, because of poor decision making outside the scope of existing TPR powers.”

It is debatable whether these Regulations constitute improvements to the scheme funding regime. We should like to know what aspect of the current funding regime lacks clarity, why the remedy for a failing of the Pensions Regulator should be further impositions upon schemes. The ambition is clear: an extension of TPR powers.

The Impact Assessment’s stated preference is for

“Option 2: Introduce secondary legislation to provide detail of the requirements in the Pension Schemes Act 2021 to:

Impose a duty on trustees to have a funding and investment strategy so that as a minimum by the time the scheme is significantly mature there is low dependency on the sponsoring employer and investments have high resilience to risk.

Require trustees to set out the funding and investment strategy in a statement of strategy that is signed by the chair of the trustees on behalf of the trustee board, who must appoint a chair if they do not already have one.

Introduce a new regulation, to be used alongside existing regulations to support clearer funding standards by clarifying key terms such as “appropriateness” and “prudence”, in secondary legislation.”

The third of these bullets does not follow from the Pension Schemes Act 2021. Neither ‘prudent’ nor ‘prudence’ appear in that. Similarly, ‘appropriateness’ does not appear, and though the word ‘appropriate’ appears eight times, in no instance is it offering clarification.

There is no such Regulation in the proposed Funding Regulations.

Again, neither ‘prudence’, ‘prudent’, nor ‘appropriateness’ in the Regulations; the context in the seven times in which the word ‘appropriate’ appears does not go to clarification of its meaning. Indeed, neither clarity nor clarify appear in the proposed Regulations.

We would refer readers back to our earlier blog 6, which discusses the concept of proportionality for which appropriate may be a synonym. The absence of the concept of proportionality, particularly in terms of the costs to sponsors and trustees in these Regulations and this Impact Assessment is noteworthy and of significant concern as to the cost of what is being proposed.

Moving to the section headed:

“Setting the long term objective – costs and benefits to businesses”

“Background information – scheme liabilities; and scheme running strategies and objectives”

We are informed that:

“The most relevant measures for the purposes of this impact assessment are the Statutory Funding Objective (SFO) and the International Accounting Standard Nineteen (IAS19):

Statutory Funding Objective: The “statutory funding objective” requires schemes to have sufficient and appropriate assets to cover its “technical provisions”. A scheme’s “technical provisions” (TPs) are defined as the amount required, on an actuarial calculation, to make provision for the scheme’s liabilities. Trustees and employers agree the methods and assumptions (which must be prudent) used in the actuarial calculation. The Pension Schemes Act 2021 introduces a new requirement for a scheme’s TPs to be calculated in a way that is consistent with the funding and investment strategy as set out in the statement of strategy.

In other words, Technical Provisions will increase substantially in amount and cost.

International Accounting Standards 19 (sic) : This valuation method is used when companies report their annual accounts. The methodology is set on a common basis to facilitate international comparisons.

The authors of the Impact Assessment appear unaware that:

the relevant accounting standard for the majority of companies is FRS 102, not IAS 19.
that the adoption of IAS 19 by the UK Endorsement Board is under challenge as it does not meet the criteria for its adoption and retention, including the legal requirement of being conducive to the long-term public good in the United Kingdom.

The Impact Assessment compounds this later with:

“However, when it comes to company balance sheets, the overarching DB liability measurement standard is IAS19 which is based on a standardised set of assumptions for schemes. We anticipate that this should not affect the IAS19-based deficits since it is based on standardised assumptions that are not likely to be affected by the changes.”

There is no “standardised set of assumptions.” Moreover, the authors of the Impact Assessment appear unaware of the obligation of preparers and auditors of accounting to report the substance of transactions, and where these are legal obligations, to report them accurately. The authors appear to be condoning misleading accounting practices and are likely to have their hopes of no impact dashed.

There is some discussion of contribution costs in the Assessment:

“for some the plan may be largely aspirational and does not drive funding and Deficit Repair Contribution (DRC) commitment. Such schemes will need to adjust their funding plans and sponsoring employers will need to fund their schemes in line with their LTO. Any schemes with a LTO which is currently weaker than low dependency funding by significant maturity will need to set a stronger long-term target as part of their new funding and investment strategy and must be funded to that level.”

This is an increase in scheme costs, plain and simple, but outside of the scope of this Impact Assessment. This admission is followed by a poor attempt to deny this:

“Employers are already required to fund the pension benefits and the new funding and investment strategy does not itself increase overall costs. But it may well bring forward contributions and increase costs in the short and medium term.”

It is true that employers are liable for the ultimate pensions payable but the cost to those employers is offset in whole or in part by the investment returns of the asset portfolio. Investing in low risk assets can be expected to raise the costs of provision to sponsor employers. Moreover, bringing those costs forward will raise the cost to employers; among other things, this may limit the sponsor’s ability to invest in their business activities and impair their growth potential.

The increased funding requirement is also recognised in the section:

“Costs and benefits to scheme members”

“There will be no costs to members as there will be no need for them to familiarise with the changes or implement them. The requirement is aimed to improve scheme funding. Better scheme funding is anticipated to improve the security of members’ pensions – i.e., to increase the likelihood of members ending up getting their pensions paid in full. It is not deemed proportionate to monetise this benefit.” [Emphasis Added]

There may be no direct costs to scheme members, but it is to be expected that their wage and salary levels will be lower to reflect the costs introduced by the Act, the draft Funding Regulations and the yet-to-be-seen final draft of the Regulator’s DB Funding Code.

We find it astonishing that it is not deemed proportionate to monetise the ‘benefit’ to scheme members; this is what motivates the Pension Schemes Act 2021, and these proposed Funding Regulations. It is not possible to determine the proportionality of the legislation without such a cost/benefit comparison. For more on the losses that may be experienced by member of schemes entering the PPF, see Box 1 below.

It is evident from our analysis that the total of these benefits is a very small fraction of the costs imposed by the proposed Regulations, and that they are totally disproportionate. The Regulations and this Impact Assessment are not fit for purpose.

Box 1

We have made enquiries of the PPF as to whether they have conducted any analysis of the cost to members of schemes which have entered the PPF. As they have treated this as a formal ‘Freedom of Information’ request, we expect a response no later than October 19^th. We have had no response as at the time of writing.

We thought it might be useful to remind readers of a few aspects of PPF ‘haircuts’ which are often overlooked.

PPF future indexation of PPF compensation can be cut by the Board of the PPF and the accrued pension can also be cut by the Secretary of State.

The batting order is future indexation until reduced to zero and only then the accrued nominal benefits. So quite a large buffer before the nominal benefit is hit.

Remember also that if you have taken early retirement there is a haircut of 10% (as well as the indexation haircut) if your employer becomes insolvent before you hit normal pension age.