It has long been a central tenet of UK policy that government should not seek to control or direct the investment of private sector savings. Such practices have been widely regarded as markers of ‘banana’ republics for almost as long. There is a very sound reason for this policy – without it, markets would cease to fulfil their fundamental economic role of allocating capital to the best use in terms of productive investment.
Indeed, the sponsors of DB schemes recognised from the very inception of these voluntary occupational pension arrangements that the cost to them had two elements, the initial contribution made and the implicit returns necessary to achieve the promised benefits. The investment returns from the initial contributions were no more than a device to defray their investment performance exposure and manage those potential further costs. Though this obligation may have been absent from black letter law, it was more than a question solely of good faith and morality; it was sound industrial relations policy, with a labour force of active members.
It is extremely doubtful that many sponsor employers would have created these voluntary schemes had government direction of their investment practices and allocations been seen as a serious prospect, as that could only too easily become another form of taxation by stealth – an explicit form of financial repression.
Risk misconceived and misunderstood
The proposed new Funding Regulations and associated DB Funding Code drive a coach and horses through that principle and do so without any consideration of the externalities and the costs this will introduce to UK financial markets. The impact assessments for the proposed Regulations and Code, where they even exist, are simply risible.
In order to justify such a breach, one should expect some truly momentous risk, but this not one that is immediately obvious. The risk is that of diminished pensions arising after sponsor insolvency from the lower Pension Protection Fund (PPF) compensation schedules. In other words, this is a risk arising from previously misconceived and mis-executed regulation.
There never was, and still isn’t, any economic justification for paying scheme members reduced pensions once a scheme had entered the PPF; the PPF could and should have paid the full benefits due to a scheme member. There is no moral hazard or adverse selection problem. Indeed, the existence of these PPF reductions introduces such potential problems, though fortunately they do not appear to have occurred widely.
The obvious question is: how large is this risk?
And the obvious place to start would be to ask what the experience of the Pension Protection Fund has been. Over the past 17 years, a wide cross-section of schemes has entered the PPF but the losses of members under PPF compensation have never been calculated. Perhaps the most telling statistic for the PPF is that there have only been three years in which the deficits of schemes entering the PPF have exceeded the annual levy receipts.
Schemes have overwhelmingly closed to new members and further accrual and so their liabilities are being steadily run off as pensions are paid. The degree of dependence on the sponsor employer in this dimension reduces with the passage of time. Moreover, as time passes and the pension amounts payable diminish, the ability of the sponsor to meet these payments, if required, increases.
The risk to members, by virtue of the PPF’s compensation structure, diminishes more rapidly than the dependence on their sponsors. It seems reasonable to estimate this currently at around 15% of pensions projected, which will diminish as pensioners in payment increase as a proportion of the scheme populations. With UK corporate insolvencies running at just 0.4% pa and likely to decrease in this population, the total risk is simply not large enough to warrant the proposed interventions that the new DB Code will create.
We can but conclude that the DWP and the Pensions Regulator see dragons where none exist. Moving to an asset allocation which exhibits ‘low-dependency on the sponsor’, which is simply code for moving to an all-bond portfolio, is entirely unjustified. As we saw with the recent gilt market turmoil, it is also not the low-risk strategy that either thought an all-bond portfolio was. Despite the recent evidence, DWP and TPR both continue to push a strategy of concentrated risk on sponsors and members. They are in effect attempting to make the Pension Protection Fund redundant. The one thing which is certain here is that if implemented as proposed, the costs to sponsor employers will far exceed any benefits to scheme members.
It is also not as if the Pensions Regulator has a stellar track record when it comes to directing pension fund asset allocation across the universe of DB schemes. Was it the hallmark of a skilled regulator to encourage investment (or to bully pension funds to invest) in a gilt market being rigged by the Bank of England under its quantitative easing programme aimed at artificially reducing interest rates and to encourage pro-cyclical investing?
As the Bank of England said:
Their promotion of LDI proved to be promotion of a strategy in which the gains of a decade or more could be and were lost in just nine months. The idea of not learning from the mistakes of the past is an error usually applied to the lessons of history. To not learn the mistakes of a crisis which is still unwinding goes beyond error and strays into very dangerous territory indeed.