This is the testimony of a member of a defined benefit pension scheme.  It’s anonymous but none the worse for that. Anyone who is in a corporately sponsored defined benefit pension plan should be considering the implications of their scheme selling-out to an insurer.

The author of this blog is not Henry Tapper.

Premature buy-out?

This is a condition that affects an increasing number of pensioners and prospective pensioners in the UK.  I am a sufferer and my pain is increased in the current inflationary environment.

My Suffering:

I have just received my pension forecast for 2023 showing an increase of 0.5% over 2022 against reported inflation of 10.7% and  in the knowledge that if the events that triggered the buy-out of my pension had taken place 2 months later my annual pension would have been 4.2% greater.

While my particular circumstances and losses may be representative of only a relatively small group of sufferers, the unthinking dash to buy-out pension scheme benefits with an insurance company at the earliest possible opportunity appears likely to create a substantial new batch of pension scheme members who are at risk of becoming fellow sufferers in the years to come.

Underlying Problem:

Trustee Boards failure to recognise that their primary duty is to the Members of the Pension Scheme and to fully consider the implications of their actions on the beneficiaries of the Trust.

Symptoms:

1. Recent articles[1] suggest that it comes as a revelation to find that by delaying buy-outs by 5 years FT350 companies could expect to receive cash repayments totalling £70BN while at the same time increasing pension benefits by 5%. This is on the assumption that 2/3rds of the surplus should go to the employer and 1/3rd to the Members[2].  Why this split and why do the buy-out at all – if the employer is prepared to fund additional contributions to meet the increased cost of a buy-out over self-sufficiency, is that really reducing the risk to Members’ future benefits?
   

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2. The draft DB Funding Regulations state that the statutory requirement on Trustees is to ensure that the pension Scheme is in a position to pay the pensions as they fall due. In my opinion it is an admission of failure of the fiduciary duty of the Trustees to protect the Members interests when they admit failure and resort to the highest cost option of buying out the pension rights with an insurance company at the first available opportunity.  This does often appear to be undertaken without regard to the interests of Members or even an evaluation of the relative risks of running the Scheme on for a period of time or consideration of other alternative “end games” such as scheme merger, use of a consolidator preferably one that doesn’t itself target buy-out, or hopefully in future a conversion to Collective DC, all of which provide the opportunity to enhance Member’s benefits using the existing asset base of the Scheme.
   

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3. Although the Regulator denies this, the Pensions Regulator’s draft Code of Practice appears to be widely interpreted as requiring Pension Schemes target sufficient assets to match the highest cost option of buying out the pensions with an insurance company without having regard to the likelihood of the pension scheme actually requiring additional support from the employer. A large number of pension schemes are now reported to be in surplus, surely this means that such schemes should be in a position to pay pensions as they fall due into the indefinite future without further deficit contributions from the employer.  The surplus thus represents contributions paid by both Members and Employers in excess of what was required to secure the accrued pensions. Yet trustees are being encouraged to discount their fiduciary duty to use the assets vested in them for the benefit of the Members of the Pension Scheme.
   

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4. The Bank of England has reported that it made a £3.6BN profit on its market interventions after the LDI crisis in September. That represents a £3.6BN loss to pension schemes who in order to meet collateral calls had to sell their existing higher yielding Gilt holdings to the Bank of England at a reduced price only to buy them back again at a higher price and with a lower yield three months later.  If they had not entered into the leveraged LDI vehicle, the pension schemes would have had £3.6BN more to enhance Member benefits in a high inflationary environment.  The loss only occurred because Trustee Boards chose to fix the cost of the buy-out at time of exceptionally low gilt yields without considering the value that the buy-out represented at that cost against running the Scheme on a self-sufficiency basis, if only for a period of time.
   

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5. A recent article suggested that a survey of professional trustees indicated that a large proportion expected to retire within the next few years. This suggests to me such trustees took on the role as an ease into retirement and did not expect to have to consider the long term role of managing a self-sufficient pension scheme.
   

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6. The “risk reduction” actions now being suggested as appropriate where an immediate buy-out is recognised as not being possible (or should this be a buy-out at the valuation date?), include diverting the employer’s contributions into an “escrow” account [rather than having them invested by the Pension Scheme to generate cash income to pay the pensions as they fell due}; or to proceed with a partial buy-in at current gilt interest rates of say current pensioners ( and thereby foregoing the scheme experience / mortality risks of a pensioner only closed scheme); or to sacrifice a substantial part of the income stream of the Scheme to fund the assumed (historic) capital cost of a current buy-out through leveraged LDI, even though we are now in a raised interest rate environment. In such an environment, the assumption, so profitable to the insurance company, that the buy-out cost is related to the gilt yield comes under increasing pressure (there appears to be no evidence that insurance companies use gilts to match to their liabilities – instead making their profits from using higher yielding assets).
   

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7. Advisors promoting commercial products to the sponsors of the pension scheme on the assumption that the end game of buy-out is the only thing they should consider. Surely they should be trying to sell the product to the Trustees (In his presentation to the Work and Pensions Committee considering the LDI crisis, Sir John Kingman of Legal and General consistently referred to his customers as being the sponsoring employer).  While there will come a time when a pension scheme needs to be wound up that should only be when the ongoing administration costs avoided exceed the additional cost of the alternative product.  Until then self-sufficiency i.e. being in a position to pay the benefits as they fall due out of the Scheme itself should surely be the objective of all Trustees.  Alternatives to a buy-out as the end game do not appear to be considered, although at present they may be restricted to scheme mergers and also consolidators (here one of the current player’s product appears to be effectively a deferred buy-out) there are likely to be others which develop in the future (CDC looks particularly interesting, although there currently appear to be some issues around the draft Regulations affecting potential pension transfers).

My Case History:

I developed the condition as a result of being a member of a small to medium sized final salary pension scheme for more than 20 years which provided the then standard 1/60^th accrual rate and a generous level of inflation protection in retirement (uncapped RPI in my case).  In my belief that my pension was secure as the most recent actuarial valuation showed the Pension Scheme was 98% funded, the deficit recovery plan was realistic and not too challenging on the Company, and the Scheme income stream from a balanced portfolio covered the pensioner payroll and other outgoings several times over with inflation protection provided by index linked gilts and equity dividend streams (as you may guess I was not totally naïve in these matters although never a trustee), I took voluntary early retirement with an actuarial reduction.

Not long after the provisions of the 2004 Pensions Act had come into play, and after the Scheme had been closed to accrual a few years earlier, the then management of the Company controversially undertook a “pre-pac” administration, the sole aim of which was to force the pension scheme into the PPF (this was before the pre-pac rules were tightened). The excuse was that the most recent actuarial valuation had shown an increased deficit but in fact the only significant difference from the previous valuation was that the future income assumption had gone down to align with the gilt yield at the valuation date and which was also ½% below the gilt yield when the valuation was signed off, even though the actual income to the Scheme from dividends and interest had gone up over the three years roughly in line with inflation.  This was not long before my next annual pension increase.   My pension was therefore converted to the PPF basis and largely based on service prior to 1997 which has no inflation protection.

After some years being run as a closed scheme under their rules, the PPF refused admission deeming the Scheme to have been 108% funded for PPF level  benefits.  After a further delay, despite now having gone into the low gilt yield environment that followed the “Financial Crash” and also equalising GMPs, the Trustees secured a buy-out with an insurance company that provided a small uplift to some benefits (over PPF levels).  Gilt yields had fallen from over 4% to just over 2% in this period.   My pension was converted into an annuity with one of the large players.  In the next few years after the buy-out, I learned of the death of a number of my former colleagues (we are all of advancing years) including some of the most highly paid directors who had close to 40 years’ service (including a former CEO who in the early 1980s said “we must avoid at all costs allowing the pension scheme to fall into the greedy hands of the insurance companies”).

[1] Deferring DB buyout could provide a valuable uplift in rising inflation – by Sophie Smith, Pensions Age 9/12/22

[2] Under s37 of the Pensions Act 1995, only the Trustees have the power to agree a pay a surplus back to the Employer (subject to a 35% tax charge) and in exercising that power they have to be satisfied that the repayment is in the members’ interests.  They also have to give 3 months’ notice to members explaining why they think the repayment is in their interests.  Could be difficult to justify in a closed Scheme where pension increases have been and are capped at levels well below inflation.