In this blog, I give four recommendations to Government as to how they can improve the pension prospects for those in corporate defined benefit shcemes.
Too late to call for evidence -the evidence is with you!
In its call for evidence on options for DB schemes, the Government finds some evidence that they are underinvested in productive assets compared to international comparators. It asks for confirmation or contradiction.
I don’t’ mean to kick off my response by berating Government, but they have better data on this matter than anyone else. What they mean by “productive assets” is by now fairly clear, they are assets that move the UK economy forward by enabling British companies to become more productive. They might take the form of a bridge that allows goods to be transported quicker and with less damage to the environment or they might be capital to allow a fintech to build the technology that allows Mrs Miggins to set up new cakeshops, it’s for the Government to determine the definition and it’s up to pension schemes to decide whether to invest using the Government goalposts as a target.
What’s annoying about the question is that despite cries to the contrary, trustees have been doing what they are told on the disposition of scheme assets for 2o years and that has resulted in schemes now being invested in LDI (supercharged gilts) and low cost trackers which have invested primarily in listed securities weighted in line with world stock markets. Not only has this starved private companies of productive capital , it has meant that companies which would have listed in the UK, now list abroad.
This is (at least to Government) the unexpected consequence of the Pension Regulator’s demand that schemes de-risk by closing to future accrual, seeking buy out and eliminating dependency on a sponsoring employer. Keeping schemes out of the PPF has been the main aim and it has worked. The PPF is short of business and long on funds, bloated by levies paid to it to ensure it itself does not become a burden on the state.
The Government has asked for prudence and it has got it in bucket-fuls. But rather than accept what it knows full well, it asks the pensions industry for evidence, as if it had any choice in the matter. The Government has got us into this mess and now it is trying to encourage us out. For most schemes this is too late, they are gliding into the lock, there is no room to reverse.
There is a second question in this call for evidence
The DWP asks
“what changes might incentivise more trustees and sponsors of DB schemes to consider investing in productive assets while maintaining appropriate security of the benefits promised and meeting their other duties?”
To which the obvious answer is to encourage such behavior through legislation. Right now, most schemes are sitting waiting to go into the lock or waiting for the lock gates to close. They have no reason to purchase productive assets and every reason to invest in liquid assets that can be sold or passed on to insurance companies who will put employers out of their misery , by buying out the scheme’s assets and liabilities, allowing the trustees to retire.
Unless the insurers themselves are incentivised to invest in productive assets (something that looks highly unlikely even it Solvency rules are changed) then there are three obvious alternatives that the Government could encourage
Schemes could resist buy-out and persist in their original plan to pay pensions to the last man standing.
This option , known as roll-on allows trustees to evert to funding on an ongoing basis with a higher allocation to less liquid, UK focussed growth assets. But it carries residual risk that sponsors would once again be called upon to fund deficit contributions and show the scheme deficit on its balance sheet. Trustees will also be mindful that reliance on the sponsor risks putting the sponsor’s business at risk meaning the scheme might fall into the PPF.
LCP have suggested that trustees might pay a super-levy to the PPF to ensure that in the case that the sponsor fails, the members do not get a haircut, that’s a good solution for trustees , but not for sponsors (or the people who work for them). This blog has called for the Pensions Regulator to scrap parts of its DB funding code to encourage schemes to “roll on” rather than prepare for their imminent demise.
It would seem from a recent flash survey by Aon that there is a degree of support for the approval of “superfunds”, which to continue the nautical analogy – would take on the cargo of the occupational scheme and manage the journey as was the intention of the original trust (to the payment of the last pension).
This allows pension assets to stay invested as pensions (rather than insurance) and that gives fertile ground for productive assets to take root.
However, it falls short of the standards of member protection that TPR consider ideal. “Ideal is risk free” is still the motto. Until recently holding gilts was considered “risk free” but the LDI crisis has shaken that notion. Insurance companies are still considered “risk free”, but investing with insurers carries the risk that the 2 trillion pound golden goose, that is DB pensions, could stop laying golden eggs
Consolidation into pension superfunds is not more risky, it creates shared risks rather than transferred risks. The transfer of risks so obviates the possibility of upside, that were it to take over most of the assets, the Government would not just lose the opportunity of investment into productive assets, but a maintenance of the gilt investment that underpins its financing. As insurers don’t invest in gilts, the maintenance of pension funds investing in gilts and productive assets is attractive to Government too.
The argument for consolidation turns on the interpretation of “appropriate” in relation to member benefits. If the only appropriate security is insurance, as the Association of British Insurers would argue) then there is no place for consolidation.
The less defined benefit
As a coda to this response to Government, we should remind ourselves that most people are accruing a benefit that is defined only by the contributions made by them, their employers and the taxman. There is no definition of the benefit in terms of outcome – only speculation.
Between DB and DC lies a range of risk sharing options that have yet to be implemented. We all know that Royal Mail is on its way, though it has yet to kick off its CDC scheme. We know that one master trust – the Pensions Trust is discussing converting to a CDC scheme, at least for some clients (it seems the social housing sector are keen to move to CDC).
The risk sharing within CDC is of a scale more dramatic than the marginal questions on security between superfunds and insurance. CDC asks DB members to give up guarantees for future accrual and DC members to swap the prospect of a capital reservoir and freedom to spend, for a stream of un-guaranteed pension payments.
CDC is neither a variant of DC or DB, it is a different concept, which requires a new mindset from sponsors, trustees , Government and members.
But if the duties of trustees are to pay a pension (rather than a pot) and to invest productively (rather than for the short term) then CDC may be considered “appropriate security”.
A new mindset
There can be no change without a new mindset from everyone, and that includes Government. It would seem that with the arrival of a new team at the DWP and Treasury, we have that new mindset, it is articulated in the Mansion House reforms.
But while Governments come and go, trustees tend to stick around, as do pension scheme liabilities.
Whether this new mindset from Government lasts long enough to make a difference, depends partly on the response to these consultations. My response to the first two questions posed by Government is that we need to
- Change the mindset that led to the LDI fiasco, the DB funding code and the misappropriation of the term “de-risking”
- Encourage schemes where employers are prepared to sponsor by allowing a PPF upgrade in exchange for a super-levy
- Promote superfunds as an alternative to buy-out and roll-on
- Promote CDC as a means of providing future pensions for DC members and for DB scheme members prepared to swap guaranteed for non -guaranteed pensions.
It should be noted that will all these four options, there are opportunities to deliver better pensions than through buy-out , where there is zero upside beyond what is initially promised.
All four require an element of risk-sharing (rather than risk transfer).
All four require a change of mindset to accept that a risk shared , while still a risk, has an opportunity attached to it. If the Government believes its own projections, that opportunity is worth the taking.