Dr Iain Clacher and Dr Con Keating
At nearly 17,000 words this blog is a quarter of a way to being a book. But it is an important piece of work and has become more important since HMT have published plans to repurpose the PPF as a consolidator. It is a critique of much that was said at a recent meeting – but more fundamentally it asks questions as to whether the PPF is fit and proper to expand its remit.
A Commentary on the PPF evidence to Work and Pensions Committee
Iain Clacher & Con Keating
Introduction
As a way of starting this analysis of the evidence given to the Work and Pensions Select Committee on the 8th of October 2023, it is worth asking the question whether the PPF has been a success. In its own terms, the PPF claims to have been just that, and now may be considered self-sufficient, having reserves of £12.1 billion and pension liabilities of £20.3 billion, which depending upon the choice of measurement would give the PPF a funding ratio of 156% or 160%.
The PPF underwrites private sector DB, stepping in to take over the management of pension schemes when their sponsor has become insolvent. In common with insurance, the risk which it is covering has two elements; it is the product of the likelihood of sponsor insolvency and the consequence of that event.
Here, the primary driver of this risk is sponsor insolvency and without an insolvency event occurring schemes do not enter the PPF. However, the PPF outsources the estimation of this risk to ratings agencies, rather than developing its own capabilities and it has done very little by way of management of this primary risk. It has only participated in the restructuring of a handful of companies to lower this risk and in most of those interventions, it has taken the pension scheme under its wing.
As such, the PPF has focussed on mitigation of the consequence of an insolvency event as opposed to limitation of the risk of the event in the first place. PPF also has, by statute, limitation of its exposure to the liabilities of schemes with a failed sponsor by the reductions of its benefits payable. It is interesting to note that these cuts were sold to the public and schemes as being rather inconsequential; a specious moral hazard argument was used to justify these cuts. As we have explained elsewhere, there is in fact no moral hazard which may be exploited by scheme members. The principle of moral hazard is simply that once an individual has insured something e.g., a garden shed, then they may no longer care for it and maintain and look after it and take reasonable steps to ensure it does not burn down for example. As such, by act of omission or, in more limited circumstances, commission fail to take reasonable care of it. There is no moral hazard vis-à-vis PPF as the scheme members are not the decision makers. The trustees of a scheme have a fiduciary obligation to the scheme, and the management of the sponsor company have a fiduciary duty to their shareholders. It should also be noted that not all schemes entering the PPF results in losses to the PPF i.e., with a deficit; schemes funded above the level of PPF benefits but below the s143 level (this is the level at which schemes may buy out benefits with an insurer) provide windfall gains to the PPF.
More recently, there have been calls for the improvement of benefits, given the considerable surplus that sits in the PPF. However, the PPF has produced analysis purporting to show these increases would be as large as 57% of liabilities, which seems excessive.
We have noted before the ability of the PPF to about turn. For example, in our earlier note Small Beer: A Sober Look at the PPF, which observed,
“…perhaps the greatest surprise is the remarkable degree to which the PPF’s submission of evidence to the DWP consultation differs from their earlier submission of evidence to the Work and Pensions Select Committee DB inquiry in late April 2023.”[1]
This scheme funding approach has been counterproductive. It has increased the likelihood of sponsor employer failure, the primary risk to the PPF materially, as is evident from the higher failure rates of companies sponsoring DB schemes. It has also contributed substantially to the decline in productive investment that currently is of such concern to government.
In the commentary which follows, we show the Committee questions in bold, PPF responses in italics and our analysis to these in red. We have deleted only the introductory remarks from the official record.
Work and Pensions Select Committee Hearing, 8th of November 2023
Witnesses: Barry Kenneth, Oliver Morley and Sara Protheroe.
Q167 David Linden: The Pension Protection Fund now has £12 billion in reserves. Is it time to remove the regulators’ objective of protecting PPF?
Oliver Morley: We have been fairly open, more widely, about that objective’s looking a little bit anachronistic now, given the scale of reserves and the funding level. What I will say is that we are obviously going to come on to some of the calls on those reserves in the future—not only changes to compensation, but potential claims that are still out there, even though they are looking less likely. So it is not completely true that the PPF is safe under all circumstances in terms of providing compensation on that basis, but it is looking much more likely that we are.
What I would say is that it is still really important that there is an objective for the regulator. Obviously. this is not my decision, but we still certainly believe that it would be worth having an objective specifically around the protection of DB savers.
This really does not answer the question posed. It is worth noting that the September 2023 PPF 7800 index reported potential claims of just £2.2 billion when the surplus is £12.1 billion. Later testimony makes much of the low-risk nature of their investment strategy. It is interesting that no mention is made of the conflicts that would arise if PPF were to become a consolidator given TPR’s various roles in approving both consolidator and individual transactions.
It was our impression at the time of creation of both TPR and the PPF that the objective was poorly drafted. To our minds, it was meant to deal with corporate transactions and that should continue. It was not about funding.
Note, also, the reference to ‘savers’ when these are pensioners. This is a recurrent feature of testimony.
Q168 David Linden: What would that revised objective look like, in your view?
Oliver Morley: I think it would be that wider sense of making sure—I would not want to get into drafting it—that there is clarity that DB savers are still a really important part of the pensions landscape, even if we make a transition to a world where there is much more DC.
Q169 David Linden: The 2022 review recommended that you work with DWP to ensure that the levy could be reduced, but of course raised again if needed. What progress have you made?
Oliver Morley: In terms of the PPF levy?
David Linden: Yes.
Oliver Morley: We have made very significant progress over the last five years since I joined the PPF. We started around the £600 million level in terms of levy collection, and our most recent consultation is bringing that down to £100 million. As someone said to me, it is a rare thing, particularly in these days of indexation, that you will see costs reducing. We have made very significant strides in reducing levy over that time.
The total levy collected since inception of the PPF has been £9.4 billion while the surplus is £12.3 billion. Indeed, it would appear that the levy and the investment income generated by it account for almost all of the surplus.
The levy was always too high. It appears that the Board of the PPF was able to take advantage of industry participants who were trying to oppose a PPF by saying the estimated costs were too low. On a very prudent set of assumptions, it should have been £300m a year, not the £600 million seen.
Q170 David Linden: Assuming that necessary legislative changes are made, what are your plans for the levy?
Oliver Morley: Certainly, if we had the right legislative framework, which would allow us to put up levy in a case of either significant changes on compensation or, indeed, large claims, then we would certainly be able to take levy—notwithstanding those two possibilities—to zero, ideally, over time.
Q171 Sir Desmond Swayne: Comrades, you were listening attentively to the demands that we discussed on indexation earlier. Which of those would you be prepared to accommodate? If you were, should the rule be an equality between FAS and PPF, and should any indexation of pre-1997 benefits be restricted to the original rules that members had signed up to in their schemes?
Oliver Morley: I will ask Sara to take you through some of the figures. Going to the point about the £12 billion in reserves, I think it is clear there are options for Government. Notwithstanding Roger’s comment, we have made absolutely sure that the representations of the Deprived Pensioners
Association and others have been made clear to the DWP and Ministers more widely. We think it is really important that that is transparent, and we have tried also to be transparent with the Committee in terms of the options.
These are choices we feel should be made by Government, because it is not true to say that the PPF is, effectively, a free fund; the reserves of the PPF are included in the whole of Government accounts, so they are offset against Government debt. It is important to note that any increase in spending on compensation for the PPF is, effectively, still borne by the taxpayer from that point of view, because of the implications for debt.
This latter paragraph is economically incoherent. The surplus would constitute an asset in the whole of government accounts (WGA); there is no ‘offset’ in that it does not reduce government borrowing. It simply lowers the net indebtedness figure reported. The WGA contain PPF liabilities of £28.9 billion as at March 2021 of which £1.1 billion were current liabilities. The WGA reports remote contingent liabilities of £140 billion while the PPF 7800 index reports the total shortfall for all schemes in deficit as £62.9 billion. The PPF annual report at this date reports assets, net of investment liabilities of £9,055.4 billion, as £38,017.5 for a net surplus of £9,057.3 billion.
We would also note that the PPF is highly leveraged (£9,055.4/£38,017.5) at 23.8%. As the source used by the WGA is the PPF 7800 index we would have concerns over the difference of £196 billion between PPF and ONS estimates of aggregate scheme assets at March, 2023. However, that was not a concern at the date of the most recent WGA, March 2021, when the PPF reported aggregate assets of £1,669 billion revised down from £1,721 billion while ONS reported assets of £1,706 billion revised up from £1,696 billion. TPR reported assets of £1,717 billion.
The PPF also appears to have a policy of not drawing attention fully to its revisions – instead simply changing the entries in the historic data spreadsheet.
So, it is a choice that we feel needs to be made more widely. I do not think the PPF should be in a position where it is making those decisions, even if I think there is a good case, on equity grounds, around pre-1997; certainly, I think some of the witness testimony there was compelling.
Sara, do you want to give a comparison on some of the costs?
Sara Protheroe: Absolutely. As was recognised in the first session, our primary role is to implement the existing legislation, but we think we also have an important role in informing the debate about any potential future policy changes. That means sharing the member concerns you have just heard with colleagues at the DWP, but it also means providing analysis about potential future options, which we have obviously done with the Committee, both from a financial point of view and in terms of the wider implications for the broader pensions system. We have shared with you costs that range from about £2 billion up to £12.3 billion—so there is a very significant range of costs—on the PPF side. We have shared some higher-level costs on the FAS side, looking at paying pre-1997 increases prospectively at CPI, capped at 2.5%. That would add £1 billion to FAS liabilities over the lifetime of those payments, with £57 million being paid out in the first five years.
These figures are meaningless other than perhaps for the FAS. The sharing reference is to Oliver Morley’s letter to the committee of 27th October which contains many figures for possible changes but contains insufficient information as to the assumptions and parameters, such as the future inflation curve and discount rates, under which they were derived. We have learned to treat PPF published analysis with a great deal of caution. we supply an illustration of this concern as Appendix A to this commentary.
We would also note that the figures contained in that note seem very high. We are asked to believe that reinstatement of full benefits could increase costs by as much as sixty percent. This is far higher than any of the estimates produced at the time of the creation of the PPF and the fixing of their compensation terms. It is also not consistent with the differences between the Pension Regulator’s estimate of scheme TP liabilities and the PPF s179 7800 index numbers. In the absence of full publication of the modelling and assumptions, it appears possible that someone is being ‘actuarial’ with the truth.[2]
Your question covered quite a lot of ground: it covered the PPF and FAS. As was mentioned in the previous session, it is important to recognise that, typically, a greater proportion of FAS member service was before 1997; 92% of FAS members have pre-1997 service, and 40% of those FAS members have only pre-1997 service. So, this issue has a particular impact on FAS, but again, as covered in the previous session, FAS is funded by general taxation, so there are particular considerations there in terms of the funding source. But we do understand the concerns of both PPF and FAS members.
Q172 Selaine Saxby: There have been improvements in DB scheme funding levels over the last year. Within this overall positive picture, what do you see as the main risks to the PPF?
Barry Kenneth: Well, of course, most of the funding level improvement been a back-up in long-term interest rates, and obviously that has been improving funding levels through the last two years, since we have, effectively, come out of the quantitative easing programme.
n terms of risks to the PPF, obviously the higher the funding levels, the less risk there is to the PPF, specifically on the basis that those funding levels have been locked in. So, I think one point worth considering is this: how much of these funding levels has actually been locked in and, if there is a reversal of interest rates, do we end up in the position that we were in before?
In general, funding levels have improved, so that is a positive for us and for the overall community, but it is important that the universe of schemes continue to risk-manage these schemes and ensure that they can lock in the funding-level improvements they have had.
The emphasis here on locking in gains is deeply concerning on several levels. It would mean that increases in longevity and inflation, if they were to occur, could not be accommodated, without further sponsor contributions. It would also mean that schemes could not invest their surpluses in productive assets which are riskier than government bonds. It also fails to recognise that there are many schemes which are not in surplus even on a technical provisions basis. If the ONS estimate of assets is correct, much of the improvement in funding levels would be seen as illusory.
The funding levels reported are:
Where the liabilities are taken as TPR’s estimate. We expect the first ONS analysis of liabilities to be published in late November or December of this year. If we take the ONS figure for assets, the PPF funding ratio would decline to 115.1% from the 133.2% published.
There is however a higher, more important, public policy concern. If schemes are ‘locking in’ gains, they will be unable to pursue the productive investment agenda.
Q173 Selaine Saxby: Would you be able to track the extent to which they have been able to lock them in?
Barry Kenneth: Like any data source that we get, it tends to be retrospective, and we will get different scheme funding levels through time. What I can tell you is that, obviously, I am involved in and dealing in markets every day, and I would say the level of demand for liability protection over the last 12 months has certainly been less than it has been previously. The jury is probably out on how much of that funding level has been locked in. Many schemes have now given their long-term plans. You would expect that, as funding levels improve, they continue to reduce the volatility in their schemes in order to get to the end solution.
Of course, the level of liability protection would decline, as the value of liabilities has fallen since December 2021, by PPF estimates from £1,688.7 billion to £1,080.5 billion, some 36%. Repo leverage has also fallen, by 36.4%, over this time. It would appear that the level of ‘lock-in’ is actually (proportionately) around the same as it was at the beginning of rate rises.
Q174 Selaine Saxby: Are there any underfunded schemes that are of particular concern?
Oliver Morley: Generally, we obviously do not talk about them more widely. We work very closely with the regulator on concerns around particular schemes and particularly where there is a potential for insolvency. At the moment, I would say that the overall level of insolvency, particularly in our universe, is very low. The level of risk and indeed the overall volume of claims—even though we have obviously had a relatively high-profile one recently—both in terms of numbers and liabilities, has been relatively low recently.
Q175 Siobhan Baillie: Barry, I would like to look at the significant decline in asset values. We have got the PPF estimate at about £400 billion lower than the ONS estimate at £626 billion. I think that, looking at the prep we were doing, the ONS starts from a higher place at over £2 billion. Can you explain the difference between your assessments and is there work under way to try and agree a figure with the ONS?
At December 2021 the ONS figure was £1,821 and the PPF £1,818.0 billion – this difference is not statistically significant.
The difference has actually grown steadily over this period:
£bn
The PPF now offers this note of their asset values:
“We have produced this update using our standard methodology, which is summarised in Note 4 on page 7 of this document. In particular, while the approach will capture the liability impacts of government bond yield movements, the impact on assets will often be less accurate. This is because we do not hold sufficient data to capture the impact of any structural changes to asset allocations nor to accurately capture changes in any leveraged LDI portfolios.”
Of course, over this period both structural changes to asset allocation and leverage have been extremely significant. Indeed, one possible interpretation of this difference is that it is the cost to schemes over and above the basic movement in interest rates.
Barry Kenneth: First, we have had engagement with the ONS in terms of their data collection. I think it is worthwhile pointing out that the rationale for the collection of both sets of data is different, and the construction of how we extract the data is different.
From a PPF perspective, we obviously take the last funding levels of schemes that we have on a section 179 basis and project that forward. There is an element of an expected movement through the roll-forward basis. The ONS has a smaller sample of schemes; I think they sample about 900 schemes broadly across both DB-DC and some hybrid schemes, and their extraction of data is every three months.
The ONS DBH sample is of 614 schemes.
In an attempt to reconcile the large differences between the ONS figures and those of the PPF, we have estimated[3] full sample response statistics and obtain the following:
Our estimates of the full sample response show a decline in asset values of 21.2% over this year. This means that the non-sampled mainly smaller schemes show a decline of 40.7%, from £516 billion to £306 billion. This large decline in smaller schemes accords with some of the anecdotal ‘horror’ stories we have heard. By contrast, for the PPF numbers as reported to be correct, we would have to have seen the assets of these non-sampled schemes rise from £479 billion to £502 billion. This PPF increase conflicts badly with what we know has happened more broadly in markets and so these smaller schemes cannot have been immune to this.
It is also worth noting again that there is reference to the purpose of collection. The amount of assets held by schemes is a fact. The only difference that could arise is in the basis of the valuation of certain assets. The valuation of buy-in policies held by schemes should be higher for the PPF than schemes as those policies pay full benefits, not PPF reduced benefits. It might also be possible that private investments are worth more to the PPF than to other schemes, but there are concerns currently that schemes are already overstating these values and at a total of £81 billion for all schemes, these investments are hardly likely to be material in that regard.
From an asset-side perspective, the ONS has a different data set than we have. We are trying to do slightly different things, whereby we are trying to look at the risk on the PPF’s balance sheet in terms of what schemes may come into us. The funding level is extremely important on a section 179 basis.
Yet again the fallacious “difference” in purpose assertion. The value of assets should be an objective fact with little difference in values irrespective of who is collecting the data, and this was this situation when there were small but immaterial differences between TPR, PPF, and ONS at the figure below shows. It is not that there is a difference in purpose, it is that there is a material difference in estimate.
To my understanding, the ONS is more dedicated to the asset side valuation, of which it takes a different data set on. There are differences for the reasons I have explained. Are we trying to get to a homogeneous place? I do not think so. We collect data for our balance sheet and for the risk to the PPF. We are quite comfortable in the methodology with which we collect data. As I said, I think the ONS collects it for a different reason.
In fact, there has been no explanation of the difference (£196 billion), merely assertions without foundation.
This complacency is not becoming of an official statistic. We are talking here of asset values. About the only significant difference should arise from the fact that buy-in policies are worth more to the PPF since they pay benefits as promised by the scheme rather than the reduced benefits of the PPF. These differences are however small – as may be seen by comparison with TPR’s estimates in figure 1 below:
Figure 1: PPF, TPR and ONS estimates of scheme universe assets: December 2021 to March 2023
Oliver Morley: We are very keen that we understand the differences and that we work with the ONS, but the data is effectively collected for two different purposes. The other thing I would say is that of course an asset value decline inherently is not a bad thing if the other side, i.e. the liabilities, have gone down at the same time. There was some reporting around asset prices going down. As long as the other side—in terms of pension liabilities—is going down simultaneously, that effectively reflects a good hedge, as opposed to bad news across the board.
This is a different tone from that of Barry Kenneth earlier. However, the purpose to which data is to be put is not relevant. Other than for the small differences in value mentioned earlier, the values of assets are facts. The difference from the ONS we see with TPR’s data is £181 billion, £15 billion less than the PPF difference,
Q176 Siobhan Baillie: My next question was going to be about the extent to which, and under what circumstances, does the decline in asset values have a negative impact on the scheme. I think you are saying that, if the other side is not going down, then that is where it has the negative
impact. It is case by case.
Oliver Morley: Generally, in terms of the markets, it has been more than offset by the liabilities, and that is as a result of the interest rate changes. You would see a problem if asset prices have declined without a related decline in liabilities.
This is true, but as we illustrate in Appendix B, the effects of LDI are asymmetric. In the real world we are unlikely to see such proportionate declines arising from those strategies unless they are of the projected cash flow matching type (dedication).
Siobhan Baillie: Do you want to come in, Nigel? You were sucking teeth—noisily.
Q177 Nigel Mills: I suppose it wanders us back into the accounting questions, doesn’t it? If I have invested in index-linked investments and inflation just changes the assets and the liabilities because it is the same calculation, that makes sense, but there is not necessarily a logic for why. If interest rates go up, your asset value has gone down—it is just a function of the accounting methodology we are using, I suppose.
Barry Kenneth: I do not think it is just accounting, ultimately. Effectively, if you have a long-term payment to make and you buy some form of fixed-income security in order to make that payment, then the value of the asset and the prospective payment should move in tandem.
This is not answering the question. What is described is cash flow matching rather than the matching of transitory variation in the present value of liabilities with scheme assets, which is what is achieved with LDI.
You can maybe look at it as an asset-side issue, whereby you can turn around when rates were lower and say there is a hurdle rate in which to meet liabilities—let’s say when interest rates were closer to 1 or 2%. The asset side needs to generate 1 or 2% in order to meet that liability. Now, given that interest rates have gone up, for the same liability the hurdle rate increases. With interest rates now around 5%, the asset-side hurdle needs to be 5% in order to make that long-term payment.
In other words, schemes have increased materially in risk to their sponsors who are liable now for any shortfall relative to 5%, not the previous 1% or 2%. In addition, the cash outgo on pension payments has increased as a proportion of scheme assets. This means that if asset sales are needed to meet pension payments, they are now much more significant. The schemes are now riskier to all involved.
So fixed-income solutions do allow the volatility of that payment and the certainty of that payment to be realised. I do not think it is just an accounting point.
This would only be true in a world of perfect foreknowledge and total accuracy in projections – when in reality these elements are of radical uncertainty, and ultimately unknowable.
Q178 Nigel Mills: I suppose if pension schemes have invested in gilts, you have still got all the same cash flows you thought you were going to have—it is just that in theory, if you wanted to sell them, they are worth less because there are new gilts at a higher rate. You could have an asset value reduction on your balance sheet, but in actual fact it does not change any of your future cash flows, so it is a slightly counter-intuitive position, isn’t it?
Barry Kenneth: It leads us back to Oliver’s point. In terms of the asset and liability values, if you’re holding a gilt versus a liability, if the gilt value goes down and the gilt is used to hedge that future payment, the asset value deterioration and the liability value deterioration should be equal—
which is no different from the converse side of that post-2008 when the liability values increased materially in value but, on the same side, if you were holding Government bonds at that point in time they would have increased at the same rate in value.
This would only hold true if the scheme was using the yield on the gilt held to match the cash flow of a particular cash flow rather than the notional gilt curve. There would then be difficulties in aggregating these across the entire sequence of pension payments. Most importantly, this ignores tax effects.
While schemes may not have these considerations, many other market participants do. The result is that bonds trading at large premiums to their par value tend to be cheap relative to the ‘curve’ and bonds trading at large discounts to parity tend to be expensive in terms of their yields to maturity. Indeed, these effects are the basis of a well-known bond management strategy, the ‘convexity trade’.
Q179 Nigel Mills: It just makes you wonder how meaningful these numbers are, doesn’t it? “I’m holding a gilt, I’m going to hold it through to maturity—all I really care about is the future cash flows that are coming in to meet my outgoings, and yet somehow my balance sheet has materially changed by £400 billion in the last year.”
Barry Kenneth: The actual expected payment you would receive would be the same regardless of the mark-to-market variability through time.
But it is larger in terms of the value of the portfolio.
Nigel Mills: Yes. It doesn’t actually give me any useful information as to whether I am going to be able to meet my pension obligations at all. It is just a point-in-time set of assumptions that do not tell us anything.
Q180 Chair: Can I pick the point up a little? The figures you have given us— asset values of £1.8 trillion, and now £1.4 trillion. That is a huge fall. How much of that £400 billion would you expect to come back if, or when, interest rates go in the other direction? It certainly isn’t all of it, is it? Is it any of it?
Barry Kenneth: If the £1.4 trillion of assets you talk about was purely invested in fixed-income related assets or Government bonds, and the current liability was £1.4 trillion—without going into too much technical detail, that is discounted cash flow. Cash flows you make in the future—you discount a certain value to get to today’s value. If you discount that the gilt yield, then you will have equal and opposite for your assets and liabilities. Through time, if long-term interest rates fall, both the assets and liabilities of any scheme will increase. If interest rates continue to rise, then you would expect the assets and liabilities both to fall.
This assumes that all of the losses are attributable to changes in yields and that there have been no material effects due to scheme dealings. Schemes have in fact sold many assets to meet margin calls on the derivatives positions held as a result of Leveraged LDI, and at prices often far from their values at the beginning of the year.
Schemes sold some £3 – £5 billion of private investments as best we can estimate at discounts of around 25%. Schemes sold sufficient overseas investments that the repatriation of those funds reportedly caused sterling to strengthen on the foreign exchanges.
It appears possible, likely even, that the £196 billion difference between ONS and PPF figures can be explained by such effects. We have the £3.8 billion lost to the Bank of England, but much more importantly, there is the £49 billion lost due to the leverage of schemes and the £51 billion of funds paid into pooled LDI funds.
There are obvious other effects such as the extent of the fall in index linked gilts but we do not know what if any account the PPF roll-forward model takes of this. When a single large scheme reports a decline of 46% in its LDI portfolio and massive reorganisation of its other assets, it is not difficult to come to believe schemes overall may have incurred costs £80 billion plus from those activities.
These losses will not be recovered if rates fall again.
As the gentleman explained there, mark-to-market through time is just a point-in-time valuation. Ultimately, when we are putting these types of strategies in place, you are doing it with the future cash flow payment you are expected to make in time—you are trying to figure how you actually meet that payment with a large degree of certainty. Buying fixed-income instruments allows you to do that.
This is only true of the super expensive cash flow matching, ‘dedication’ approach. In fact, what most were doing as LDI was not this, it was an attempt at capturing the sensitivity of portfolio liability valuations to further interest rate declines. See Appendix B for more detail on this.
Q181 Chair: But how much of the £400 billion loss do you think resulted from the LDI problems and those particular difficulties?
Barry Kenneth: Most of it, I suspect. [Let us say he misspoke here] To say it is a loss—it is a fallen asset value, but in the same vein as that when interest rates deteriorated, the value of these assets and liabilities would have gone up, so they are just changes in values.
This is grasping at the distinction between realised and unrealised losses, but it should be recognised that even unrealised losses may not be recoverable. Index linked gilts are the prime example where that may be expected to hold true. For example, the 1/8th % ILG 2068 is most unlikely to return to £334 – its December 2021 high – from its current price of £61 even if conventional rates decline to 1.2% again.
But we are here to try to build an asset allocation, like many of my colleagues and peers out there, to try to meet these compensation payments that have been defined, in the future. Part of that strategy will always be to invest in fixing—
This is describing cash flow matching but that is not what the PPF or most LDI players have been doing.
Q182 Chair: Can I push you a little bit on this LDI point? You are saying that most of it, if not all, was down to the LDI problems. A lot of panic selling happened at that period, as we have heard in the Committee. That is not going to be recovered at any time, is it?
Oliver Morley: Sorry, just to clarify—Barry can correct me if I am wrong—that the asset decline is not due to the LDI problems per se. Some amount of that will come from the LDI problems—the fire sales, as Barry spoke about. The decline in assets comes from the liability-driven investment approach as a whole, as in using fixed income to effectively hedge the liabilities. So, it is not the problems, per se, that created that asset decline.
This is a rather indirect way of saying that the increase in interest rates is responsible for some of the decline and the actions of schemes for some more. Indeed, we would suggest that the £400 billion decline registered by the PPF could all be attributed to rate increases while the ONS captures both the effects of interest rate increases and the actions of schemes. This would be consistent with the PPF’s caveat to their methodology:
“We have produced this update using our standard methodology, which is summarised in Note 4 on page 7 of this document. In particular, while the approach will capture the liability impacts of government bond yield movements, the impact on assets will often be less accurate. This is because we do not hold sufficient data to capture the impact of any structural changes to asset allocations nor to accurately capture changes in any leveraged LDI portfolios.”[4] (Emphasis added)
Q183 Chair: How much of the £400 billion do you think was caused by the fire sale problems around September of last year?
Barry Kenneth: You are effectively talking about the actual loss that these schemes, from a balance sheet perspective, have lost?
Oliver Morley: As a short-term disruption.
Barry Kenneth: I think it is difficult to tell. For those schemes that were able to hold the asset, or hold the LDI fund or security or Government bond: by definition, if they haven’t sold it, it would still be there in order to pay for the future liability. Where the losses would have come is for the schemes that have invested in these securities or these products—pooled funds—that were forced liquidators of these funds and were not able to then hedge back into the market.
This fails to consider the fact that much of the disruption and losses arose not from the forced sales needed to meet immediate margin requirements at the time of the crisis but from the reallocations of assets effected by schemes both before and after the crisis weeks. Half of the PPF / ONS asset disparity had occurred by June 2022, and it appears that the reallocations only finally ended in June 2023. July was the first month in which repo exposures by schemes rose by our estimation, as well as a small increase evident in the Bank of England’s Bank stats M4L series (by 5.8%, June – September).
The growing disparity is shown here:
What I can say is that the values of long-term interest rates today are not quite back up to where they were at the time of the crisis but have certainly moved back there post the Bank of England’s operations of buying gilt securities at that point in time.
Q184 Chair: Is it possible for you to estimate the aggregate value of the fire sale losses through the mechanism that you have just described?
Barry Kenneth: I think we will find that through time, because different schemes are in different positions.
As schemes report full triennial revaluations the full extent of the losses to schemes should become evident. This may though only be seen in terms of the disparity between ONS and PPF estimates closing over the full three-year cycle given the possible confounding effects of further interest rate volatility. It is still staggering and hugely concerning that nobody has a full picture of where the sector is at.
Q185 Chair: How long do you think it would take us to find it?
Barry Kenneth: I think that will depend on the data we receive, but I imagine it would be years until we find out the true extent of what has actually happened for each individual scheme.
This is likely to prove the case.
Q186 Siobhan Baillie: There is a real-life scheme in all our post boxes, because Wilko has stores near all of us—we have lost jobs everywhere.
We understand that the Wilko scheme used LDI and lost about £30 million of assets. We understand it also might be entering the PPF. Are Wilko members likely to experience an absolute loss? Sara, can you tell us about any conversations or engagement with Wilko?
Sara Protheroe: The Wilkinson Group pension scheme has entered a PPF assessment period, and this is precisely the situation that PPF was set up to deal with, which is employer insolvency. Member payments are continuing uninterrupted, and those above the scheme’s pension age are receiving 100% of their starting pension. It is hopefully a reassuring time for members, where they know they will ultimately receive at least a minimum of PPF level of benefits, if not more. As is usual, we take on the creditor rights during the assessment period, and so we will be actively seeking to maximise recoveries from the employer.
Q187 Siobhan Baillie: Can I turn to Barry on the LDI involvement with Wilko?
Barry Kenneth: In terms of the data that I have seen thus far, the LDI programme they adopted was there to hedge the scheme, so they have not over-hedged the scheme. For any paper loss that they would take on the asset side, there would be an equivalent write-down on the liabilities side. Their LDI programme, per se, did not cost any money, but they have adopted that programme in order to hedge their liabilities. I would expect to see an equivalent on the liability side to what you would see on the asset side.
We have seen only the letter from the Pensions Regulator which is incomplete from the perspective of any consistent and reliable analysis of the Wilko position, but we would doubt the assertion that “For any paper loss that they would take on the asset side, there would be an equivalent write-down on the liabilities side. Their LDI programme, per se, did not cost any money,…” and the expectation of an equivalence between asset and liability movements. See appendix B for an illustration of some of the issues with LDI performance.
From that letter, we see that Wilko’s assets declined by marginally more than their liabilities. Assets fell by 23.3% (£38.6 million) while liabilities declined by 21.8% (£44 million). We have no knowledge of the amount of benefits paid in the year or if any contributions were paid in.
However, these are unlikely to produce effects as large as the £5.4 million difference between assets and liabilities. We have no knowledge of the scheme’s overall asset allocation, but over this period global equities produced positive returns and investment grade corporate bonds lost just 6.3%, which suggests that the LDI portfolio must have performed poorly.
It seems likely that the extremely poor performance of long dated index linked gilts over this period may account for the poor investment performance – the 1/8th% ILG 2068 fell by 47% over the period. This would be consistent with the performance, that we have seen, of other schemes’ LDI portfolios over the period.
Q188 Shaun Bailey: I want to touch on the debate around a potential increase in PPF compensation, and perhaps funding that through easier access to fund surpluses. I want to get your take, first, on whether that is a feasible option, and secondly on the risk-to-reward factors that are involved, particularly with access to surplus. My potential concern is that there is perhaps a benefit to larger schemes that may have a surplus, but for other schemes that may not necessarily be a viable option. I am curious to get your perspectives. Barry or Oliver, would you like to start?
Oliver Morley: Specifically on providing them access, for example, via the LCP proposal?
Shaun Bailey: Yes.
Oliver Morley: Barry, do you want to speak on this?
Barry Kenneth: There are two elements to the LCP proposal. The first concerns pension schemes re-risking their balance sheets to try to generate a larger surplus that can be used to fund future pension payments from the company.
The first thing I would say is that we have been on a journey for the last 20 years whereby pension schemes have de-risked and have tried to manage the volatility of their funding levels, certainly from a corporate sponsor and trustee perspective. As we have previously mentioned, the scheme funding levels have improved materially in that time.
Scheme funding levels have only materially increased in the PPF data since December 2021. The average scheme funding levels, by total amounts of money, have hardly improved. We show below the funding levels which might have been reported using the ONS asset figures and TPR estimates of liabilities.
The increase of 1.3% in average funding scarcely warrants consideration as a significant improvement. We would also note that the dispersion of results over this period has been exceptionally wide, which means that on the ONS average funding level, we would expect some 27% – 32% of schemes to be funded at or above buy-out levels. We have seen consultant reports which place this number at between 16% and 25% of schemes. But those are more than the Buy-out insurers can cope with.
From a corporate sponsor perspective, I would imagine—this is certainly our experience—that to get closer to the end solution but then re-risk the pension scheme and create more volatility, not only on the pension fund balance sheet but on the corporate balance sheet, would be unlikely to result in a large take-up. It is a question that you would have to ask them, but it is unlikely that the corporates would allow that to happen.
When put to finance directors as ‘would you like to recover the deficit repair contributions you have made’, we have found more than 60% in favour of using the surplus, or in a few cases the entire fund, to achieve that end.
Obviously there have been other parts to it, with regard to enhanced PPF benefits and so forth. I will open this up to my colleagues as well, but I would guess that in order to create a new proposition to enhance benefits, you would need a wide levy pool and a wide breadth of businesses. The intelligence that we have received thus far is that there would not be a wide take-up, so it would be a challenge to get a breadth of levy and timespan.
This is a consideration only of the LCP proposal. The PPF already has a wide levy pool and breadth of business which means that increasing benefits broadly cannot be criticised in this manner.
The last thing I would say is that it would take a long time to get the benefits from investing in riskier investments, which I think was part of the proposal. With increased volatility, and generally on the riskier side of the asset spectrum, you would expect to receive these returns through time.
This is not in general true – for example corporate bonds pay higher coupons immediately and continue to do so until they default.
Obviously, if there is a funding level drop in the intervening period, I would imagine the trustees would be asking the corporate for more funding payments through that time. It is something that schemes can run on, and they can add a little bit more risk to the portfolio, depending on the corporate sponsor, but I think it would be a challenge to get a large take-up.
This again is a critique of the LCP proposal and does not have general applicability. It fails to answer the question posed. Running on is in fact being considered by many schemes – they see no reason to pay the insurer’s cost of buy-out. As one put it: “I would have to have a pretty disastrous investment outcome to suffer a loss equal to that.”
Q189 Shaun Bailey: So what you are saying, Barry, is that the LCP proposal could in some respects create more risk for certain schemes when you are pulling from that funding pool, in terms of those levies? Am I understanding that correctly? Apologies if I am misunderstanding you.
Barry Kenneth: I would expect it to create more short-term risk, because of the underlying investments. If we are talking about UK productive finance, in putting more capital at risk for these assets you would expect them, by definition, to be slightly more volatile, and for their returns to come to fruition through time. You would expect more balance sheet volatility within that time span.
This is not an answer to the question posed. In fact, even if many schemes adopted the LCP proposal there should be no impact on the levy pool, if that increase in benefits awards is properly priced in the levy setting process. It is schemes entering buy-out and becoming the liabilities of insurance companies which shrink the levy pool. Schemes being taken on by consolidators remain in the levy pool, which is one of many reasons why the PPF should not be a consolidator (it would be setting its own levy).
The whole question of volatility or risk is surprising given the high leverage and associated volatility which the PPF has assumed. It seems that they expect and encourage schemes to be risk-averse while being risk seeking themselves.
Q190 Shaun Bailey: I suppose that this is the question from a policy perspective: do you take the short-term volatility, but potentially the longer-term security that may come from that? Clearly, it is how you manage that short-term volatility in that initial period, were those proposals to be adopted.
Oliver Morley: It is also a problem for trustees under those circumstances, because we are effectively asking them to make a short-term decision, notwithstanding that they may have protection for that decision. When we talk to trustees about this issue, it certainly seems to be an understandable worry when it comes to their fiduciary duty and their duty to members. Even that short-term risk is of concern to them.
As noted earlier, much lies in the way the question is posed to trustees by the PPF.
Q191 Shaun Bailey: What would you say in answer to the question whether the risks outweigh any potential benefits? I know we have talked about it in the context of short-term risks, but is it inconclusive?
Oliver Morley: I am sure you could structure it in such a way as to mitigate some of those risks and make it worthwhile, but it is quite a complicated hammer to crack a nut, in terms of being able to get that policy to work in such a way that you get the right kind of scale, trustees go for it, it makes sense for members in particular under those circumstances and it gives you scale on productive finance. That is quite a lot to ask from a policy.
This exhibits another misunderstanding of productive finance. The lower demands made on employer sponsors are, the more they retain for productive investment.
Both traded listed equity and corporate bonds may be productive investments and can be achieved in sums as small as a few thousand pounds and can be diversified – the purchase of units in a collective investment is one direct way to achieve this – and can be done at large and small scale.
It is true that private illiquid untraded investments usually have size requirements measured in millions or tens of millions of pounds, but there are already many large schemes active in the market. Similarly, listed investment trusts can invest in private and public corporations but have the traded characteristics of listed equity to pension funds investing in them.
Q192 Shaun Bailey: I want to turn quickly to the DB code, particularly the new DB funding code. Do you think the code still has a role to play within the pensions landscape, or do you think it may be time to re-evaluate where we are with that?
Oliver Morley: I am sure colleagues will have a view. I think some of Barry’s comments apply more widely. It is this question as to whether this is a point in time of DB pension surpluses or whether that could change in future. We strongly believe that there is still a role for a DB funding code in a situation in which schemes do not necessarily maintain surpluses or have funding issues in the future. Although it may look extremely positive at present, and we are obviously pleased about that, there certainly is still a role for a funding code.
This is extremely dangerous ground. We are being asked to adopt a code because something might happen in the future, with no consideration given as to how that future circumstance might arise.
Sara Protheroe: I support what Oliver said. We are conscious that there remains a subset of stressed schemes. There are 240 schemes, for example, that are funded below 80% on a PPF basis and have sponsors that, on our levy methodology, are ranked 8 or worse. There are still schemes that are facing significant challenges, and it can only make sense for schemes to have a long-term objective and a journey plan for how they are going to get there.
The latest published PPF 7800 index reports 461 schemes with assets of £23.3 billion and a combined deficit of £2.2 billion. That is an average deficit of 8.6%. It is hard to see how nearly 50% of them, funded at less than 80%, could fit into that overall picture. If 461 schemes have a total deficit of £2.2 billion, they have average funding of 91.4% and have on average liabilities of £55.3 million. For 200 schemes to be 80% or less funded, say 75% on average, they would need to be far smaller than £55.3 million each on average, around £26 million on average, and with a total value of £5.2 billion and deficit of £1.3 billion out of the total of £2.2 billion. This is very small beer in the overall picture and certainly would not justify the imposition of the proposed funding code.
We will point out that if the ONS asset figures prove correct, the total of schemes in deficit would, by our estimation number around 1,800 with a combined deficit of close to £100 billion, not £2.3 billion.
We have written extensively on the problems with the proposed code and would just note here that it would run strongly counter to HMT’s productive finance agenda. With discount rates at 5%, the majority of schemes would be considered sufficiently mature to be required to be holding low dependence asset allocations.
Barry Kenneth: I have nothing further to add.
Q193 Nigel Mills: It almost feels a bit like “job done”, doesn’t it? We have had 20 years of the PPF; we have had a cocaine-fuelled rollercoaster ride for the last 20 years, and now everything is fine and so well-funded that we can all just let these things mature into the distance and worry about something else.
But I think you are going to tell me that that is not a fair assessment of the sweet spot we have got ourselves into, and there is still quite a lot of risk out there.
I think Sara said that there are 240 schemes that you still have on your watch list. If they are really, at this present pension optimum, funded at below 80%, is there any realistic chance that they will ever be able to pay the full benefits that they have promised?
Oliver Morley: Let’s start with the cocaine-fuelled rollercoaster. I am looking back for various reasons at the moment, as you can imagine. Since the PPF has started, there have only been two years in which our reserves have fallen. I do not think, in terms of consistency of performance, you would really describe that as a rollercoaster. We have managed to give that kind of consistency over time. That is part of the reason things have worked, but also one of the reasons we have been able to give assurance to members.
There is a gambler’s fallacy at work here. We have bet and won so far, it must be our skill and judgement. Indeed, it could be said that the PPF was always going to work, as the game was so loaded in its favour, from benefits reductions, variable levies and funding overseen by The Pensions Regulator. It was possible at the time of creation of the PPF to establish a scheme paying full benefits with a fixed annual insurance premium.
One of the reasons we have engaged with the call for evidence around the future of DB is that we believe that there need to be some solutions to the schemes that are not necessarily attractive or on an elegant path to buyout. We need to think in policy terms about what we do with that, and we think it is a useful debate to get into. What is going to happen to those schemes in the long run, because they may well not be able to solve the question of those long-term benefits? We certainly believe that there is a discussion to be had about that.
A more jaundiced view might be that the PPF has a maximum future size with nowhere to go and nothing to do other than pay pensions as they fall due.
Q194 Nigel Mills: Which takes us neatly into the consolidator options. My first question is: are you saying that there is a better solution than you sitting around, waiting for things to go pop and then picking them up?
Could you proactively take on schemes before they go pop, although there is an expectation that, at some point, that will happen anyway? What are the advantages of doing that?
Is it just that you can invest better and use the funding better, so in the long run it is less of a hit on the scheme because you can manage the deficit down better than the scheme could? Is that the kind of pitch you are making?
Sara Protheroe: We have a really strong track record of delivering against our current remit. We have transferred over 1,000 schemes into PPF, and a further over 1,000 schemes into FAS. We have reached a position of financial and operational maturity with strong in-house capabilities. As the DWP review that some of you referred to mentioned, it is perhaps time to think about what more we could do in the pension space. We feel we potentially have further value to add.
It is clear that the PPF would like to become a consolidator. We believe that this would raise unmanageable conflicts, within the PPF itself (see Levy point above for example) and with TPR and other competitors, and it would suppress the interest of other parties in becoming competitors in this potential market and curb innovation.
Q195 Nigel Mills: Where do we draw the line? We never really wanted to have a nationalised DB sector, and obviously there are commercial consolidators out there.
I think we all agree that that consolidation would probably be a good thing—we have seen the first deal go over the line this weekend—so is your pitch, “Let’s have a nationalised super-DB scheme. We’re so great that we don’t need all these other ones”?
Or are you saying, “We shouldn’t touch schemes that can get to buy-out. We also shouldn’t touch schemes that can’t quite do that, but the private consolidator can get them there; that should be left”? Do you only want the ones that are a problem and will never get to buy-out or private consolidation? Is that what you are pitching? Is that what your role could be?
Oliver Morley: In some ways, this goes to the question you are trying to answer. If there is a wider productive finance question, you need scale.
It is not true that scale is needed, see earlier.
That is something we can address at scale. I wouldn’t go to the extent of a nationalised DB, etc., but you do need scale. At a smaller scale, you are really solving for a different question, which is the question of smaller underfunded schemes. That is where you start talking about drawing lines.
Barry Kenneth: I just thought that a couple of stats might be important here. The deal you allude to—the Sears pension scheme—was £600 million. Ultimately, in terms of the capacity in the buy-out sector, the types of scheme that commercial consolidators are looking at tend to be of higher value. There are lots of well-funded pension schemes out there for the insurance model, and they only have a limited amount of capacity to price transactions, so they get the biggest bang for their buck from larger transactions.
The commercial consolidator approach is to get scale in asset management. Again, as we have seen previously—the two super-funds have obviously been trying to do business for the last few years—the schemes that are on their radar tended to be the higher-value ones. If you take that back into our universe, 3,500 of the 5,100 DB pension schemes are less than £100 million. The solutions that are open to those smaller schemes are more limited than might be suggested. From a scale perspective, the top 4,500 schemes out of those 5,100 schemes account for only about 15% of the total DB assets, so there is a huge amount of concentration at the smaller end of the DB universe.
From a consolidator approach, whether it is for stressed schemes or just the smaller elements, as Sara mentioned, our experience of transferring in schemes is important. The second thing is that, when trying to improve the efficiency of these small schemes, they have high governance costs and limited access to investment management solutions. They tend to be pooled approaches. They do not really have the access to a wide array of diversified investments, and they have high governance costs.
It is not true that small schemes do not have access to diversified investments. It is true that small schemes tend to have high governance costs, and we would add that caution that adoption of the proposed DB funding code would greatly add to that. Indeed, the most likely outcome from the adoption of that code would be that distressed schemes become less likely to achieve full funding and that sponsor insolvencies increase from the added strain on their finances.
In terms of consolidating these schemes, I think there are two elements. One is that they are quite inefficient at the moment, and I am sure that most companies would like to get these smaller schemes off their balance sheet. The second thing is that, on the solution side, there are actually more limited solutions out there for these schemes. Certainly, that has been our experience when we have talked to some of these schemes.
If you link that back into the Chancellor’s objective in his Mansion House speech—getting growth into the UK—then scale allows you to be able to do that, so effectively you can solve the two issues with one consolidator.
Consolidators may be capable of solving the two issues described, though we would note that Clara the only one currently operating serves as a bridge to buy-out, and in that role has a short investment horizon, perhaps five to ten years. A single consolidator would be prone to exploit its monopolistic position.
As Oliver has mentioned, in terms of the time horizon, we look at long-term investments, so we take a different approach from that of a typical DB scheme, where the corporate has to announce its balance sheet every year and so one-year returns are important. Time horizon, scale and professional management allow these smaller schemes to lose the governance cost and invest in diversified asset pools that should give them better outcomes.
In fact, both the PPF and corporate sponsors must report their financial results annually. If there is a governance cost saving to the PPF it arises from two sources – the first is that all schemes entering it are paid on the basis of a single benefit structure (their reduced benefits structure). They may diversify as they wish through collective investments. Indeed, there is an echo of the claim that ‘sophisticated’ investment achieves better results, when the evidence from US university endowments (among the most sophisticated of investors) suggests otherwise.
Q196 Nigel Mills: I get all that. I am just trying to work out what your pitch is. Are you saying to DWP and the Government, “We would like to be the consolidator for all small schemes that want to be consolidated, please”? Is that what you are asking to do?
Oliver Morley: I probably would not use the word “pitch”. In terms of where we are, we are engaging in the policy discussion. Putting aside the huge-scale policy discussion, which is in some ways separate, at this smaller-scale level we are conscious that there is a desire to avoid encroaching on areas where there is no market dysfunction. Where there is a functioning consolidated/buy-out market, we should obviously not supersede that area, unless you wish to have that huge scale.
We cannot necessarily define that, and we are very conscious that a lot of the stakeholders, for example the insurers, will want to be involved in it.
They want to be able to engage in that too. We are not overtly saying, “This is the market; this is the level.” We understand that there is going to be more policy discussion to define where those areas are. I would add one other thing about the efficiencies if we do consolidate: the quality of administration is one of the areas that is a real challenge for small schemes. We see them when they come into us—when there has been an insolvency, obviously—and there are certainly efficiencies and improvements that can be made around the administration of small schemes too.
It does not seem to have occurred to the PPF that the schemes that they see are not representative of the whole universe. The difficulties faced by their sponsors have limited the resources available to their pension schemes, with insolvency of the sponsor being the trigger for PPF getting visibility of the scheme in the first place.
Q197 Nigel Mills: I don’t know if I am any further forward. So, let the schemes that can reach buy-out run themselves to buy-out. I think we have had evidence that even small schemes can get buy-out, and there have been quite a lot of buy-outs at the smaller end of the sector, so we are not saying that there is a problem there.
Oliver Morley: I have had discussions with the insurers. I think that that is for the most part right, but it is not always true. If they are administratively complex, more marginal on funding and very small-scale, it is not always that attractive for the insurers to take them on. They may issue a quote, for example, but that quote may not be competitive.
Note that in their earlier submission, the PPF clearly envisaged not paying benefits as promised by employers (administratively complex) but rather paying all according to some formulaic set of rules, as yet undefined, but similar in nature to the homogenous benefits of current compensation. We would note also that the PPF does not have the administrative burden of reporting to the Pensions Regulator.
Sara Protheroe: There is also an issue of timescales. The largest level of buy-out business in a previous year was, I think, £44 billion in 2019. We expect this year to be a landmark year in terms of its size. But against the backdrop of £1 trillion in liabilities, it will be many, many years hence before all schemes would get the opportunity to buy out, and it is likely that smaller schemes would fall towards the end of that queue.
Q198 Nigel Mills: I think I’m getting there now. You are basically saying that if the Government decided we wanted to strongly encourage consolidation of smaller schemes and trustees were minded to agree with that, you in theory would be quite willing to clear up the tail if somebody asked you to do that. You are not necessarily asking to do it, but you would be willing if somebody else thought that it was a good idea.
It leaves us in a slightly counterintuitive position, which you alluded to earlier. You are on the Government balance sheet—you are on the books—and so we end up with this huge pension scheme having, effectively, lent the Government a load of money.
This would only be the case if assets were sold, and the liabilities were left unsupported on the government balance sheet.
It almost looks like it is lending itself a load of money to pay for gilts. Then what we are effectively doing is that, on balance sheet, we are investing in slightly risky parts of the economy. Generally, the Government has decided that it is not the role of the Government and public finances to go wholesale investing in risky things around the economy; that is for the private sector to do. So, don’t we end up in a slightly odd position?
We want more money in productive finance, but do we really want that on balance sheet?
We are unravelling years of public sector financial orthodoxy here by starting to go in and, effectively, invest ourselves.
Oliver Morley: It would be separate —
That does not actually resolve the issue in question.
Barry Kenneth: When we build a strategic asset allocation investment strategy of the PPF—I am sure this would be similar to a consolidated model—we are doing that with risk management in mind. If we look at the assets in terms of that, the PPF’s current asset allocation is that about 70% of our assets are invested in what you would classify as an annuity or bond-like strategy; the remaining 30% is in what you would maybe classify as productive finance, and that productive finance is distributed geographically and in different sectors. So, there is a huge amount of diversification. It is not sitting in the UK specifically.
A consolidator is radically different from the PPF. It has no further income beyond that arising from the original pricing whereas the PPF has the annual levy as income. In this regard, the PPF is more like an open DB scheme than a consolidator. Note that the PPF has collected some £9.4 billion in levies over its lifetime.
I think that about 6% of our total assets are in UK productive finance, so we don’t have a huge exposure, in terms of our whole balance sheet, to UK productive finance. And 24% of the fund will sit in different geographies, and that could be split between private and public equity— infrastructure, real estate and the like. So, in every investment strategy that we would run, whether it be a public consolidator or the current PPF model, diversification is huge, and risk management is also paramount.
So just 20% of their productive investment is in the UK, perhaps £2.5 billion. That compares extremely badly with the £9.4 billion of levies extracted from schemes and their sponsors. It is frankly insignificant when compared with the £300 billion of deficit repair contributions extracted from scheme sponsors.
There is little disclosure of their productive investments, other than a rather uninformative PPF blog by Barry Kenneth published on September 22nd 2023.[5] That blog makes the rather bold statement that
“I should stress at this point that our asset allocation and risk levels are monitored in real time, and we can adjust our exposures as we need to, to make sure that risks are maintained within our strategic risk budget at all times.”
which of course is simply not feasible for untraded private assets. The blog does list four of their UK investments within their growth allocation. It does not tell us if these are equity or debt.
However, this listing itself raises a number of concerns as it pertains to investment in real (UK) assets. For example: “Our investment in soft and hardwood forestry hit a milestone of £1 billion in 2021/22, with key sustainable forestry assets across Australia, New Zealand, the USA, the UK, Ireland, the Baltics, and the Nordics.”, and another named real asset was Cross London Trains (XLT) – isn’t this a fleet of new Siemens rolling stock?
So, I wouldn’t say that the way we invest is risky.
We would. The PPF is 36% leveraged, far more than all but a few pension funds. Long dated index linked gilts experienced drawdowns in excess of 80% last year. The riskiness would also appear to have been confirmed by the imputed LDI or matching portfolio.
In fact, I think our risk budget, certainly in historical terms, has been a fraction or a percentage of that of a general DB scheme.
We do not believe that this assertion would prove true if tested.
So, I think that our investment strategy is relatively low risk. It is extremely well diversified in order that we are never exposed to one factor or one geography that would hugely impact the investment strategy of the scheme.
Q199 Nigel Mills: At what point does the levy model start to become a bit odd? If we see a lot of buy-outs taking schemes out of the market and we saw you consolidate a lot, presumably there are not many people left for you to levy on if things start to go wrong. We are effectively then towards the end of the—
Oliver Morley: And that is exactly why we have been taking down the levy over time as the risk has declined in terms of the wider universe.
Certainly there are arguments—if we were to be a consolidator that could actively deal with some of those schemes that were more of a risk to us, that would also reflect in the levy, not directly, because as I said it would certainly be seen as two separate funds with two separate approaches, but, in terms of the overall risk to the PPF as it currently stands, we would believe that we would be in a position to gradually reduce that risk also as we took out some of the tail at the same time.
This necessary separation is precisely why the PPF should not be a consolidator.
Q200 Nigel Mills: Let’s say the Chancellor got creative and decided, “I’ve got this great idea. I can go and effectively not quite force but strongly regulatorily encourage a large amount of consolidation quite quickly into a public consolidator.
I can get myself several hundred billion pounds in there and I can then use a good chunk of that to invest in the kind of productive growth investing that we all want to see.”
Are we not basically just nationalising the risk? Will we have to have taxpayers on the hook, because if this goes wrong we will have to meet the promise? That is effectively where we would be. If it was all on the balance sheet, we would have effectively directed this.
We would go from a situation where we have tried to keep the taxpayer off the hook for a long time, not giving people pre-1997 indexation and not taking on all those old liabilities, to saying, “We are near enough maturity now. We will take the risk now and use the money how we want to.”
Oliver Morley: May I refer to Barry’s previous comment? It needs to be understood in the context of a wider portfolio. The scale and longevity would mean there is more opportunity for productive finance, but you are not saying that you are going to make significant changes to the overall risk. Within a very large-scale, diverse portfolio, there would be more opportunity for productive finance without increasing the overall risk of that portfolio considerably.
These are closed schemes, no matter how they are aggregated, it is not possible to increase their longevity. When we look at the overall volatility of large scheme results, there is very little difference from the returns of smaller schemes. There is well-known result in empirical finance that a relatively small number of assets, usually in the 30 -50 range, offer as much diversity as the overall index. Any more than those numbers simply adds costs.
Q201 Nigel Mills: So there is no chance this could go wrong and effectively put the taxpayer on the hook.
Oliver Morley: It all goes to the policy design and the legislative framework that you would have for the consolidator. On the PPF, there was always the chance that the PPF could have gone wrong. From a legislative perspective—Sara was there from the beginning, as others were—the design of that legislation was scrupulous in making sure that the risk was carefully managed and that the board had a responsibility for managing that risk.
The PPF has always had the backstop that benefits may be cut if needs must. There is no recourse to government other than perhaps a moral argument. Against this background, we are at a loss to understand why such remote contingencies should appear in the whole of government accounts.
Q202 Chair: I have a further question on consolidation. On a different aspect of consolidation, Nigel mentioned in passing the fact that earlier this week Clara Pensions has announced its first transaction, which is perhaps a positive indication for the prospects of a superfund consolidation.
On the other hand, there wasn’t a pensions Bill in the King’s Speech yesterday, although the Chancellor has referred to the importance of a statutory framework for superfunds. Do you think that in the absence of legislation it will be harder for superfunds to develop?
The tribulations of the superfunds in their dealings with TPR and DWP are reminiscent of the treatment of ‘Tiny’ Rowland in his attempt to purchase Harrods. To quote from a Guardian story in 2010, long after the episode had passed:
“The ruling on House of Fraser – which stated, among other things, that it was against the public interest for Lonrho to own Harrods since it also owned Brentford Nylons and might therefore discriminate against other suppliers of bed linen – was widely ridiculed by City journalists.”
Oliver Morley: Obviously it has taken a long time. We were first generally talking about superfunds when I arrived at PPF five years ago and the first sale has just happened. It has taken a long time. The lack of regulatory clarity has to an extent hindered the development of options.
It is not the whole story in terms of some of the reasons that it has taken a long while to get to this point, but clearly for a new business, having that regulatory clarity does help. We have engaged throughout with the regulator and both of the consolidators to talk to them about how to implement levy and things like that for a consolidator. So, yes, I think that on balance I would be more positive. A clear regulatory environment would help consolidators.
The problem is that much of the current regulation and guidance, such as the ‘gateway tests’, seems designed to stifle the development of consolidators and is consistent with the regulatory risk aversion that has dogged pensions for well over 20 years, and led to the situation we now find ourselves in.
Q203 Chair: I think your first appearance in your current capacity before this Committee was five years ago. At that time you said to the Committee that superfunds could be a risk for the PPF. This is your last appearance before the Committee in your current capacity, but you might be back in a different one shortly. What is your view now? Do you still see risks to the PPF from the development of superfunds?
Oliver Morley: The same risks exist. This was always a question around capital adequacy and the ability to make sure that the promises made to members at the time of a consolidator taking over would be able to be supported. Obviously, that depended to an extent on the scale. Certainly, at that point, our view was that consolidators could be a real, considerable shift in the market in terms of them being able to take over schemes. That has been less because the volume has been lower, and the risk therefore is significantly smaller.
If consolidators did take off, there would still be a risk and that is indeed part of the reason and the purpose of the regulatory framework that would be put in place to ensure that was managed.
The question of capital adequacy and support for a consolidator would also apply to the PPF should it become one. But they have gone unaddressed in this evidence.
Q204 Chair: So if a regulatory framework does come forward, you would be reasonably relaxed in the PPF?
Oliver Morley: We would be supportive if it were the right regulatory framework and it ensured that the interests of members were protected.
That could mean almost anything.
Q205 Chair: Can we go back for a minute to the discussion we were having earlier about what happened around the LDI event? I want to press you a little bit further. Your figures say that £400 billion in defined benefit pension scheme assets has been lost pre-LDI and post-LDI.
Some of that was a result of the fire sale difficulties that a lot of schemes got into at that point. You made the point that it is going to take quite a long time until we know how much of it was that, but some of it certainly was. Are you able to give us a finger-in-the-air guess as to how much of the £400 billion was a result of that fire sale?
Barry Kenneth: It is a more complex issue than just how much money was potentially lost on pension funds that were forced to liquidate their hedges because they had to liquidate assets in order to get the cash.
This seems an overly complicated answer. If a scheme liquidated its hedge, it would have to pay the cost of the hedge at that time – raising the funds for that may have required the liquidation of other assets. In the majority of cases, schemes were liquidating other assets to meet the margin calls and hold onto their LDI positions and as such remained exposed to further calls if rates rose further.
It is possible to estimate the extent of liquidation of equity and corporate bonds from the ONS survey reports.
Some schemes were able to liquidate assets to get cash in order to pay collateral into the positions that they had, so you could argue that the assets they sold maybe did not sell for true value. The actual loss—it is going to be almost impossible to look at that crisis in isolation, or the Government yields rising so quickly in isolation, and try and figure out a number. There were lots of different moving parts for different pension schemes in order to satisfy the ramifications for interest rates moving higher in a very short space of time.
If you want to confine it to, “How many schemes lost money on the liquidating of hedges?”, I suspect over time you will see that through the funding level of schemes. But in the round, as the PPF, we would never get data on schemes that have liquidated hedges and on what it cost them to liquidate hedges based on what they invested in at. I do not think we will ever come up with a true number. What we do know is that there was a significant amount of pooled vehicles that were liquidated around the same time. I would guess that the biggest asset managers who look after the pooled vehicles will be able to give you a better steer to what that would be than the PPF. We will get information in the round as opposed to on specific parts of investment strategy.
It is certainly possible to estimate some aspects of scheme losses. As previously, £49 billion from leverage. £51 billion paid into pooled funds and the overall difference between the PPF and ONS figures, £196 billion, is likely to be reasonable first order estimation of total losses.
Q206 Chair: A finger-in-the-air guess?
Barry Kenneth: I would not know how to answer that.
Oliver Morley: The problem for us, and we are not trying to avoid it, is that it is perfectly possible for a single scheme—as a kind of case study—that has lost significant amounts of money liquidating for cash to have actually come out with a very large asset decline, but also now have a much rosier picture in terms of surplus. All those three things can happen in one scheme over that period as a result of the asset disruption. It is almost impossible, in terms of the way they would report, to have picked out that one element of a decline on the asset.
This is just an attempt at obfuscation and to not answer the question. It is once again more than a little concerning that the PPF have no idea about the scale and impact of the LDI crisis over 12 months hence and seems no better placed to answer this question today than a year ago.
Q207 Chair: Let me ask you about one specific scheme that we have touched on—the Wilko scheme.
This morning, we published a letter sent to us from the Pensions Regulator showing that the value of the Wilko pension scheme assets fell from £158 million in the second quarter of 2022 to £121 million in the second quarter of this year. That is a big fall—£37 million or so—and of course that has now crystalised, given the insolvency of the company.
You have obviously looked at Wilko very carefully. Are you able to tell us how much of that loss was a result of these fire sale problems around LDI?
Oliver Morley: We would have to come back to you. I am not overly sure we could, but we could come back to you and see if there is any breakdown. I think it is unlikely that we would be able to piece it back to that specific level. If the surplus as a whole—I think it is very slightly in surplus on S179—has improved, that would almost entirely be netted out anyway, so we would have to have a look. We could give you some breakdown, based on our figures.
Q208 Chair: That would be interesting to know. It is not anywhere near surplus on a buy-out basis, is it?
Oliver Morley: No—on S179.
Sara Protheroe: And I think we are still looking into the situation.
Q209 Chair: I imagine the £37 million loss will have had a material impact on the outcome of your assessment.
Sara Protheroe: As we discussed earlier, it depends on what has happened to the liabilities during the same period. I don’t think we have the figures in front of us today.
Chair: It would be very helpful if we could see those.
From TPR’s letter, we may conclude that Wilko will enter the PPF and that it will have more assets than needed to satisfy the PPF’s costs. The letter reports the Wilko deficit to PPF as £19.8 million implying that the total PPF liabilities for Wilko will be £141.2 million. With assets at June of £121.4 million and a further contingent asset of £20 million, already secured by TPR, and a further £4.5 million of expected recoveries on the s75 debt, the PPF will make a gain of £4.7 million from Wilko’s admission.
This is an illustration of the fact that some schemes entering the PPF generate gains for it, rather than losses.
Q210 Siobhan Baillie: I think Wilko had quite a lot of problems. I listened to Barry when he said that they didn’t over-hedge the scheme, so it seems quite a complicated picture.
I have almost a wrap-up question, subject to the Chair’s final points. My assessment—and not just because they are “my gang”—is that we have a very capable and caring Pensions Minister and a very financially literate Secretary of State, and the Chancellor of the Exchequer is taking direct aim at pensions in big speeches and things like that, and yet if His Majesty the King had talked about pensions yesterday, I would have fallen off my chair, because it is just not sexy.
It is really hard to get parliamentary time for any changes in legislation. I was thinking during the previous panel that all the political parties—Labour, the Conservatives and the Lib Dems—are on the hook for not making improvements to pensions legislation over the years.
I just wanted to get your comments—Oliver, in particular. I don’t want to put words in his mouth, but Roger Sainsbury pointed out that he felt slightly let down that PPF had not started fighting a bit harder or using your very capable voice.
Sara said—I wrote it down—that PPF has more to add in using your voice to do things like arguing for changes, post the Hughes case, to the compensation cap. Can we hear more from PPF, and all of you with your expertise, to get some of these changes? It is quite hard for MPs to get this stuff heard, even with all this attention that we are getting.
Oliver Morley: We are conscious that we are an arm’s length body, so there are limitations. I understand Roger’s frustration with it, but we are limited, particularly in what we say publicly. We make absolutely sure that these representations are passed on, and we try to be clear with everyoneinvolved. We haven’t been opaque; we have been explicit about some of the trade-offs. Where Roger and I differ is that I feel strongly that these are big decisions.
Regardless of anything else, even if it is not pre-’97—not retrospective—this is £2 billion. Even if it is not directly taxpayers’ money, it still has implications, and there are still wider choices that need to be made. It is not just about DB; it is about DC pensions obligations, etc.
There is a wider framework around pensions. For me—I am not a civil servant but a public servant—it is important that these decisions are made in the right way by Parliament and Ministers. We will always be as transparent as we possibly can be about those trade-offs so that people can understand them and make the right decision.
Q211 Siobhan Baillie: Sara, you are close to the schemes coming in. Is there anything else that you want to add to that?
Sara Protheroe: We recognise that PPF’s position has evolved since the legislation was introduced back in 2004. We recognise that our funding is now more robust and that the risks that we face have reduced. As we talked about earlier, the current inflationary environment is of significant concern. We see why that is leading to renewed interest in our compensation levels, and we would be open to direction from Government on that issue.
Q212 Siobhan Baillie: I have one more question. If you get to self-sufficiency in 2030, does that change how you are governed as an arm’s length body or is it literally about your financial status?
Oliver Morley: We actually have moved away from that approach. It is probably fair to say that in some ways we are reaching, or have reached, self-sufficiency much more quickly than we would have expected. That is the reason for our funding strategy work, which we have effectively completed. I think we are already in a different place, in terms of our long-term sustainability, and that is also why we are looking to reduce levy.
The objective of funding to self-sufficiency was actually an invention of the PPF itself. It is purely financial in nature though it has greatly influenced the levy setting process. The PPF has collected £9.4 billion in levies and currently has £12.3 billion of surplus.
Sara Protheroe: But it doesn’t give us any greater powers.
This is true. Self-sufficiency was an objective created by the PPF. It seems that this self-sufficient funding objective was motivated in part by criticism of the sustainability of the PPF. To quote from the aforementioned 2004 paper, Being Actuarial with the Truth,
“No wonder that many commentators have, cynically, re-assigned the initials “PPF” to Partial Protection Fund.”
Siobhan Baillie: It doesn’t change the way you can push the Government. Okay.
Q213 Chair: You said you have reached self-sufficiency. Is that what you are saying?
Oliver Morley: We haven’t had a fundamental point where we have assessed whether we have reached self-sufficiency or not, but I think the implication of our reserves and our financial position is that—I put it in terms of levy—we can substantially reduce levy.
Given the magnitude of the total levy collected since inception, it could be argued that the levy was always redundant. Certainly, it has throughout the life of the PPF contributed materially to the growing surplus of the PPF. Indeed, there have been only two years in which the surplus did not grow.
Chair: Thank you. It has been a very helpful and interesting session. Thank you all very much indeed. Oliver, all our best wishes, and we look forward to seeing you again with a different hat on, hopefully before too long.
Appendix A: PPF Estimates of Sources of Funding
The PPF publishes from time to time, the sources of its finances, broken down into four categories; Assets received from schemes entering the PPF, Investment returns, Levy receipts and Recoveries from the insolvent sponsor estate. These are shown for 2022 and 2023 below:
There are some surprising elements to these proportions, such as how can the asset receipts have declined, let alone declined so precipitously. There are similar concerns as to how the proportion attributed to investment returns have risen in a year when investment returns were subdued at best – the PPF reported an asset return of just 1.9% on growth assets, though these are the minority of their investments.
We show the key figures reported by PPF below:
The first point we would note is that the PPF lost £8.4 billion of gross assets or £8.8 billion of net assets over the year. The present value of pension liabilities fell by £7.1 billion resulting in a funding ratio improvement. This improvement in funding ratio is a denominator effect; a mathematical artefact.
The PPF reported that its growth assets returned 1.9% on the year. With the growth portfolio accounting for 30% of the asset allocation, this implies that the PPF LDI portfolio lost far more than its liabilities declined – that it was in fact a very poor hedge. In this year the PPF paid £1.2 billion of pension benefits; this is 5.9% of scheme liabilities.
Investment liabilities fell from £13.4 billion to £11.8 billion, a difference of £1.6 billion. Note that investment liabilities are simply borrowing by another name, and as such the leverage of the fund is high, respectively 32.5% and 36.5% of the net assets. It is surprising that such a large source of finance goes entirely unreported in the PPF analysis.
To draw meaningful inferences, we convert the published proportions into their monetary equivalents, using the reported net assets of the PPF. The table also shows the percentage change attributed to each of the four categories:
Now the first point to recognise is that borrowing, or investment liabilities, was the largest single source of funds in 2023 and it was the second largest source in 2022, exceeded only by the total receipts of assets from schemes entering the PPF. It passes unreported in the PPF sources of funds.
We simply cannot understand how total levy receipts can decline from one year to the next and at £7.5 billion that is £1.9 billion below the £9.4 billion sum of levy receipts. We also cannot understand how the total assets received from schemes entering the PPF can decline from year to year and the same applies to the recoveries made. If this is some marking to market of assets it is misconceived.
Finally, the total investment returns have risen, by £1 billion, which is not compatible with either of the declines seen in both gross and net assets. We are at a loss as to the purpose of these attributions, except perhaps for exaggerating investment performance. Our interest in the overall sources and uses of funds was motivated by the observation that last year (2022/3) the PPF lost some £8.8 billion of its net assets, and that is actually more than it has paid in compensation to beneficiaries since in inception, the idea that the Chancellor of the Exchequer thinks that this constitutes a performance deserving of a wider and arguably much more important role as a consolidator is something we simply cannot square.
Appendix B
Liability Driven Investment: An illustration
It is genuinely hard to estimate the cost and loss aspects of LDI. While it is usual to express this hedging using financial analytic concepts such as modified duration and convexity, in this note we will limit our use those terminologies and techniques.
Our illustrative model uses the annual projected pension payments of a scheme over its lifetime, which we set out as 78 years. With a discount rate of 2%, these liabilities have a present value of £85.317 million. The scheme has a modified duration of 21.620 years.
Now suppose we believe that interest rates and our discount rate will fall from 2% pa today to 1% pa in one year’s time. The present value of liabilities will rise to £105.896 million in 12 month’s time at 1% and we wish to be fully hedged against this.[6]
Next let us suppose we have three possible hedging instruments, zero coupon bonds of maturity ten, twenty, and forty years. At a discount rate of 2% pa, these have current prices, respectively, of 90.238%,74.027%, and 49.816%. The modified durations are 9.804, 19.608, and 39.216 years.
The modified duration approach would commence by considering the product of the present value of liabilities and the modified duration of those liabilities (£85.317 * 21.620) = 1844.577. We then need to consider what amounts invested today in each of the three hedging bonds will produce this product (this is done by dividing 1844.577 by the modified duration of the hedging instrument).
The answers to these questions are, respectively, £188.147, £94.073, £47.037 million. Given the price of these bonds, as above, the nominal amounts of these bonds which need to be purchased are, respectively, £208.5, £127.080, and £94.417 million. The cost of these portfolios is, as above, £188.147, £94.073, and £47.037 million.
If we suppose the fund was fully funded to the level of liabilities, namely £85.317 million, this would leave the scheme having to borrow £102.829 in the case of the ten-year hedging instrument, £8.756 million in the case of the twenty-year hedging instrument and having a surplus of £38.281 million in the case of the forty-year hedging instrument. Obviously, the borrowing would have a cost, but we shall ignore this for simplicity in this illustration. It implies gearing of 2.21 times assets in the ten-year case and 1.1 times assets in the twenty-year case.
Next, we consider the position, as above, when one year from now when rates have fallen to 1% pa, the liabilities then outstanding have a present value of £105.896 million. With the prices of the three hedging bonds, then being: ten-year 91.434%, twenty-year 82.774% and forty-year 67.837%, the gross values of these three asset portfolios, respectively, are: £190.64, £105.19, and £64.05 million. Net of borrowing, these portfolios have values of £87.81, £96.43, and £102.33 million. These are respectively, funding ratios of 82.92%, 91.06%, and 96.63% for a scheme which was fully funded (100%) at the beginning of the year. In addition, in all cases the scheme has disbursed £2.24 million in pension over the course of the year.
This poor-quality performance as a hedge of discount rate declines results from the fact that duration is a valid measure only instantaneously and only for very small changes in the discount rate. Over larger moves, it would be necessary to include a second order term, convexity, which is a partial compensation for the non-linearity of the price/yield curve.
Next, we consider how these hedges performed when rates rose to 5% over the year. The prices of the ten, twenty and forty-year bonds fell to, respectively, 64.461%, 39.573, and 14.915%. The values of the bond portfolios fell to £134.40, £50.29, and £14.08 giving net assets of £31.57, £41.53, and £52.36 million respectively. Relative to the value of liabilities, £48.77 million, these are funding ratios of 64.7%, 85.2%, and 107.4%.
A different approach to calculating the hedge ratio
A far simpler way of determining the appropriate hedge portfolio, given that both the future price of the hedge instruments and future value of the liabilities is knowable is to pose the question, What allocation to these bonds today will give me a future asset portfolio value equal to the then present value of liabilities?
We calculate the future value of liabilities at a 1% discount rate as £105.896 million. With the bond prices being, as previously, 91.434%, 82.774%, and 67.837%, we need the following nominal amounts of these hedging bonds, £115.817, £127.934, and £156.104 million which have a cost today of £104.512, £94.701, and £77.768 million. The scheme which is currently 100% funded has assets of £85.317 million. This in turn means that the scheme will need to borrow to buy the required amount of bonds, £19.19 million if hedging with ten-year bonds, £9.39 million with twenty-year and have a surplus of £7.55 million for the forty year.
The remaining question is how did these portfolios fare when rates rose to 5%? The bond prices fell to 64.461%, £39.573% and 14.915% respectively, giving bond portfolio values of £74.657, £50.628, and £23.283 million, respectively. These are net assets of £55.463, £41.240, and £30.832 giving funding ratios of 113.7%, 84.6%, and 63.2%.
These hedge portfolios all assure the scheme remains at 100% funded if rates decline to 1%, but if rates rise, we see an improvement in the funding ratio for the portfolio of ten-year bonds but declines for the twenty and forty-year hedge portfolios, in the case of the forty-year a catastrophic 36.8%. In fact, if we were to take account of the £2.24 million of benefits paid in the year, these funding ratios become 109.1%, 80.0%, and 58.6%. It should be noted that we have not attributed any cost to the borrowing or returns to the surplus in the case of the forty-year.
These illustrations falsify the statement that: “…asset and liability matching works in the real world because, although asset values have fallen, the liabilities have reduced to the same extent…” Our own statement ‘In theory, if schemes were perfectly hedged (and none were from what we have seen) then the cost of provision would be unchanged.’ would hold true if the rate changes were instantaneous and extremely small, say one basis point at most, but that is emphatically not the real world. Intra-day gilt yield changes of the order of 5-10 basis points are commonplace.
To add insult to injury, these portfolios would also need to be rebalanced in order to hedge the changed situation – for example the modified duration of the liabilities at 5% is 15.97 years down from 21.62 years. These are not file and forget strategies.
[1] https://henrytapper.com/2023/09/23/small-beer-keating-and-clacher-take-a-sober-look-at-the-ppf/
[2] Being actuarial with the truth: A story of economic confusion over defined benefit pension schemes, Simon Carne, Staple Inn Actuarial Society, 2004. This is an insightful paper which warrants reading in full.
[3] Details of our method are available on request.
[4] See, https://www.ppf.co.uk/-/media/PPF-Website/7800/2023/PPF_7800_Update_November_23.pdf
[5] https://www.ppf.co.uk/blog-posts/Productive-finance-and-how-we-think-about-it-at-the-PPF
[6] The scheme will have paid £2.24 million in pensions over this year.
Whilst this blog is very long, it is an excellent attempt to shine a light on how “experts” may attempt to respond to probing questions in a way that suits their own agenda, and perhaps persuade a policy driving committee to move in a certain direction.
It is rare that the reality behind “statements” is exposed.
Iain and Con should be congratulated for doing so.
I just hope the WPSC read this long article and take on board the context and implications for developing ongoing pensions policy.
It is very important that policy in which ever direction it takes is based on as near as possible a complete and unbiased assessment of the status quo, and a realistic understanding of future needs.
Agreed Bob.
We need the Policy buffs to consider the overall policy objective from first principles. So many at DFT/TPR have been brought up on the nonsense language that buy-in is the ‘gold standard’. It’s not! And those words are straight out of the PR depts of the insurers.
Buy-in was originally considered as the provider of last resort for tired or failed sponsors. It was thus accepted by all sensible actuaries as being very expensive, and by exception.
Also no one ever thought buy-out was a systemic solution, so didn’t considered the system risks associated with :
a) concentration risk of so few insurers; and
b) system risk and impact of de-risking on an economy wide scale.
Policy makers need to forget most of what they’ve told. And go back to basic to consider an invested integrated solution to provide a reliable living wage for workers in retirement.
Con and Iain’s critique is an important counter-balance against the perpetuation of the vested interest, and should help bring us back to investment fundamentals.
sorry for the typos, iPhone autocorrect,on the move, no specs !
Hopefully the points are clear.
Should have said also – buy-in and its younger sibbling, is a solution that gives no consideration of cost. Fine when money was cheap, and the upfront tax relief of company contributions covered the near zero facility cost to fund. But times have changed; debt/capital is now expensive, scarce,and better employed in the economy.
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