Yesterday we heard from John Towner, today we hear from Pensions Oldie. Pensions Oldie must not be unmasked ( a condition of publication) but he is known to me as a kind gentleman whose views are articulated with a depth of understanding you will not find with the Pension PlayPen.
PensionsOldie says:
January 11, 2025 at 7.32 (Edit)
If we consider the very much diminished private sector DB Funding universe, the bulk purchase of annuities not only reduces the asset base of the sponsor but as a result increases their future employment costs.
If we assume that the cost of the buy-out and buy-in matches the (PPF/TPR) solvency valuation assumptions, itself increasing challenged by the erosion of the credit risk premium, then the assets required (As Con Keating points out) are for most schemes something just short of 40% more than those which the best estimate (? the neutral valuation) suggests would be required to run the scheme on.
Depending on the level of gearing, those schemes which have LDI assets have seen the realisable value of their assets fall as the yield on the matched gilts rises creating a greater requirement for deficit recovery contributions to reach the solvency required for the risk transfer transaction.
The risk transfer salesmen, whether in the insurance companies or in the wider pension industry (? and Regulators) have been highlighting that those pension schemes which have been remained invested in growth assets have seen the realisable value of their assets approach a level that matches or exceeds those required for the risk transfer transaction (the funding level). If however the assets, whether by additional contributions or merely not having been invested in assets matched to the falling gilts, are at that level they will be at 40% over the best estimate of those required to run the scheme on. There is therefore minimal risk to the members of those schemes of sponsor failure – so from their point of view a buy-in or buy-out is not a risk reduction exercise.
The Employer with a pension scheme with sufficient assets to meet solvency funding levels is almost certainly likely to be reporting a pension scheme surplus under IAS19 (with the liabilities discounted using the AA Corporate Bond yield at the accounting date). In the following year, the sponsor has a Profit and Loss credit equivalent to the the yield percentage of the surplus (? c.5.5% at 31st December 2024) at the preceding year-end. This applies whether or not an asset value ceiling has been applied (ala NatWest) to reflect an expectation that the surplus will be swallowed up by a future buy-in or buy-out transaction.
If the employer uses the run-on surplus of the DB scheme to fund future DC contributions, the profit and loss cost of the DC contributions is reduced but this is offset by the reduction in the surplus on the DB Scheme and the interest credit in the following year.
If however the employer continues to provide or restarts DB benefits from the pension scheme not only is the interest credit retained (and the surplus itself should generate additional future surpluses) but the past service surplus can be used to reduce the future current service costs both in on P&L A/c and cash bases. Further the maintained employee contributions will account for a larger proportion of the current service costs.
The same principles apply even if a pension scheme has not reached solvency levels of funding. In this case provided the additional pension liabilities created in the year have a lower valuation costs than the contributions paid in during the year (Employer regular plus deficit recovery plus employee) the interest charges to the sponsor P&L A/c will diminish year on year with the reduction in the accounting balance sheet deficit.
Should shareholder activation challenge employers that are paying too much to reduce or eliminate possibly non-existent risks and not taking the opportunity to reduce their future employment costs by running on and reopening to DB accrual?
I believe there is an additional point about using DB scheme surpluses to fund DC contributions, whether in a DC section in the same scheme or separately through a surplus refund to the employer:
Although there may be cash flow advantages if the employer uses the run-on surplus of the DB scheme to fund future DC contributions, the full cost of the employer’s DC contributions is charged to the profit and loss account in the contribution year. (NB: under IAS19 para 46 this would include the full cost of any buy out policy purchased in the year unless the employer retains a legal or constructive obligation to guarantee the benefit payments – as in a buy-in). This will be compounded by the reduction in the surplus on the DB Scheme and the interest credit in the following year. The effective pension costs in the P&L A/c will therefore be increased.
This applies whether the DC contributions are made to a DC section within the same pension scheme as the DB benefits or by the employer receiving a refund from a DB scheme and using the proceeds for DC contributions into another arrangement, The tax effect is also neutral as there is no tax relief on the surplus allocated to DC benefits in the same pension scheme as the DB benefits whereas if the DC benefits are outside the scheme the tax relief on the contributions will offset the tax charge on the DB surplus refunded to the employer. Also it is likely that the Trustees will still have to be satisfied (as under the Pensions Act 1995 s37) that it would be in the interest of the DB Members to move the scheme’s assets from the pooled fund to the individual DC accounts and also give advance notice to Members.
So much for accounting standards being “neutral”.
Yet another example of the accounting/audit profession bayoneting the already severely wounded?