Frank Field – a great man to the end
At 11.30 am on a Sunday morning, Mark Kleinman of Sky News disturbed the sermon with this news.
The Sky article was quickly followed by one from the FT, with Mary and George Parker referencing Sky’s coverage at 5pm
So what is Reeves bound to say this Wednesday?
Here are Mary and George
A shift in focus to DB schemes comes as the chancellor is gearing up for her growth speech on Wednesday. Pension experts estimate allowing companies to access scheme surpluses could unlock up to £100bn for investment.
If you’ve been reading this blog this past week you will have noticed quite a few pictures or Rachel Reeves and exhortations to take notice of our DB’s capacity to provide the certainty of a pension while investing in a way that an annuity cannot.
The FT also reported
In an interview with the Financial Times in November, former pensions minister Emma Reynolds said she had prioritised reforming DC workplace schemes because that was “where the growth is”.
Fortunately I did not have access to anything in the latter stages of November being in a coma, had I not been, I might have lost my temper and lost what’s left of my brain.
Let’s be clear, DC workplace pension schemes are dismally failing to invest, opting for life-styling into cash and bonds far too early, because they don’t have a pension strategy.
You may be thinking that the annuity is the answer to the pension. It is not – the pension invests you and creates that return over time as surplus. The FT are also spot on in pointing out that this is not the answer to an economy needing growth and a Government wanting investment
Access to scheme surpluses could slow the pace at which pension funds have been offloading their pension obligations to insurance companies, with around £50bn of assets transferred in so-called bulk annuity transactions in each of the past two years, according to pensions consultancy WTW.
Halting this trend could help support UK government bond and equity markets in the longer term because insurance companies typically sell gilts and invest in higher yielding corporate bonds — many of which are overseas — as well as infrastructure to make their profits.
The reality of selling your scheme to an insurer is that you lose the right to invest and they haven’t got the capacity to. The same goes to individuals looking to exchange their pot, they don’t have the certainty of a pension and if they choose an individual annuity they will lose 10-15% against the pension rate you could get if you could transfer your pot into a scheme (as you can if you work for Local Government and have recently joined its DB plan).
A spokesperson for the PLSA told Mary and George of the FT
“Lowering the legislative threshold for allowing returns of surplus could potentially encourage trustees (in conjunction with their employers) to adopt a more ambitious mindset and take on slightly riskier investment strategies for their DB assets, including greater investment in UK assets,”
What is needed is a radical shift in investment strategy (not a slightly riskier investment strategy). You can invest more if you have young people in your scheme for whom you are building rights to a pension.
What is needed is an end to the silly practice of giving surpluses to insurance companies to reward the insurer’s shareholders.
What is needed is DB schemes that young people can join rather than getting stuck in DC pensions (I include myself, a 63 year old, as young).
What is needed, as Sam points out, is that if you don’t want a DB pension on your books, you should give the opportunity to manage it for profit to someone like Edi Truell, who will give your members and you a happier time.
What is needed is a TPR who works out that for 20 years, they have been holding back growth in the British economy and our DB pensions. If we are to get the economic miracle of DB pensions back, we need to help them invest their way forward.
Frank Field when DB schemes were in their prime
It’s worse than ironic that TPR is a regulator whose statutory objectives include business growth.
The Pensions Act 2014 introduced a specific business growth objective for TPR by amending section 5(1) of the Pension Act 2004 to say “in relation to the exercise of its functions in respect of Scheme Funding only, to minimise any adverse impact on the sustainable growth of an employer”.
TPR, who seem to like tinkering with statutory wording they may not like, interpret this as “making sure employers balance the needs of their defined benefit pension scheme with growing their business”.
Note the (un)subtle introduction of “balance”, the removal
of “adverse”
and the relegation of “growing” to the end of the sentence.
I also note TPR were NOT one of the regulators summoned to a recent face-to-face with Rachel Reeves to discuss ways to improve business growth.
Maybe Rachel Reeves will on Wednesday coming call TPR (and others) to account for what they have been up to these past ten years?
There are some of us who think that scheme members might have an interest in what happens to scheme “surpluses”. Are their interests going to be protected adequately?
To Derek, the question isn’t why TPR haven’t done very well but whether they can improve. I think they can!
Bryn, the sharing of surplus with members and those who work for the sponsor employer seems a good plan. Productivity followed when I was in a DB plan!
You both have done a lot of people proud.
The BP Pension Scheme Actuary always used to say to us Trustees that we’d know whether or not the scheme was in surplus when the last member of the scheme died. If BP believe they know that the scheme is in surplus, is there something they are planning for scheme members that we don’t yet know about?
Yes, sorry, I’m being factious(ish).
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We had a surplus release scheme (“excessive surplus”) between 1987 and 2004, on which I worked while at GAD. Out of 84 analyses, 3 were found to be fine. Out of the 81, several actuaries clearly failed to understand the regulations, which was disturbing. So any new system will have to be very carefully crafted. No, I wouldn’t want the 1987-2004 system reinstated, partly because it relies upon discounted values. If anyone is interested, I published a visual guide (jonspain.com/sur) a long time ago but there’s been no reason to update it. The email address doesn’t work.
market conditions, has resulted in the cost of a £1 of pension increasing from £6 in 1980 to £18 in 2016. Immediate annuity values at age 65 – single life / nil increasing 9 Schedule 22 of the Incorporation and Taxes Act 1988 (previously Finance Act 1986), which set out provisions in relation to ‘statutory surplus’. Until their repeal in 2006, these provisions required regular actuarial valuations on a prescribed basis. If assets were shown to exceed liabilities by more than 5%, the scheme administrator was required to submit proposals to the Inland Revenue for reducing it to an acceptable level (not more than 5% of the scheme’s liabilities) or eliminating it altogether. The Pension Scheme Surpluses (Valuation) Regulations 1987 (SI 1987/412) required the valuation of the assets and liabilities of a scheme to be submitted to the Inland Revenue by the scheme administrator whenever any other actuarial valuation of the scheme was made. The regulations also prescribed the manner in which the actuary was to value the assets and liabilities of the scheme. 10 http://www.plsa.co.uk/PolicyandResearch/DocumentLibrary/~/media/Policy/Documents/0587-DB-Taskforce-Call-for-Evidence2.pdf Pension promises, such as fixed 5% p.a. compound increases on preserved benefits and pensions in payment, were made, and hard coded in scheme rules, based on conditions the likes of which we are unlikely to see for many years. It is no exaggeration to say that we may not experience them again until long after the last pension instalment is paid from a traditional private sector DB pension scheme. Nevertheless, employers still need to stand behind these promises. In most cases they need to do so without recourse to members, as the scheme will now have ceased accrual. So employer contribution rates have increased – in some cases exponentially – but there are no active members left to pick up at least some of the growing cost. This is not to say that employees are not affected. Indeed, current employees are indirectly paying for their predecessors’ pensions whilst being offered retirement and death benefit schemes that are far less generous. We’ll return to this question of intergenerational unfairness later. 3. MANAGING VS COPING: THE EMPLOYER RESPONSE Companies have deployed a range of strategies to respond to the increasing cost of their DB pension promises. These include: • Deficit reduction contributions and, in schemes still open to some members, increased employee contributions • Liability reduction / de-risking exercises • Reduced benefits for the future • Investment strategy • Asset pledges / contingent funding • Profit sharing agreements • Scheme closures • Switching to defined contribution (DC) arrangements • Business failure, often leading to PPF entry Which of the following actions: 1) has your DB scheme completed in the last 5 years, 2) is your DB scheme currently considering in order to ensure that it meets its liabilities?11 11 JLT survey, 2016 (as part of the research leading to this report, we conducted a survey of nearly 200 employers and trustees) By 2006, 58% of schemes were already closed to new members. By 2015 just 13% of schemes were admitting new entrants12.There is no longer any company in the FTSE 100 with a final salary pension scheme still open to new entrants. In fact, according to our latest research13, only 5% of FTSE 250 companies still offer DB pensions to their employees. In terms of the impact of the cost of DB pensions on how trustees invest scheme assets14, over the last 30 years there has been a large shift in investment strategy thinking. Until now schemes predominantly had large equity holdings in order to drive performance. This had replaced ‘balanced mandates’ because investment managers had merely driven up equity holdings to raise their league position. Now a true consideration of risk has come into play as trustees became concerned about volatility of returns and liability values, particularly where the scheme sponsor’s covenant was in doubt. These initially merely led to increased costs through increased holdings of bonds (gilts) in place of higher yielding growth stocks. Fortunately, the investment fraternity has not been idle and now clients are able to moderate the cost aspects without sacrificing long term returns through use of leveraged liability driven investment (LDI) funds. Nevertheless, the need to reduce volatility and target buy out (the ultimate run off) has caused clients to worry about increased costs, both through lost investment opportunity cost and concerns over locking into low yields. As it happens, and somewhat perversely, these strategies have reduced costs for early adopters (and indeed even for those who thought they were late to the party but still wanted to de-risk). The number of pension schemes now looking at higher yielding asset classes to meet liability cash flows is increasing, albeit this often requires accepting illiquidity and an understanding of the risk of default. The primary response to the pensions black hole in recent years has, however, been de-risking exercises. These are multi-faceted in both options and impact, as illustrated overleaf. 12 http://www.thepensionsregulator.gov.uk/doc-library/research-analysis.aspx#s16224 13 JLT Employee Benefits, 2016 14 Under the Pensions Act 1995, trustees have the same powers of investment in relation to scheme assets as if they were the beneficial owners of the assets. The scheme’s sponsoring employer has no right to restrict the trustees’ investment powers. Given the breadth of the power, trustees can use the investment powers to increase pension scheme liabilities. Pension Scheme Solutions Some employers have also used alternative finance initiatives (AFIs) to help finance their DB pension schemes. AFIs are methods of financing a pension scheme that do not involve the immediate application of cash (or other assets) into the scheme. They include: • Parental guarantees • Security over assets • Letter of credit from a third party • Enhanced creditor status or ‘subordination’ • Escrow accounts • Asset backed contributions This list is by no means exhaustive and new AFIs are still emerging. However, their objectives are often the same. To bring this all to life, here are a couple of examples that illustrate the impact that de-risking can have on a scheme’s liabilities depending on the characteristics of the scheme (e.g. the amount of small pensions that are eligible for payment in lump sum form) and, where members are offered an alternative to their DB pension, the level of take up in respect of the offer. Illustrative Transfer Value Exercises Scheme 1 Scheme 2 Scheme 3 Number of members in scope for exercise 1,004 28 42 Total Transfer Values for members in scope £126m £6.4m £3.7m Percentage of members who sought financial advice 61% 86% 79% Total Transfer Values paid out £25m £1.8m £1.8m Percentage take up rate 20% 28% 48% Saving against current buyout deficit £24.9m £0.7m £1.1m DB PENSION SCHEME (CASE STUDY) In 2001, our client – a privately-owned engineering company – had two DB schemes with four sponsors, and assets totalling £20m. They realised that, with the introduction of FRS17, the assets in the schemes were effectively part of the company and so part of their wealth. Their choice was either to hold on to their assets on the balance sheets outside the schemes and give underfunded benefits, or transfer assets in to the schemes and so give fully funded benefits. Further, the next generation of family expressed a desire to exit from the business. So selling the company became an important agenda item for consideration in future. With an FRS17 focus, potentially underfunded schemes would simply mean the sale price would be lowered because of the deficit, or even no sale would be possible. As a result, they would simply have to asset-strip the business as they came to retire. If they funded the schemes, they would target getting their money ‘back’ through an improved price and increased saleability. Equally, the trustees did not want to be left without a sponsoring employer as the current family generation aged or exited. They either wanted to have a sale to a stronger employer (for which they appreciated they needed the schemes to be better funded) or ideally get to a fully secure or at least self-sufficient position themselves. A plan needed to be put in place. Initially the plan was to get to 100% funding against FRS17 (and so funding assumptions were broadly aligned to the accounting assumptions) as this was believed to be the metric appropriate for a sale. Buyout was seen as the long term goal but at the time, was too far away to realistically focus on. We settled on a plan made up of four tasks: TASK ONE: STABILISE THE POSITION The schemes were closed to future accrual in 2001. The stakeholders realised they could not keep providing an open-ended provision, so a reasonable DC, contract-based scheme was put in place, which we benchmarked against their competitors. TASK TWO: FINANCE THE SHORTFALL We advised the Trustee to implement a 12-year strategy orientated on high-growth to achieve a 100% funding position against FRS17. Significant contributions were made to make this likely, but the overall strategy had not yet built in a significant liability management de-risking strategy – a philosophy the Trustee took some time to agree was needed! Little progress was made over the next five years, but we convinced the Trustee to consider ways to manage and reduce the scheme liabilities, rather than simply focus on growing the scheme assets. Also, it was agreed that FRS17 was no longer the relevant measure for any potential corporate activity and that a journey to self-sufficiency or buyout would be necessary. TASK THREE: AGREE A REVISED STRATEGY We sought efficiencies and as a result, managed the merger of both schemes to allow a simplified focus on the required tasks, make cost savings where possible and at this point recommended a small cash injection to equalise funding to allow this. The Trustee and sponsor agreed to offer full (not reduced) transfer values to those members who wanted it, and provided fees for the cost of advice. As a result, 19% of liabilities were removed. Following a gap of two years, the owners of the business transferred their benefits out of the scheme – again part of realising that the money was theirs either within the scheme (but lower business sale price), or out of the scheme of smaller value (but higher business sale price). To aid the group company sale, it was realised that group participants needed to be freed from the shackles of the scheme, rather than being linked to an acceptably funded scheme. So with our help they underwent restructurings and apportionments – to leave a company comprising properties alone being responsible for the scheme: As a result, the Trustee required significant funding improvement to mitigate the loss of covenant. The group companies borrowed money to inject into the scheme, to make surplus funding on the self-sufficiency measure and the Trustee moved to a ‘lock down’ asset position within LDI and bonds to give a fully hedged position, given the need to protect funding due to the resulting reduced covenant. However, it was appreciated that buyout must now be put in place. TASK FOUR: DEVELOP THE STRATEGY Noting that they needed to move slowly to a buyout position, the Trustee used surplus assets as a small growth component in their portfolio (equity and hedge fund), plus corporate bonds rather than gilts for additional returns in addition to LDI. Strong bond/equity performance meant funding improvements. Sighting an opportunity for a buyout, we suggested a capital injection of around £7m would be needed. We agreed to continue monitoring until the required injection reduced down to £4m, when the group (not the remaining employer) might consider further payment. A full data cleanse and trivial commutation exercise was carried out and the former revealed unmarried members, dates of birth differences, and odd member deaths, which resulted in further improvements in funding of around £1m. Following the sale of some group companies, which was possible following the previous restructuring that took place earlier, an amount of capital was freed up for additional payments for a buyout so it was decided to approach the insurer market in 2015. We approached three insurers, with one on an underwritten basis. A significant discount relative to the non-underwritten alternatives was received, which required a further small cash injection and the buyout process was concluded. Now the wind-up of the scheme is completed, the property company can divest its assets back to the family owners. Key events Funding 2001 2002 2005 2007 2009 2011 2012 2013 2014 2015 MFR 85% 85% 83% Ongoing 70% 75% 70% 65% 71% 103% 105% 115% 121% Solvency 40% 40% 41% 45% 50% 77% 80% 90% 95% Action • Closure to future accrual • Growth oriented investment Strategy: 80% Equities / 20% Bond • Sensible contributions • 12 year plan agreed • More prudent target agreed upon: Recovery plan now 10 years • First Transfer Value (TV) exercise: Agreed to unreduced TVs’ 19% of liabilities removed Merger of the schemes: Small cash injection to do so Brought about focus and some efficiencies / cost savings Second TV exercise with 20% of liabilities removed Owners opt out – a further 20% of liabilities removed Significant cash injection to allow group restructuring “Lock down” investment strategy: LDI 15%, Bond 70%, Equity / hedge 15% First buy-in sighting targeted Data cleanse, trivial commutation exercises carried out Second buy-in sighting targeted Approached insurance market, 3 insurers, Buy-in deal done: Underwritten exercise concluded: Small cash injection made There are, however, limitations to existing solutions for managing assets and liabilities: • Their effect is often confined to benefits attributable to future pensionable service, only. Subject to the rules of a particular scheme, this was not always the case prior to the introduction to Section 67 of the Pensions Act 199515 . • They can be very expensive. For example, pension scheme buyouts although, with the benefit of hindsight, more schemes should have secured their liabilities under contracts of insurance long before ‘risk transfer’ became as common as it is today. • Above all else, as evidenced by growing deficits, despite the response of corporate UK, the existing solutions to the pensions black hole are, in an environment where most schemes are already closed, not always sufficient. 15 Modification of schemes and the requirement for actuarial equivalence or member consent in relation to ‘regulated modifications’ 4. OUTLOOK The time has come to start thinking more radically, if we don’t, we risk undesirable consequences, including: EMPLOYER / SCHEME FAILURES A recent study from the Pensions Institute16 suggests that around 1,000 of the remaining 6,000 DB pension schemes are at risk, with the employers of some 600 of these schemes likely to be forced into insolvency in the next 5 to 10 years. A further 400 could survive if relieved of their pension obligations. RAISING CAPITAL – EQUITY AND DEBT FINANCE A study by Llewellyn Consulting17 found that the UK market appears to give large and significant weight to the DB pension net asset positions of FTSE 100 companies – as significant in many regards as to their non-pension related book values and earnings. This is then fed directly to the share price of the sponsoring company. Also, the relative size of a corporation’s liability compared to its market capitalisation can have an impact on how equity investors view a company’s stock18 . Research compiled by Citi’s Pension Solutions team shows that companies with moderate or severe underfunding materially underperform the equity market. In addition, they tend to have a higher beta, suggesting a higher cost of equity. Survey data from equity investors suggests that an unfunded pension liability starts to become a concern when it approaches 10% of a company’s market cap19 . INTERGENERATIONAL UNFAIRNESS Current employees who have never been in a DB scheme are picking up the DB deficit tab through lower earnings. In the words of Paul Johnson, Director of the Institute for Fiscal Studies20: “Pension promises are a burden on the young who can’t hope to enjoy them”. A further articulation of this issue can be found in the research by the Intergenerational Foundation: “People in older generations have built their life plans on the assumption that these promises will be honoured, but people in younger generations are having to constrain their life plans because they have to honour them. Someone has to lose out”21 . 16 ‘The Greatest Good for the Greatest Number’, December 2015 17 http://www.cimaglobal.com/Documents/Thought_leadership_docs/white-paper-hub/Llewellyn_report_brochure_final_visual_small.pdf 18 Citigroup – ‘The coming pensions crisis’, March 2016 19 Ibid 20 The Times, 3 May 2016 21 http://www.if.org.uk/wp-content/uploads/2016/06/Pensions-Throttling_Final.compressed.pdf LEGACY DB AS A DRAG ON DC Automatic enrolment is getting more people into workplace pensions schemes (see the graph below22), but legacy DB pension promises are holding back the amount that employers can afford to contribute to their, usually DC, schemes for current workers. According to the Intergenerational Foundation, if the deficit reduction contribution alone was eliminated, then £35 billion would be available to, among other things, boost the DC pension pot of each younger worker by £12,00023 . Scheme memberships by type of scheme 22 Annual Survey of Hours and Earnings, 2015 23 DB Pensions: Chocking Hazard, June 2016 THE WIDER ECONOMY The impact that funding DB schemes can have on a business’s activities means that, in many boardrooms, the issue remains at the top of the agenda. According to the Confederation of British Industry24 , the cost of DB is negatively affecting: • businesses’ ability to invest to grow (according to 65% of business leaders) • their results in company accounts (according to 82% of boardroom leaders) • internal reorganisations, asset sales and mergers and acquisitions (according to 56% of business leaders) The media has recently reported on ‘ballooning pension fund deficits’ affecting the ability of companies to make dividend payouts to shareholders. Carclo has reportedly scrapped plans to pay a dividend as a result of an expected pension deficit25 . In short, the pensions tail is wagging the corporate dog. So, there are many compelling reasons for considering new solutions to the pensions black hole. The following sections consider in detail the current thinking, including the hitherto almost unimaginable case for no longer treating accrued benefits as sacrosanct. 24 http://www.cbi.org.uk/news/cbi-mercer-pensions-survey-2015/a-view-from-the-top/ 25 The Times, 4 September 5. NEW THINKING Employers were not always required to effectively underwrite their DB pension schemes. Until fairly recently, through the strengthening of pension deficit legislation (see the box below), members could not be certain that pensions would be paid in full on the winding up of their DB pension schemes, even if their sponsoring employer was solvent and able to fully secure accrued benefits. Over the past 25 years, successive governments have turned employers into insurers of their DB pension schemes. They’ve also introduced legislation to stop employers reducing accrued benefits (unless member consent is obtained). The tide, however, is turning. Very recently, the consequences of DB pensions policy over the past 25 to 30 years have received considerable press attention due to the different fortunes of British Steel and BHS and the implications for their respective DB schemes. These cases, reported in the media, have prompted a wide ranging debate about DB regulation, including consultations and inquiries from the Pensions and Lifetime Savings Association26, the Work and Pensions Committee27 and the Government28 . As a result, new solutions for getting out of the black hole are being put forward. These include: • Allowing pension schemes to reduce pension increases, for preserved pensions and pensions in payment, in respect of benefits attributable to past as well as future service • Contingent increases to pensions, dependent on a pension scheme’s funding level • Allowing employers to do bulk transfers, without member consents, from their current DB pension scheme to a new scheme that provides lower benefits than the current scheme (but is more generous that Pension Protection Fund benefits29) • Moving away from market accounting30 • Changing the approach to technical provisions funding • Ceasing all deficit reduction contributions31 • Changing the composition of trustee boards32 • Giving employers more input on investment strategy. Our view is that finding a lasting settlement depends on focusing on what is possible. Depending on the solutions adopted, it might also mean employers have to give something in return. If employers are allowed to reduce accrued benefits, any solution should not simply be a ‘get out of jail free card’ for all sponsors with legacy DB pension schemes. Against this backdrop, our conclusions and recommendations are set out in the final section of this report. 26 DB Task Force call for evidence, June 2016 27 http://www.parliament.uk/business/committees/committees-a-z/commons-select/work-and-pensions-committee/news-parliament-2015/defined-benefitpensions-16-17/ 28 https://www.gov.uk/government/consultations/british-steel-pension-scheme 29 http://www.pensionprotectionfund.org.uk/Pages/compensation.aspx 30 Where current interest rates are used to estimate how much of today’s money will be needed to pay a debt in, for example, 20 years time 31 See the Intergenerational Foundation paper, DB Pensions: Chocking Hazard, for more detail of this very radical solution 32 Ibid 6. CONCLUSIONS AND RECOMMENDATIONS Given everything that we have said and, in particular, our comments on the DB deficits in the last ten years, we hope that we are not alone in reaching the unequivocal conclusion that we cannot continue to follow the same path for the next ten years or longer. Without more drastic action, there could be a 50 to 60 year run off for existing DB pension schemes and, quite frankly, continuing to just ‘kick the can down the road’ is not an option. So, we need to take a fresh look at how DB deficits are tackled. This is the time to do so, for at least two reasons: 1. The bright spotlight cast on high profile cases such as BHS and British Steel 2. The UK’s decision to leave the EU. Whilst this decision, in some ways, compounds the problem, it also creates the prospect to reconsider legislation around the funding, investment and compensation for members of failed pension schemes without having to take into account EU pension directives and decisions made by the Court of Justice of the European Union. For some examples of recent suggestions for changes to the DB pensions framework, which precede the EU referendum, see the OECD paper on counter-cyclical scheme funding regulations33 and the Pensions Institute Paper on the Pension Protection Fund (PPF) compensation structure being arbitrary and unfair on younger members34 . Our own thoughts, on future change, are included in our recommendations. We also need to decide whether the most radical solutions, if implemented, should apply to all or just some employers. For example, if we allow schemes to reduce accrued benefits, should we only do so if the employer is otherwise likely to fail and its scheme to be transferred to the PPF? This approach has already been mooted by the Pensions Institute35. The first appendix to this report contains our own variation on the proposal. However, the rules of the game already change when a company is in distress and options that fall short of securing all liabilities in full are available in these circumstances and have been used36 . In any case, restricting solutions to some employers or schemes would not necessarily resolve all of the issues this report identifies, such as the intergenerational unfairness of companies putting aside £23,600 per DB member p.a. and only £1,200 per DC member p.a37 . 33 http://www.oecd.org/finance/private-pensions/45694491.pdf 34 http://www.pensions-institute.org/reports/GreatestGood.pdf 35 Ibid 36 See, for example, how pensions and jobs were protected at Halcrow – http://www.thepensionsregulator.gov.uk/press/pn16-33.aspx 37 Intergenerational Foundation, DB Pensions: Chocking Hazard So, there is a case for solutions to be available to all sponsors of legacy DB pension schemes provided that, if employers avail themselves of the new solutions, they give something in return. The task now is for all stakeholders (employers, trustees, members, policy makers and the pensions industry) to, together, explore the options and achieve a consensus that gets us out of the black hole. In terms of what is possible, realistic, and arguably fair to previous, current and future generations of members, our recommendations for achieving a lasting settlement can be split between those that will entail an actual reduction to accrued benefits and solutions that could help without any such diminution; at least not to the value of these pension promises (although, the form and security of them would change). RECOMMENDATIONS THAT MEAN REDUCING THE BENEFITS PEOPLE HAVE ACCRUED • Change bulk transfer regulations, so transfers to new schemes are possible without consent in more circumstances – not just where the benefits in the new scheme are largely the same. For example, a member interest test could be applied38 . • Allow schemes to reduce pension increases for preserved pensions and pensions in payment, in respect of benefits attributable to past and future service, to reflect prevailing rates of inflation as measured by the Consumer Price Index. In return, employers should commit to improving their workplace pension arrangements for current workers. One way to do this would be through the Pension and Lifetime Savings Association’s Pension Quality Mark39 . RECOMMENDATIONS THAT DON’T REDUCE THE BENEFITS PEOPLE HAVE ACCRUED • Introduce regulations similar to those for conversions of Guaranteed Minimum Pensions (GMPs)40, to allow wider simplification of complex benefit structures on a nil consent basis. For example, employers could be allowed to consolidate many complex benefit structures into one simple one on a ‘broadly actuarial equivalent basis’. This could lower the ongoing costs of administration and reduce the scope for errors. It could also lead to more efficient liability management and greater ability for members to ‘self-service’ their benefits and options. • Reintroduce State Scheme Premiums for formerly contracted-out schemes, allowing members’ SERPS benefits to be reinstated with corresponding reductions to DB pension promises. • Remove obstacles to liability de-risking (such as trivial commutation, enhanced transfer values, retirement options and pension increase exchanges), whether in scheme rules or otherwise, through statutory overrides. This would mean that all options would be available to all scheme sponsors. 38 See the decision of the High Court in the Halcrow case (http://www.bailii.org/ew/cases/EWHC/Ch/2015/3685.html) for a detailed consideration of some of the difficulties arising from the current regulations 39 http://www.pensionqualitymark.org.uk/ 40 The Occupational Pension Schemes (Contracting-out) (Amendment) Regulations 2009 The Trustees’ role would be confined to making sure members can make informed decisions – they would not be able to prevent or unnecessarily frustrate any option. • Review the rules around transfers and conversions and, in particular, partial transfers / conversions. For example, if employers were permitted to transfer out members’ tax-free cash entitlements, then there would be an improvement in funding levels, in schemes without assumptions for commutation in actuarial valuations. • Amend funding regulations so that advance funding is required only in respect of pension promises up to the level of PPF benefits. Allow promises in excess of PPF level benefits through unfunded ‘top-up’ schemes41 . By changing the form of pension promises so that they are delivered partly through funded DB pension schemes and partly through unfunded contractual commitments42 , the value of the promise is still the same from an accounting perspective (so there is transparency in company financial statements). However, given that 25% of DB liabilities exceed PPF benefit levels (see the graph, below43), there would be a huge and immediate impact on measured deficits, the amount employers have to contribute to their schemes and the capital available to grow their businesses. Key funding statistics as at 31 March 2015 s179 Full buy-out Total number of schemes 5,945 5,945 Total assets (£ billion) 1,298.3 1,298.3 Total liabilities (£ billion) 1,542.5 2,099.2 Aggregate funding position (£ billion) -244.2 -800.9 Total balance for schemes in deficit (£ billion) -285.3 -804.9 Total balance for schemes in surplus (£ billion) 41.1 4.0 Funding ratio 84% 62% 41 In HMRC terms, unfunded employer finance retirement benefit schemes 42 Insurance could be purchased or assets charged to provide additional security 43 Purple Book 2015 • Consideration also needs to be given to a prospective change in direction of the funding regime alongside increased responsibility from the PPF. For example, imagine pension schemes across the country no longer needed to invest in gilts and could take a genuinely long-term view. They would then start to invest in growth assets like equities and infrastructure projects. We would have the benefit of harnessing pension scheme assets to improve the UK economy long-term. It is expected that, over the long run, this would reduce the cost of providing pension benefits for most companies. Using significantly higher discount rates would take away the burden of an underfunded pension scheme and give many companies a new lease of life. Contributions to defined benefit pension schemes would fall and so would the government cost of tax relief associated with it. Of course, the issue with this is that some companies will fail and the PPF will have to step in. We would expect fewer companies to fail if this policy were adopted, at least in the shortto-medium term. We’d need to consider the effect on PPF levies, but the PPF might be able to stand behind the full pension promise. Even if PPF levies had to rise it would potentially still result in a net saving for employers. The reforms we suggest may mean reconsidering the role of The Pensions Regulator too, which in turn affects sponsor and trustee relationships. However, as the Pensions Institute has said, revising the Regulator’s remit could be a simple as changing their duty from protecting members’ ‘benefits’ to ‘interests’44 . In all events, the potential benefits of a lasting settlement for the pensions black hole extend far beyond a ‘let off’ for scheme sponsors. Potential benefits for stakeholders include: • For members of legacy DB pension schemes, greater sustainability of past pension promises (which may be lower than original expectations, but are more likely to exceed PPF benefit levels) • For trustees of these schemes, less dependency on sponsoring employers and whether or not they will still be around in decades to come • For current workers, more generous contributions in respect of current workplace pension arrangements and higher wages • For companies, more resources available for research, investment and business activity • For the economy, a boost from increased business confidence and enterprise. For all these reasons, this opportunity to get out of the pensions black hole is one that we cannot afford to miss. There should now be an open and transparent debate about which solutions will work best. We must recognise that it is not heretical to talk about removing guarantees that will never be delivered and that the status quo is not in the best interests of all stakeholders. 44 ‘The Greatest Good for the Greatest Number’, December 2015 APPENDICES APPENDIX 1 A GOING CONCERN TEST, OR ‘THE POINT OF NO RETURN’ How do we know when a pension scheme is no longer sustainable on a ‘going concern’ basis? We present a proposal for a ‘going concern’ test that aims to allow Trustees, sponsoring employers, advisors and regulators to evaluate whether a pension scheme has passed ‘the point of no return’. We propose that, if a pension scheme fails this test, the stakeholders would be able to engage directly with both The Pensions Regulator and the PPF to discuss potential solutions. These solutions might include: • compromising on benefits – with the scheme paying a lower level of benefit • cutting the pension scheme free from the employer • the pension scheme going into the PPF, with the PPF taking control of the sponsoring employer. THE TEST WOULD HAVE TWO PARTS – THE ‘BALANCE SHEET’ TEST AND THE ‘CASH GENERATION’ TEST. We understand that some sponsoring employers will be asset rich but cash poor and vice versa. That’s why a scheme would have to fail both parts for the overall test to fail. The responsibility for carrying out the tests could fall to either the principal employer or the pension scheme Trustees. We recommend that the company directors are responsible for the test, which would be carried out every year as part of producing the company accounts. The directors would have to sign an annual ‘going concern’ statement confirming whether the test has been met or not. THE BALANCE SHEET TEST This checks whether the participating employers have the resources they need to fund the scheme if the employer becomes insolvent. There is a definition of “insufficiently resourced” which is already used by The Pensions Regulator to decide whether a corporate group is able to support a scheme . We suggest that this could be used as a starting point for the balance sheet test: A company is insufficiently resourced if it is unable to meet 50% of the scheme’s liabilities (calculated on a full buyout basis) in circumstances in which one other group member, whether on its own or collectively with any connected and associated entities, can bridge that gap from its (their) available resources. If that is the case, each and every such associated or connected person is susceptible to a financial support direction. THE CASH GENERATION TEST This checks whether the employer can support the scheme on an ongoing basis through cash contributions. The participating employers would need to identify the maximum cash funding (MCF) that could be directed towards the scheme. This could be defined in various ways, but the establishment of the maximum measure would need to take into account the need for the employer to be able to survive (but not necessarily grow) on a going concern basis. We then need to identify an objective measure of self-sufficiency. This could be a prescribed set of assumptions, like the ones the Pension Protection Fund issued for carrying out section 179 valuations. The current deficit on a self-sufficiency basis would be estimated at the test date. The next step would require projections of the funding position which incorporate the MCF contributions. This would be carried out using a stochastic asset liability model. The assumed investment strategy is a key component of this analysis, in particular when projecting the position over a long period of time. The current strategy could be used, but this might encourage pension schemes to take more risk in their strategy – we recognise that this is not necessarily an unsuitable strategy to follow depending on the specific situation. A maximum level of investment risk could be established. This might be set to ensure that the probability of the strategy leading to a failure, or further deterioration, of the balance sheet test is limited (say less than 33%). Or it could be set to limit the risk that funding levels on a PPF measure deteriorates over time (including an allowance for PPF drift). We would then calculate the probability of success under the model at different time horizons. If the probability of ever reaching self-sufficiency is below a specified threshold (using a maximum period of, say, 25 years) then we would say that this part of the test is failed. An example scheme is shown below. This scheme is currently 50% funded today on a self-sufficiency basis. Funding Level, % Measurement period 10 years 15 years 20 years 25 years Median funding level 56% 60% 68% 74% Probability of reaching self-sufficiency 1% 5% 13% 20% As the probability of this scheme ever reaching self-sufficiency is very low, we would likely say that it fails the cash generation test. COMBINING THE TESTS The proposed test is either a pass or a fail, so there is clearly a cliff edge beyond which a scheme would be justified in approaching tPR and the PPF. This is illustrated in the diagram below. However, the progression against this test would be monitored under our proposed approach so that schemes in the amber area can consider remedial action before the ‘point of no return’ is passed. APPENDIX 2 ACT BRIEF SUMMARY BROAD IMPACT Finance Act 1970 Creation of New Code Approval for occupational pension schemes Pension schemes provide mainly discretionary benefits with no minimum funding or security requirements. Social Security Act 1973 Creation of the Occupational Pensions Board, introduction of preservation requirements for early leavers (with more than five years’ service), introduction of provisions for the financing and security of minimum benefits Guarantees and minimum funding requirements typically relate to less than 10% of liabilities. Social Security Pensions Act 1975 Introduced State Earnings Related Pension Scheme (SERPS) and contracting-out via Guaranteed Minimum Pensions (GMPs), extension of adequate financing provisions to include GMPs Improved level of guarantees and minimum funding requirements maybe extend to 20% of liabilities. Social Security Act 1985 Introduced anti-franking and statutory revaluation of deferred pensions, also introduced a statutory right to a cash equivalent transfer value Early leaver benefits become much more valuable, and now have a guaranteed transfer option. Level of guarantees now represents maybe 50% of liabilities. Social Security Act 1986 Extended preservation requirements to early leavers with more than two years’ service and reduced future SERPS and GMP benefits by 20%, introduced personal pensions Finance Act 1986 Introduced overfunding regulations and taxation of excessive pension scheme surpluses Companies are discouraged from overfunding. Finance Act 1989 Introduced new Inland Revenue limits (the earnings cap) and the creation of funded and unfunded retirement benefit schemes (FURBS and UURBS) Company management start to look elsewhere for separate pension provision Barber v GRE 1990 E.U. Court case requires equalisation of benefits for men and women Forces equalisation of retirement ages and some improvements in benefits. Effect still being felt, with unresolved issues such as equalisation of Guaranteed Minimum Pensions Social Security Act 1990 Extension of provisions for the revaluation of early leaver benefits to cover all service. Also introduced enabling legislation for debt on the employer regulations and guaranteed pension increases (but these were delayed until the introduction of the Pensions Act 1995). Significant (and retrospective) increase in level of guarantees for early leavers. Pension Schemes Act 1993 Consolidation Act N/A Pensions Act 1995 Introduced statutory minimum funding (the Minimum Funding Requirement or MFR) and guaranteed (Limited Price Indexation or LPI) pension increases for future service benefits, as well as many provisions on the governance and management of pension schemes Level of guarantees now 70%-80% of liabilities; changing economic climate and extension of guaranteed LPI increases to all service, raises level of guarantees to almost 100% of liabilities for most schemes; MFR funding requirement typically covers 80% of guaranteed benefits. 1993 and 1997 Budgets Pension schemes no longer able to claim tax credits on equity dividends Makes equities less attractive to pension schemes MFR changes (1998 and 2002) On 15 June 1998, changes to the MFR formula reduced MFR liabilities by up to 19%. On 7 March 2002, changes to the MFR formula reduced MFR liabilities by up to 8%. By 2004, the MFR funding requirement typically covers no more than 50% of the guaranteed liabilities. 11 June 2003 Government announcement The debt on an ongoing employer if a pension scheme winds up is the deficit on a ‘buyout’ basis Significant increase in the level of security attaching to guaranteed benefits. Finance Act 2004 Single tax regime and introduction of Annual and Lifetime Allowance for pension savings Amended in every year since introduction making regime hugely complicated, and reductions in AA and LTA making pension provision less attractive to higher earners Pensions Act 2004 Abolition of MFR and creation of scheme specific funding. Creation of PPF and Pensions Regulator. IASB introduces IAS19 Full balance sheet recognition of pension scheme assets from 1 December 2005 Pensions Act 2007 State Pension and State Pension Age reforms Pensions Act 2008 Workplace Pension Reforms Employer automatic enrolment duties commence from October 2012 Finance Act 2011 High Earner pension tax changes reduce Annual Allowance to £50,000 and Lifetime Allowance to £1.5 million. Pensions Act 2011 State pension age equalisation and increase to age 66; amendments to automatic enrolment; amendments to existing pension legislation which contains indexation and revaluation requirements; and a new definition of money purchase benefits. Attempt at reducing increases to pensions, but only for future service and not overriding Finance Act 2013 Reduction of LTA to £1.25m and AA to £40,000, from April 2014. Pensions Act 2014 New flat rate State pension, and the ending of DB contracting-out, from April 2016 Finance Act 2014 New drawdown and trivial commutation limits from 27 March 2014. Taxation of Pensions Act 2014 New flexibility for DC savers from April 2015. Pensions Schemes Act 2015 Conversion of benefits and transfers. Definition of ‘money purchase scheme’. Brexit On 24 June 2016, the UK voted to leave the European Union It has been estimated that the outcome of the referendum, combined with the decision of the Bank of England to cut interest rates to 0.25% and start a new quantitative easing programme, has increase DB liabilities by £70bn. CONTACTS JOHN WILSON Head of Technical +44 (0)131 456 6850 john_wilson@jltgroup.com MURRAY WRIGHT Consultant +44 (0)131 456 6868 murray_wright@jltgroup.com JLT Employee Benefits The St Botolph Building 138 Houndsditch London EC3A 7AW Tel +44 (0)20 7528 4000 Fax +44 (0)20 7528 4500 http://www.jlteb.com JLT Employee Benefits. A trading name of JLT Benefit Solutions Limited. Authorised and regulated by the Financial Conduct Authority. A member of the Jardine Lloyd Thompson Group. Registered Office: The St Botolph Building, 138 Houndsditch, London EC3A 7AW. Registered in England No. 01536540. VAT No. 244 2321 96. © October 2016 273130 Document CompleteBack to Top11/379 Schedule 22 of the Incorporation and Taxes Act 1988 (previously Finance Act 1986), which set out provisions in relation to ‘statutory surplus’. Until their repeal in 2006, these provisions required regular actuarial valuations on a prescribed basis. If assets were shown to exceed liabilities by more than 5%, the scheme administrator was required to submit proposals to the Inland Revenue for reducing it to an acceptable level (not more than 5% of the scheme’s liabilities) or eliminating it altogether. The Pension Scheme Surpluses (Valuation) Regulations 1987 (SI 1987/412) required the valuation of the assets and liabilities of a scheme to be submitted to the Inland Revenue by the scheme administrator whenever any other actuarial valuation of the scheme was made. The regulations also prescribed the manner in which the actuary was to value the assets and liabilities of the scheme.
LGPS had an even more aggressive funding regime at one time which allowed funding targets to be lowered from 100% to 75%.
HM Government allowed administering authorities to go down this route in the 1990s as it reduced the funding target for funds to 75%. This immediately created “surpluses” for funds and resulted in them reducing contributions, and in some cases, conducting contribution holidays.
A warning from history not to go too far with any of these “releases”.
Schedule 22 of the Incorporation and Taxes Act 1988 (previously Finance Act 1986), which set out provisions in relation to ‘statutory surplus’. Until their repeal in 2006, these provisions required regular actuarial valuations on a prescribed basis. If assets were shown to exceed liabilities by more than 5%, the scheme administrator was required to submit proposals to the Inland Revenue for reducing it to an acceptable level (not more than 5% of the scheme’s liabilities) or eliminating it altogether. The Pension Scheme Surpluses (Valuation) Regulations 1987 (SI 1987/412) required the valuation of the assets and liabilities of a scheme to be submitted to the Inland Revenue by the scheme administrator whenever any other actuarial valuation of the scheme was made. The regulations also prescribed the manner in which the actuary was to value the assets and liabilities of the scheme.
Meanwhile over in the parallel universe of LGPS, HM Government allowed administering authorities to go down this route in the 1990s as it reduced the funding target for funds from 100% to 75%. This immediately created surpluses for funds and resulted in them reducing contributions, and in some cases, conducting contribution holidays.
The step back up in later years was steep.
Check out the prescribed actuarial basis set out in that 1988 tax legislation:
“The actuarial assumptions and requirements for the purposes of the valuation to which paragraph (1) of this regulation refers are as follows—
(a)the valuation rate of interest: the rate assumed to be earned on the investment of the future income of the scheme (net of expenditure) shall be 8.5 per cent. per annum;
(b)the net investment yield (pre-retirement): the margin between the valuation rate of interest to which sub-paragraph (a) refers and general increases in salaries must be assumed to be 1.5 per cent. per annum;
(c)the net investment yield (post-retirement):
(i)the valuation rate of interest shall be reduced to take account of pension increases at the rate provided for under the scheme, provided the net investment yield is not so reduced to an amount less than 3 per cent. per annum;
(ii)where it is provided under the scheme that there shall be regular reviews of pensions currently payable and for pension increases (not exceeding any relevant increase in the retail prices index) to be given at the discretion of the trustees or employer (subject to availability of funds), paragraph (i) shall apply as if references to increases included references to such discretionary increases;
(iii)the pension increases under paragraph (ii) shall be arrived at after taking account of—
(a)the average increase, measured either absolutely or relative to inflation, awarded during the period of 3 years preceding the effective date of the valuation; or
(b)such rate of increase notified to the Board [of Inland Revenue] under a declaration of intent made jointly by the administrator of the scheme and the employer to pay increases (subject to availability of funds), provided also that the extent of the increase included in the valuation (either by reference to a rate of increase or by a margin in the rate of interest) is disclosed to scheme members;
(iv)where, under the scheme, the rate of pensions increase is effectively linked to increases in the retail prices index, the net investment yield shall be 2 per cent. per annum except where the obligation to make an increase is (under the scheme) subject to a stated (or overriding) maximum when an appropriate higher net yield must be used;
(v)no reduction shall be made in the valuation rate of interest unless the requirements of this regulation are fulfilled.
If I’m reading those 1988 fixed assumptions set out below correctly, it’s an expected investment return of 8.5%, pensionable pay growth of 7% and unknown for RPI inflation, say 5%?
My first actuarial valuation at that time (with a long retired actuary) was 9% investment return, 8% pay growth and 5.75% for general inflation.
The scheme from there achieved 10% on average, pay growth was much lower, suppressed by the profit-related pay scheme, and average RPI was less than 4%.
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