Lower TVs and less DC saving…

…is perhaps an unlikely reaction to today’s budget consultation response. However, this could be the result of 2 of the measures announced today.

Locked away for too long

My first reaction following the budget this year was that DC might finally be something I have a real interest in saving money into. I am absolutely in favour of the reforms to give people more freedom with their pension savings. However, the reforms didn’t go far enough in my view. There was still the inflexibility of the money being tied up until 55, over 20 years away in my case. This is too long to tie my money up, there are so many scenarios I can think of in which I might need that money sooner whether it means I’m penniless in retirement or not.

Yet today it got worse still. Today it was determined that my money will be locked up until at least 58! That’s at least another 3 years before I can get at it and so another 3 years later before I START putting money into a DC pension. NISAs seem a much nicer way of doing things.

As an aside, the consultation response put “fairness” at it’s heart. It’s difficult to see why increasing the age at which you can access your own money is fair. Especially to the many people who don’t make it to retirement.

If all transfers are rational…

…then there’s some serious selection risk.

The area of most controversy in the consultation was on whether to ban transfers from DB schemes. Unsurprisingly following the reaction to this suggestion such a ban has not been implemented for all but unfunded public sector schemes. However, “safeguards” have been added such that independent advice must be obtained.

Given this, it perhaps reasonable to assume the majority of transfers will be rational decisions. But if this is the case then they must be better than average risks as far as the scheme is concerned. Should transfer values be reduced to take this into account?

Political football with pensions tax relief

Today’s FT Westminster blog states pensions tax relief is once gain going to be kicked around and become a key battleground as part of the election. Labour are proposing to reduce the relief to 20% for those paying 45% tax.

To me the whole concept of removing such relief is crazy. It will mean people are taxed twice on their money, 25% on the way into the pension and at least 15%, but for those in question likely 30%+, on the way out. This results in an overall tax rate of 55%! Of course the result should just be that no pension savings are made but this is an odd message to give. We already have both an annual and lifetime allowance for tax relief. Do we really need any more restrictions?

My tweet response to this was quickly followed up by Greg Kingston (@GregKingston) who summarised the political landscape well with:

@markjrowlinson @JosephineCumbo @ftwestminster always good to campaign on something most people don't understand. Lowest number will win.

It is this kind of politics that leads to division and the desire, from those that can, to look into ever more complicated tax avoidance schemes. I’m all for a progressive taxation system buts let’s keep it simple and be honest about it – that way we are all in it together.

It also reminded me of this little story who I have no idea who to credit to. There are many variants around but they are worth remembering from time to time. In particular the first part shows why it is only reasonable for the those paying more to gain more out of cuts and reliefs and the second why we should always avoid being too envious of those who earn more than us.

Let’s suppose 10 people who work together go to a restaurant after every payday, and at the end of the meal the bill comes to £100. They agree to cover the bill according to how much they earn.

The manager pays £55
The two supervisors pay £11 each
The four file staff pay £5 each
And the three junior staff pay £1 each

———————–

The regular meals continue for a few months and eventually they manage to convince the restaurant’s owner that, as they’ve been frequent and loyal customers and the restaurant is doing very well, he could give them a 20% discount. This leaves them with a £20 windfall to divide between them.

The first idea the restaurant owner proposed was to split the savings evenly between them, so each gets £2 – leading to:

The manager paying £53
The two supervisors pay £9 each
The four file staff pay £3 each
And the three junior staff receive £1 on top of their (now) free meal

Obviously the 7 paying colleagues weren’t very happy with this arrangement – so the restaurant owner said “Fair enough, we’ll divide the windfall among you, proportional to how much you contributed to the original bill.”, leading to:

The manager paying £44
The two supervisors pay £8.80 each
The four file staff pay £4 each
And the three trainees pay 80p each

The trainees then complain that their share of the £20 windfall is 20p while the manager’s is £11 – how is this fair?!

———————–

Let’s see what happens if the situation was to be reversed: the restaurant hits on hard times and raises the prices by 20%, but nobody wants to simply order less food. The manager proposes everyone contributes an extra £2 each so:

The manager pays £57
The two supervisors pay £13 each
The four file staff pay £7 each
And the three junior staff pay £3 each

The junior staff are not happy at all – the cost of their meal has tripled! So, they suggest everyone just contributes 20% more than what they used to for the original bill:

The manager pays £66
The two supervisors pay £13.20 each
The four file staff pay £6 each
And the three junior staff pay £1.20 each

To which the manager says “Sorry, I’m not going to pay £66 for a meal – I’m already paying for much more than I get. In fact, if you’re going to insist, I’ll find some less demanding friends and go to a different restaurant with them.” – leaving the remaining colleagues to cover the (now £108) bill between the 9 of them.

The moral of the story?
Don’t go to restaurants you can’t afford… And if you do, don’t get greedy with other people’s money!

The new code of practice is good, but it’s still a flawed funding regime

I’ve blogged before about how putting employer covenant into establishing a funding target is as sensible a concept as zombie cats. Therefore, whilst the new code of practice published last week is markedly better than the first draft, it is disappointing from my perspective that such a flawed concept continues to have such high billing.

Probability and binary outcomes

To briefly summarise my thinking on this again we need to consider binary outcomes.

A binary outcome is one where there are only 2 possible results. A great, albeit morbid example, is that this year I will either be alive at the end of the year or dead.

Now I might want to think about the impact of those scenarios. If I am alive then (hopefully) things will be good and I’ll continue to earn money to provide for my family. However, if I’m not then my family could be in real difficulty. What should I do?

Well I could look to try and save up enough money to make sure my family is ok if I died (let’s say this is £500,000 for arguments sake). However, this is utterly impractical, it would take years and how would we eat in the meantime?!

The probability of me dying this year is quite low though (about 0.06% based on current tables) so really all I need is 0.06% of £500,000 which is £300. I can manage that. Now if I die my family will be protected.

Oh wait no they won’t. They’ll just have £300!!!

The probability of my death is irrelevant as it will either happen or it won’t. Saving the average amount needed doesn’t help in either scenario. If I survive I’ve put aside £300 I could have spent and if I die it is woefully inadequate to provide for my family.

Applying a probability for an individual event like this therefore doesn’t make any sense.

Insurance

Of course the solution to my problem is simple. I should buy some life insurance.

By using insurance I can pay my £300 (plus an expense/profit allowance) and know my family is protected in the event of my death.

This works because the insurer is taking lots of £300 premiums. Let’s say they have 10,000 policies. It would now be reasonable to expect that 6 of those policies would involve a pay-out which should be covered by the £3m of premium income.

Insurance is an efficient way of covering such risks.

Pension scheme risks

Much is made in the new code of practice on funding of the significant risks involved in funding a pension scheme. From the member (and hence trustee) perspective though, there really is only 1 risk, the risk that the employer sponsor runs out of money. Provided the employer is around the benefits will get paid no matter what the current funding level.

This risk is again binary. Either the employer will survive and continue to make profits or it won’t. We might be able to make judgements on how likely it is but this is just a probability. The actual outcome is still binary.

So what is the solution? Well as is the case for managing my own mortality risk the solution is insurance. To fund schemes to the worst case scenario is (like me saving £500,000) completely impractical.

The government introduced such insurance in a compulsory format in the form of the PPF and PPF levies.

However, at the same time the Pensions Regulator introduced the concept of employer covenant strength.

Employer covenant

Employer covenant strength is akin to the probability of insolvency.

An employer with a good covenant is like a person that eats well and goes to the gym a lot. An employer with a bad covenant is like a person that eats too much junk food and drinks too much. It changes the probability of outcome but not the range of outcome.

As I showed before, trying to use such a probability to manage a binary outcome does not make sense. Yet the code of practice says:

It (employer covenant) should help the trustees decide how much risk it may be appropriate to take (ie when they set their technical provision assumptions and investment strategy

With the intention that technical provisions should be higher for a weak covenant and lower for a strong one clear from some of the examples:

a low value for technical provisions based on a strong employer covenant assessment

But this is just like me putting £300 aside to cover the likelihood of my death. In fact worse, it’s like me doing it twice, once put aside and once as insurance (levy).

It won’t be enough if the employer fails and is too much if it doesn’t. It just doesn’t make sense.

The code actually acknowledges the impossibility of knowing whether an employer will be around in the long-term:

It is unlikely that trustees will be able (with any degree of certainty) to assess the employer covenant too far into the future

So surely in the majority of cases it is not relevant?? There is a bar to cross perhaps that some could fail, reasonable expectation to be around maybe, but after that, and for the majority of employers, a long-term view should be taken that doesn’t differ by employer.

Funding allowing for the PPF

Acknowledge the existence of the PPF and the single risk faced by members and trustees is largely managed.

There is perhaps some debate around the level coverage of benefits and I certainly wouldn’t be averse to increases in compensation but agree this and the possibility of employer insolvency can be ignored.

Schemes can then focus on running for the long-term on the assumption that employer support will always be there. Funding can be set at a level to broadly reflect the expected cost of providing benefits. Risk management becomes about managing risks for the employer rather than to protect members. Prudence used to allow an employer to reduce the volatility of its contributions rather than build a capital reserve.

In fact, as the reason for funding in the first place was to provide some level of security there is a reasonable argument to not require funding at all. (I don’t quite subscribe to this as I think there is merit in paying contributions at the time of accrual so cash cost and services gained are aligned somewhat and intergenerational issues mitigated.)

Can we allow for the PPF in decision making?

Acknowledging the existence of the PPF is an interesting concept. There is no law to state that the PPF should not be considered in scheme funding decisions but this is the common view propagated and believed by tPR due to its objectives. The reason for this is a court judgement Independent Trustee Services Limited v Hope and others in 2009. However, if you read the actual judgement the position is much more nuanced.

In particular, Mr Justice Henderson states that:

there is no single all-purpose answer to the question whether the PPF is a relevant consideration for trustees to take into account.

The judgement really states that the existence of the PPF cannot be used to justify something that would otherwise be “improper”. Additionally, a large part of the discussion of why this is the case relates to it being against public policy and not in the public interest.

In the context of scheme funding though, given the obvious efficiency and need to avoid double counting of capital and insurance, allowing for the PPF in the context of what it is there for would seem, to me, to be a very reasonable position to take and in line with the judgment made.

Summary

The current position is one that encourages excessive and often meaningless prudence which in turn often leads to excessively prudent investment strategies (if you’re funding to it then why take the risk – employer’s don’t generally think long-term enough to wait for money to come back).

There is much to like about the revised draft code of practice but the concept of employer covenant driving technical provisions doesn’t work. If the law allowed trustees to take account of the PPF it would be of great help. But even without this the funding code does not need to bring in employer covenant which is not mentioned in the law on funding.

Once insolvency risk is managed lower funding targets that are more reflective of actual expected costs can be used. The approach to funding can also be used to reduce the volatility of contributions (funding doesn’t impact on cost, just pace of funding don’t forget). In this sort of environment a highly valued benefit could be provided efficiently with members having reasonable levels of security in outcome. Isn’t this what we should be aiming for?

Charging too much with 84% certainty

I was listening once again to a presentation from the PPF on their funding plan earlier this week. I first heard about their strategy some time ago and it made me as angry then as it did again this week.

Self-sufficiency

Anyone involved in (UK) DB pension scheme funding will have heard the term self-sufficiency thrown around. This is a term used by the Pensions Regulator (tPR) to reflect the level they believe a scheme should be funded at if there is no strength in the sponsoring employer. It is also I suspect a longer term aspiration of tPR for all DB pension schemes.

What they mean by this number is a level of assets that should be sufficient to cover expected pension payments with near certainty i.e. by investing in low risk assets. As much as I believe this to be wrong as a funding target (a blog for another day) I can understand how they have got to this position in the interests of member protection. The employer puts the money in to get to this position and it is used to pay member benefits or ultimately returned to the employer if it turns out it is not needed.

It is this latter point that is crucial. If the Scheme is not currently invested in such low risk assets then all expectations will be that a lower level of assets will ultimately be needed. So if the employer does survive it would be expected that a return of surplus would occur.

The PPF

The PPF has some obvious comparisons with an insurance company in that it pays out on an event (insolvency) to those paying premiums. However, the pay-out is compensation and the premiums are levies. There is no choice in the levy or compensation levels. There are three fundamental differences though:

  • It is not an insurance company (and therefore does not have to abide with insurance regulation).
  • If the premiums (levies) are too low it can demand more from future premiums.
  • In the worst case it can actually make changes to the compensation pay-outs.

These three differences mean there is no need to fund the PPF like an insurance company and hold substantial capital reserves/low risk investments. To put the differences another way:

  • It does not need to be concerned in the slightest about short term asset volatility.
  • It can raise more money.
  • It can pay-out less.

Given this, the PPF should be able to take a long term view of things.

Indeed, in addition to the above, the UK funding rules require ever more prudent funding targets such that in most cases there may be more than a best estimate of the cost of providing all benefits in a scheme even where there is a funding deficit. Add to this that PPF benefits are already lower than scheme benefits and, by investing in a similar manner to schemes as a whole, very little levy should be needed.

Yet despite this, it chooses to invest 70% of its assets in cash and bonds and set a self-sufficiency target.

PPF self-sufficiency

In the context of the PPF their target for self-sufficiency is that they will build up a big enough pot of money to cover all future expected claims on the PPF such that they can stop charging levies.

This means current levy payers are being overcharged as they are paying more than is needed to cover the current risk in order to build a reserve for future risks (that may or may not exist).

Not only this, the target is set with 84% certainty! This, at a very simple level, suggests that as well as overcharging through the target there is a very good chance that they are overcharging above the self-sufficiency level i.e. building up a greater pot of assets than are actually needed to meet all future claims!

So when all these Schemes have gone (which is where regulation as a whole is taking us from accountants, tPR and others) where will the money left over go? Back to the treasury I suspect. How can it be right for the PPF to be taxing DB schemes?

The annuity is dead, long live the deferred annuity!

There has been lots of discussion post budget about the new freedom in DC pensions and whether this is a good thing.

There are broadly 2 camps of people. Those who think the changes are a good thing and those who think they are a disaster.

There’s good reason for this. Even if you trust people to manage their money well, none of us know how long we will live, so how can anyone pay their own pension? Steve Webb suggested people should be informed of how long they might live but a life expectancy is just an average rate. I built the following modeller to show this:

How long will you live?

What’s most important to show is how variable lifetimes are and how great a chance there is of living much longer than average. In fact by definition you have a 50% chance of living longer than average and average these days is pretty long!

Despite this though, I’m still in the first camp and think the changes are a good thing. Fundamentally I think it’s reasonable to let people spend their own money as they see fit. For some with little money at retirement this might well mean blowing what little they have in the first couple of years. But faced with poverty for life or a couple of good years followed by very similar poverty for life I know what I’d choose. Those with huge pots already do manage their money in retirement so we don’t need to worry about them. But it’s the people in the middle we do need to think about a bit more.

And with auto-enrolment in place many more will start to find that they have a sizable chunk of money in their pension pot when they get to retirement. That’s not to say it’s enough, but a sizable amount of money all the same. So what are they going to do with it in this new world of freedom and choice?

Annuitise like before

This seems unlikely, particularly at the moment. The fact that current annuity rates look so unattractive is partly why the changes have been made in the first place. Annuity providers were hit with significant share price falls on the budget announcement in the anticipation of a significant change in practice. Annuities are dead said some.

But annuities do still offer something. They are the only way of guaranteeing a pension income. Some may decide that, whilst they don’t want to annuitise their whole pot, using some to guarantee a level of income to cover their basic needs makes sense. The rest can then be invested and drawn down as and when required.

Why do current annuity rates look unattractive?

Many of those criticising the budget changes have been pointing out the benefits of risk pooling that annuities offer. This is a very valid point. Essentially those who live a long time are subsidised by those who don’t. Given none of us know when we will die this is a reasonable way of providing certainty to all. We can’t predict when an individual will die with any certainty but we can predict with some degree of confidence the number dying at each age for a large group of people. The same can be said of other risks in life such as crashing your car, being burgled etc. and it’s the principle of how insurance works.

However, an annuity also comes with some baggage. It can be regarded as not just an insurance product but an investment product as well. The underlying investment return of an annuity is very low, especially on inflation linked annuities, reflecting the low risk assets an insurer must invest in and their solvency and profit margins. As life expectancies are so long now, at typical retirement ages the chance of dying is still so small that this low investment return outweighs the benefits of risk pooling.

Now this isn’t the insurers fault1, the rate is low because insurance regulation requires such low risk assets and solvency margins to ensure certainty. But these low risk assets currently have minimal returns due to low interest rates and, in particular, quantitative easing. But just because it’s not their fault doesn’t make the rates look any more attractive.

Annuitise later

The solution to the problem is to annuitise much later, say 80 or 85, when the benefits of risk pooling outweigh the low investment return. Before this you can invest your money and pay yourself an income. If you die before you get to the point of annuitising then whatever funds you have left will be left to your next of kin. Having cash in your control also offers other flexibilities such as being able to use it to help pay for care costs if necessary.

In order to delay annuitisation and not be worse off you need to get a return on your money before you annuitise in line with the underlying investment return and also to cover the “cost of survival”. To understand this cost consider how the chance of making it to 85 changes between 65 and 84. At 84 you only have 1 year left and the chances of making it to 85 are high. However, at 65 there are 20 years in which you might die so the chance is much lower. A payment at 85 is therefore much more expensive if you’re already 84. The “cost of survival” each year is equivalent to your chance of death in that year.

Taking an annuity from Hargreaves Lansdown’s best annuity rates at 1 May 2014 for a single life inflation linked pension at 65 suggests you can get an income of £3,525 a year for £100,000 of capital. Or in other words it costs £28.37 for every £1 a year of starting pension. Using typical mortality tables for males this suggests an underlying real i.e. above inflation investment return of -1.7%. Current long-term inflation estimates are around 3.5% so this means a nominal return of just 1.8%! At 65 the chance of dying is around 0.8%. Therefore if you can earn more than 2.6% on your money after charges you’ll be better off by delaying annuitisation (assuming the same pricing basis). I’ve plotted how this breakeven investment return changes over time:

The return needed to beat the growth in annuity rate

The return needed to beat the growth in annuity rate

At 65 this it is 2.6%. It rises to 3.7% at 75 and 5% at 80. It then rises fairly quickly to 8% at 85. Given current AA rated long dated corporate bond yields of 4.2%, standing still, or in fact doing better than standing still, doesn’t seem that hard for several years. A 4% return each year would allow you to delay annuitisation until 87 and get the same pension.

This sort of product could easily be provided as a collective to make it easy for individuals. However, there’s something even better in my opinion.

Step forward the deferred annuity

A deferred annuity is one that doesn’t pay you a pension immediately, it is deferred. For example you could purchase a deferred annuity at 65 that paid you a pension from 85, if you get there.

Why is this better than delaying annuitisation? There are 2 key reasons:

1. You get all the risk pooling benefits from 85 when the pension is paid but also get much of the benefit from 65 to 85 as well as the annuity only pays out if you make it to 85.
2. If you know you’re covered from 85, you still can’t predict when you might die but you do know exactly how long your money needs to last you!

Using the same assumptions as above the cost of such an annuity would be around 28% of the immediate annuity cost leaving 72% of your fund under your control to draw as you wish over the first 20 years. This isn’t going to give you life changing amounts of extra cash (you still need to save more for that!) but it keeps you in control of your money for longer without sacrificing on the need for some certainty.

The FT’s Josephine Cumbo wrote an excellent piece on Don Ezra, a pensions investment consultant living in the USA, this week. Don sets out why he has bought a deferred annuity and his strategy for managing his money. It’s well worth a read!

This solution could really work. So come on insurers, let’s start thinking deferred annuities.

Footnote:

1 – Other than those insurers who were no longer active market participants and only wrote annuities at rip off rates relying on lethargy for existing customers to purchase them.

Isn’t pensions regulation there to protect members?

This is what I always thought it was for. Some secondary concerns such as protecting the taxpayer and the PPF but fundamentally there to protect members?

It’s also the first objective of the Pensions Regulator (tPR) “to protect the benefits of members of occupational pension schemes”.

So when it comes to enforcing regulation you’d think that these fundamentals would be at the heart of it.

Not so it seems.

I’ve come across a scheme recently (and I should perhaps stress at this point that these are my views rather than the views of anyone involved) who changed their scheme accounting date by 1 month to align with the company year end. This was also at the time of the next valuation and would lead to a 3 year 1 month period since the last valuation.

So tPR’s views were sought on it being OK to carry out the valuation at this revised date. Commitments were also given to ensure things were done within original timescales. The response was that they couldn’t waive the requirements but would consider each case on its own merits. Given this, and awareness of another scheme that had done this, the Trustees decided to proceed with the valuation.

Time passes by

Some time later, and 9 months after submitting the valuation, tPR sent further correspondence stating that they couldn’t accept the valuation and had no choice but to request the valuation was redone at the old effective date.

Follow up discussions were had. All understand tPR can’t authorise a breach in the law but perhaps it could give an idea of what action might be taken. Nope. All communication has been utterly absent of any pragmatism. In fact they even suggested that as a pragmatic regulator they wouldn’t require it to be done within the original 15 month timetable – useful given already 24 months on!

Just 4 months before the next valuation date the Trustees had to concede that tPR will not back down and that they needed to do a valuation with an effective date of almost 3 years ago. This is despite the fact that it will be immediately superceded by the valuation that had already been done with an effective date just 1 month later.

Exactly how is this in the interests of members?

Or anyone in fact?!

The latest buzz phrase in DB regulation

The Pensions Regulator(tPR)’s statement this year introduced the phrase “Integrated Risk Management”. The word “integrated” in fact was used on 4 separate occasions in the statement. I stumbled across another tPR document recently, the 2013 occupational pension scheme governance survey. It seems clear that “Integrated Risk Management” is the buzz phrase of DB pensions regulation at the moment as it also formed a significant part of this survey.

There were a few interesting things in the results of the survey in the section about “Integrated risk management in DB schemes”.

Rather shockingly 11% of those surveyed didn’t know if there was any integration of risk management and the employer covenant. Given the survey was aimed at trustees this seems rather high!

But, even more shocking in my view, were the results for the “aims of the scheme’s journey plan” (not heard of a journey plan before – another option to flight plans, and glide paths I guess!). This showed that:

Only 88% had an aim to pay members’ benefits!

Isn’t this the primary purpose of the pension scheme? It was at least the most popular answer with “progressively derisking” coming in second at 78%. But why would any scheme not have an aim to pay member benefits?

If this is the results of Integrated Risk Management then we really need to get back to basics and remember what pension schemes are for.