Brexit – what an opportunity

88300969_flagsI’ve always been pretty interested in politics and often stay up to watch the results come in on election night. This time was different though. The results wouldn’t get interesting for quite a while as there was no historic data to compare to and, frankly, I thought there was no chance of anything but remain being the result. I was sure that inertia would prevail. I went to bed fairly early for me but woke suddenly just after 4am feeling wide awake – almost like I sensed something was happening. Leave was winning and with every result that came in a vote for out looked more and more likely. Wow.

Hysteria

Facebook hysteria soon followed. I began to think I must have missed another announcement. Perhaps we’d also declared war on Russia? How else could such panic be justified? On the school run later that morning a friend of mine showed me the post of another parent who said their children were in tears that this had happened – what on earth had they been telling them?? Many others posted in a similar vein that they were deeply worried for the future of their children.

Project fear had clearly worked well and people were scared.

Lashing out

When the hysteria started to settle the lashing out started. Another animal instinct when scared or threatened.

  • “Thank you grandma” or how dare you almost dead old people vote against my young person view.
  • It was all racists and xenophobes.
  • It was the uneducated.

So there are 17 million racist uneducated old people out there apparently!

Denial

A day later came denial with a petition getting around 3m votes (interestingly from all over the world) demanding a 2nd referendum. Petitions quickly followed requesting second chances on all sorts of events from choosing lottery numbers to Stuart Pearce retaking his penalty in 1990.

The Liberal Anti-democrats and Labour MP David Lammy said the vote should be ignored.

The SNP confirmed they would take all steps to block it. To Nicola Sturgeon’s credit she had at least indicated this before the vote.

Pause for thought

What we did last Thursday was certainly momentous. But all we really did was vote to no longer be part ruled by an undemocratic bunch of bureaucrats in Brussels.

I am reminded of one of my favourite speeches from a New Zealand MP when they were voting on gay marriage. I commented to a friend that this would have been how I responded to the vote if I were PM. Something like:

“I give you this guarantee. The sun will still rise, your teenage children will still answer back, summer will still seem to last just 3 days, we will still be European and we will all still be friends. We now have an opportunity to shape a bright future.”

I was sad to see that David Cameron resigned after the vote. However, by doing so, he has also caused a pause for thought. A time to plan and a time to see how the rest of Europe responds. Many countries may decide to follow.

The opportunity

As a country we will be in control of our own destiny. That is a real opportunity.

The biggest opportunity though is social and political. The referendum has got people talking. It has got people voting and engaged who wouldn’t normally be. A referendum result has been campaigned for by (not my description) very right wing Tories and won with huge numbers of traditionally Labour voters voting for it – it has spanned the political divide.

There is surely now a chance to open people’s minds to a different form of politics and maybe some new parties too. One where the vocal left, a group I often refer to as champagne socialists, can reflect on whether they really are speaking for those they claim to care about any more, or just following their own herd driven moral hate crusade (See who you can hate). One where the Tory opposition isn’t referred to with disdain and an underlying assumption that all such politicians are only in it for money and power. One where the Tories winning this referendum can reflect on the needs of those poor communities that helped win this referendum and the social changes needed to make their lives better. One where we can debate ideas rather than throw insults.

Maybe I’m dreaming but it would be nice to think that all could reflect a bit on this result and work towards a bright future.

Junior doctors strike action – is it justified?

In short, my opinion is it’s not. I’ll explain why…

Why is a new contract being proposed?

A new contract is being proposed to replace the current one that has some oddities to reflect a transition from an old era and is no longer fit for purpose. The stated aims for the junior doctor contract were:

image1

The government is also looking to use the new contract to reduce the cost impact of having more doctors working at the weekend.

Reviewing the current contract, whilst I can now understand how it came to pass, my initial reaction was one of surprise that: the current contract will allow someone working 41 hours a week to be paid the same as someone working 48 hours a week and anyone working illegal hours is paid more – an odd incentive system. Certainly there seemed good reason to consider something different.

Why doctors say they’re striking

This can be summed up simply as: “Patient safety”. Do they have a point?

Doctors state that the key safeguards in place under the existing contract are being removed and that this makes the new contract unsafe.

The existing safeguards that they refer to relate to the requirement to pay extra “penalty” pay if doctors work illegal hours. The NHS Employers’ submission to the DDRB commented that this was often adversarial:

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It is easy to see how this could be the case as doctors are effectively “rewarded” or “compensated” for working illegal hours.

The proposed new contract has the stated intention of making working hours better:

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But doctors said this was meaningless as effective safeguards to enforce this weren’t in place.

After reading the documents and original proposals, this didn’t seem to be the case to me. There was a specific section on safeguards and it seemed to put the power to raise issues with doctors themselves. This all sounded ok.

But talking to some junior doctors I could understand why there were still problems. There were significant conflicts of interest around raising issues with working hours. One I spoke to told me the following:

“the process of reporting would be in the first instance to your educational supervisor and this is a serious problem.”

“Educational Supervisor’s role is to oversee your learning objectives for that job and check you are achieving them…It is also their job to write all of the reports that decide whether or not you ‘pass’ that year of training and write 3 references per 6 months that stay on your portfolio for every future employer to see forever. This is not a person you want to piss off!”

“There will always be the fear that if you are a conscientious stay later, that you will be thought of as slow and inefficient and that will reflect badly on your training report so you’ll not mention it, even feel guilty about it.”

“It would be entirely feasible to ruin your training year or even your future job prospects by ‘exception reporting’ honestly.”

This is clearly an issue but it was only after discussing things in detail that I got to this. All the articles, posts etc. that I read just talk about removal of existing safeguards being bad without talking about what is being added.

However, the January negotiations have recognised this issue and added a “Guardian of safe working”:

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The revised proposals also reinstate financial penalties. However, these penalties will now stay within the health service to help improve working conditions or provide further training rather than providing extra pay:

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This all sounds positive. Is the new contract unsafe? If it is, it doesn’t appear to be any less safe than the current one.

Why doctors are really striking

It’s not about the money but…

…is the way a lot of conversations go. But money is important. I don’t mind it being about the money but I do mind misinformation about the money.

We’ve had this on both sides with doctors talking about 30% pay cuts and government talking about 11% pay rises. Both are talking nonsense.

One of the key principles of the design of the new contract was that the cost of pay afterwards would be the same as the cost before i.e. no average pay cut and no average pay rise.

Most junior doctors currently work 40 to 48 hours a week and are paid a banding payment of 40% or 50% of basic pay in addition to their basic pay. The average pay of all junior doctors is quoted in the NHS Employers’ submission as 143.5% of basic pay.

Under the new system basic pay is quoted as 11% higher on average and there are then additional payments for hours worked over 40 hours per week, hours worked at night, on Sundays and Saturday evenings, and for working on call. Finally, there are additional incentive payments for some roles such as A&E and General Practice.

Depending on hours worked, some doctors would find themselves better or worse off than under the current system. But…crucially:

  • These differences are not as significant as made out
  • The average doctor is no worse off
  • The difference in payments reflects some doctors doing greater number of hours and/or unsociable hours than others

Even more crucially, those who would be worse off under the new system will have their pay protected for 3 years. The nature of pay progression as a trainee means this should be enough to mean no “actual” pay falls.

My analysis of the proposed new pay structure based on the sample rotas is as follows (click to see larger image):

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These are % changes so, taking into account that the £ amounts are much larger later on in a career, most are better off overall with the exceptions being rotas 3 and 4.

It is certainly not the case that the new contract is fundamentally offering pay cuts. And it is worth remembering that doctors are in the top 1.5% of earners in the country. Rightly so. But worth remembering.

There are some losers though. These are part-timers and those who don’t progress through training each year. This is because under the current contract pay progression is done purely on “time-served” rather than experience. This leads to the absurd position that under the current contract there are some levels of pay that can only be reached by those who progress more slowly!

Whilst this is a worse position for those affected, the new contract is a much fairer system. My only caveat would be that I think it would be reasonable to offer extended pay protection for part-time workers as part of the transition.

There is a lot of hot air about pay with politics being played on both sides. I also think there is a lot of misunderstanding because of this.

Unsociable hours

There is much misunderstanding on hours too and their interaction with pay. I’ve seen several comments talking about the extension of “plain-time hours” as if it was an increase in actual hours to be worked.

The rate of pay for any hours only really matters if the hours worked change. Otherwise the redistribution of pay is the same. For example, if I work Monday to Friday and am paid £10,000 a year for each day worked, it doesn’t really matter if I’m instead paid £14,000 a year for Mondays (because who likes Mondays?) and £9,000 a year for each of Tuesday to Friday. In both cases I would get £50,000 a year. It would only matter if I worked more or less Mondays.

The rise in basic pay compensates the loss of pay from the extension of plain-time hours. It will vary by individual rotas how well this works. However, the change in what hours attract a premium rate is only substantially important if shift patterns change.

The desire for a 7 day service means there is a presumption of more weekends being worked under the new contract. However, many doctors already work a lot of weekends. It would be good to see a clear question and answer for how many weekends it would be expected that junior doctors may work.

Potentially working more weekends is a valid concern. It is one that is also suggested as being part of why the new contract is unsafe. Of course, working Saturday instead of Monday is not less safe in itself. But doctors are concerned that extra weekend work will be covered by sacrificing cover Monday to Friday. On the presumption that there isn’t an oversupply of doctors in the week currently this concern is understandable. However, the government did make it clear in the parliamentary debate on this that the intention is to use the extra funding to recruit more doctors to provide this cover.

Doctors don’t trust government on this but it is very difficult to see how it can be addressed contractually.

Finally, whilst some doctors having to work more weekends is undoubtedly more inconvenient, it should perhaps be considered in the round with other measures that are being made to try and make life better and the trends in other jobs.

Politics, ideology, mistruths, misunderstanding and low morale

The handling of the contract dispute has been appalling. It has been appalling on both sides and I feel I should be able to expect more.

I’ve mentioned already the ridiculous claims on both sides about pay. But we’ve also had misrepresented statistics and childish name calling about who told who what via social media (again both sides!).

There are some clear underlying encamped views on each other’s ideologies and the poor handling by government has made it easy for a few that clearly have some political agenda to stoke the fire of a demoralised workforce. This is really why we have a strike today. There is no longer any trust.

When I talk to junior doctors about the issues they have they talk about the personal pressures they feel to work hours after their shift and through their breaks; because there are still sick people to treat and rotas aren’t adequate. They talk about the inability to get time off when they need it. Simple things that many of us take for granted like taking a day off for a family event or booking a holiday in advance before the best places are booked up. They talk about the problems of moving from one place to another and trying to have a relationship. They talk about not feeling valued with constant bad news stories in the press. They worry about the future and increased pressures as funding becomes more and more stretched.

They also talk about internal problems. Interestingly, in the same discussion I mentioned before I was also told:

“A lot of hierarchy and bullying still exists in medicine“
“some consultants are very aware of how working as a junior has changed and are very supportive, and others think we are lazy for not doing the 100+ hours that they used to do.”

This is an environment in which it is no surprise that they are demoralised and it is no wonder doctors feel the need to strike. But these issues exist under the current contract. They aren’t the reasons put forward for the strike action and they aren’t really part of the contract dispute.

In fact, if anything the proposed new contract is trying to address some of these things. Better yet talks are ongoing. There is time for more of these issues to be addressed. The contract dispute is a cover the real problems faced by junior doctors.

We should all support junior doctors but strikes about the new proposed contract are not the answer!!

Some Background reading…

Original paper submitted by NHS Employers to DDRB: http://www.nhsemployers.org/~/media/Employers/Publications/NHSE-DDRB-submission-Dec-2014.pdf
DDRB recommendations: https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/445742/50576_DDRB_report_2015_WEB_book.pdf
Offer made in November: http://www.nhsemployers.org/~/media/Employers/Documents/Need%20to%20know/JD%20A4%20booklet%20FINAL%20amends%2027%20Nov.pdf
Update on discussions in January: http://www.nhsemployers.org/~/media/Employers/Documents/Need%20to%20know/Letter%20from%20Danny%20Mortimer%20to%20SofS%20040116-Final.pdf
Letter to doctors setting out progress of discussions: http://www.nhsemployers.org/~/media/Employers/Publications/Junior%20doctors%20letter%2007%2001%2016%20final.pdf

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.