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.

Volatility in pensions

Volatility is seen as the great evil of pension schemes. Be they defined benefit (DB) or defined contribution (DC), it is volatility that is the greatest cause of concerns. But should it be?

To answer this we need to look at the causes of volatility and the impact of it.

There are two types of volatility people worry about, the first of which is the volatility of asset values. It is easy for trustees and companies to overly focus on this volatility as asset values are very visible and stock market swings are publicised in the news. But is this volatility important? Not really.

If I have 500 euros it would be easy to get concerned about their value going up and down with the exchange rate. But if I’d agreed to pay 500 euros for my hotel when I go on holiday next month then it really doesn’t matter to me how much they are currently worth in sterling. My transaction has no volatility at all.

The key focus of pension scheme volatility therefore needs to consider both assets and liabilities and hence, for DB schemes, the deficit or funding level. And this can be very volatile!

I did some analysis for a recent conference talk looking at history and put together the chart below. This shows how the funding level of a scheme would change over time assuming market based (gilts+) type valuations and 10 year spreading of surpluses/deficits. The funding level routinely changes by about 10% each year.

Funding volatility

This chart also shows the recent crisis in pensions caused by a perfect storm of:

  • Not great investment returns
  • Increased mortality expectations
  • Falls in bond yields

The current ultra-low bond yields actually being the second wave of large falls in bond yields/interest rates. The first starting at the end of the 90s.

This perhaps also brings into focus what we really mean when we say we dislike volatility, and that is falls in the funding level. Upside volatility is fine. For example some people talk about volatility from mortality but actually this has generally been pretty smooth (albeit with some step changes to reflect late application) upward only (in terms of liabilities) adjustments. So, not volatile, just more costly! The fact that it is relatively smooth reflects the fact that data only arrives each year and 1 year’s data is not used to determine the future expectations. It is accepted that 1 year mortality figures can be volatile and not necessarily the best guide of the future. A useful concept to bear in mind when we look at the causes of volatility.

So what are the causes of funding volatility?

There are many specific causes but fundamentally it’s because liability values and asset values don’t change in the same way.

The biggest specific cause of volatility in UK pensions? Long dated bond yields. And this is primarily because liabilities are generally pegged in some way to these yields via the discount rate used. For some measures, such as accounting bases like FRS17 or IAS19, this is prescribed. For others, such as buy-out costs, it reflects reality in how insurers are required to reserve for the benefits. But, for pension scheme funding, it is often a modelling choice made by the actuary, led on in no small way by the Pensions Regulator and a bunch of “economists” that don’t really understand what pension scheme funding is all about (and who struggle so much with 2 definitions of the word valuation that actuarial standards now require us to attempt to explain it to them in every report we do!). You can perhaps see what side of this debate I sit on.

Essentially the biggest cause of volatility in UK DB pensions is our choice of tape measure.

Real volatility

When it comes down to it, the fact that pensions are funded at all is a choice, and it would actually be more efficient not to fund them. A pension scheme itself is merely a series of future cashflows. We fund the scheme by investing in assets to enable us to pay those cashflows. So what really matters is the volatility of cashflows that can be obtained from our assets.

Bonds are therefore of course a great asset for this as you can build a cashflow stream in line with that expected for your liability payments. Investing in bonds can therefore remove a large amount of volatility through matching – and in this case there is no debate that the yield on those bonds should be the discount rate used.

These days things are even easier as synthetic bonds can be used to provide better and/or more cost effective matches for liability payment streams.

The downside of bonds though is their return – or lack thereof – particularly gilts in the current climate.

So what about growth assets or, in particular, equities. Equities prices are extremely volatile. They also have almost no correlation to gilt yields so if your liability valuation is pegged to gilt yields your volatility goes up further still. But in the long-term (and let’s face it pension scheme are long term) the vast majority of the return you get from holding equities comes from the dividend payments, not the change in capital value. And dividend payments aren’t that volatile. So, if we look at things from a cashflow matching perspective, a low volatility dividend payment combined with greater expected long term returns looks very attractive. If you make allowance for dividends when determining your discount rate this reduced volatility can effectively filter through to your funding position.

Current equity prices, rather like last year’s mortality experience as I mentioned above, are not a great guide to their long-term future worth in many cases.

Other growth vehicles

The growth vehicle of choice at the moment is the Diversified Growth Fund (DGF) of some form or other. These are all very different in strategy but have similar aims of long-term equity like returns but with lower volatility. In actual fact their “target” is often stated as cash plus.

The reduced volatility of assets that these bring is attractive. However, they offer no form of cashflow matching at all so in some ways could be viewed as more risky than holding equities over the long term. Just a thought…

Where cash plus does come into its own though is when using derivative products to generate long term cashflow matching in exchange for cash outgo. If your DGF gives you cash plus with vastly reduced capital volatility then maybe the biggest form of volatility in scheme funding is solved without losing out on the longer-term return benefits.

I’m more traditional and holistic in view point and favour long term equity biased growth strategies with more appropriate valuation techniques. However, in the current legislative environment, a DGF + swaps type strategy looks very attractive.

Rethinking pensions saving

Anyone who knows me in pensions knows that I don’t like Defined Contribution (DC) pensions. They also know that I do like Defined Benefit (DB) pensions, that I believe these to be the most efficient way of providing pension benefits and that I am convinced that better regulation and scheme design is all that is needed for these to thrive again. However, it is hard not to accept that the change in direction that would be needed for this to happen is huge. So in the meantime we need to make DC better.

We need something new

DC pensions are actually nothing new. In fact I would go as far as saying they are very old, as old as DB pensions. What’s changed is that long ago when DB thrived DC was targeted at high net worth people who wanted control of their investments. Now DC is being targeted at the masses who don’t. What they want is either pension or savings. My biggest criticism of DC pension schemes is that they are not pension schemes, they are tax advantaged savings with strings attached.

Today’s world is very different and the young people of today have different problems. Is it right that we (as a nation) are trying so hard to encourage them to put money into a pension policy that they can’t access for 30, 40, maybe even 50 years. I certainly don’t want to and dislike the tax incentives that mean I sometimes feel I have to.

A new form of savings account

If we started with a blank sheet of paper what would we like to achieve?

I think we would look to achieve the following:
– Something that encourages people to save.
– Something that allows people to use money how they want.
– Something that encourages people to make long term savings such as for retirement

How can we achieve this?
– Tax relief on savings made (in line with relief currently on pension savings)
– Complete flexibility to take the money when you want (like an ISA)
– Pay back of tax relief on withdrawals made before retirement (to provide a disincentive to early withdrawal)

The current tax positions and flexibilities of both pensions savings and ISAs would be replicated but people wouldn’t have to make the choice of pension or ISA. Savings would be there to be used when needed.

This would be revenue neutral to the extent that we are happy with the current tax relief position of pensions and really mean it when we say we want to encourage more savings.

It would also come with the advantage of being able to abolish DC pensions with a rebranded ISA, a name that people trust.

Let’s really have a savings revolution.

Pensions, property and politicians

So last week we had suggestions that the flagship £140 a week state pension reform might not go ahead after all and this week we have the announcement of a policy that will allow pensions to be used as guarantees for mortgages. The calls are for the politicians to “stop using pensions as a political football” and those in the industry seem to wholeheartedly disagree with this latest suggestion. So is it really a bad idea?

What’s good about it?

From my perspective the basic idea of putting more flexibility into what you do with pension saving is a good one. Certainly when you think about defined contribution (DC)/money purchase pensions; these aren’t pensions so much as tax advantaged savings schemes with strings attached. Loosening one of those strings is therefore a good thing.

On the basis that the idea is the pension pot is used to provide a guarantee rather than actually provide cash, it also seems like good economics as it’s allowing money to be worked harder.

What’s bad about it?

The biggest thing that is wrong about this is what it is trying to achieve. The idea is to help house buyers get on the ladder at a time when house prices and deposits are high. Is it desirable to increase housing demand at a time when house prices are still vastly over valued and being propped up by artificially low interest rates? Policy should certainly try to ensure there isn’t a complete collapse of the property market but it certainly doesn’t need stimulating past this.

Another key criticism is that, at a time when we are talking about a pensions crisis, this scheme is likely to mean at least some people end up with lower pension benefits if the guarantee is called in.

As Ros Altman has said, those who have pensions pots large enough to take part in the scheme, almost certainly have better guarantees they could use such as their own property. Also, the scheme would need the buy in of lenders to accept such pension guarantees, and on what terms would it be offered? The money won’t be available until retirement and that date is unknown.

Looking at DC schemes the main other flaw is the potential complexity introduced for so little benefit. Comments on the Guardian’s Reality Check yesterday suggested that it is expected only 12,500 people would use the scheme. For this number the complexity really isn’t worthwhile.

For DB schemes the complexities are huge. For example, cash in DB schemes is often not taken at fair value and the benefit won’t be available on early death etc.

Summary

I think for DC only pensions the scheme could work in the future when there are more and bigger DC pots around and when the economy & property prices are more stable. However, introducing it now is bad timing and really not worth the complexity.

For DB schemes I cannot see how the policy could ever be workable. But then they’re being legislated out of existence anyway…

Shrödinger’s Pension Fund

I’ve been planning to write a blog on this topic for some time. It was the title of my session at the 2011 Actuarial Profession Pensions Conference and a topic that I am passionate about. I guess the place to start is with some quantum mechanics and Shrödinger’s cat…

Shrödinger’s Cat

Shrödinger’s cat is a reasonably famous thought experiment from 1935 (NB: as it was just a thought experiment no cats were actually injured!). The idea is as follows:

– get a box
– add some poison released by an atomic timer (such that the time of its release is random)
– put a cat inside
– seal the box

Then ask the question “Is the cat dead or alive?”

The quantum mechanics answer is that the cat is both dead and alive at the same time. It is only when you open the box that its actual state is determined.Zombie cat

This is of course nonsense as a cat cannot be dead and alive. And in fact Schrödinger agreed. It was a classic “reductio ad absurdum” (a reduction to the absurd) designed to show how bizarre applying quantum mechanics principles to real world objects is.

So how does this relate to pensions?

Well, if we modify the experiment slightly and put an employer in a box we can then ask the question “is the employer solvent or insolvent?”. In the same way as a cat can’t be dead and alive, an employer cannot be both solvent and insolvent at the same time.

A further modification. What if we put an employer with a defined benefit pension scheme in the box and ask the question “what level should we fund the scheme to?”. We know there are 2 states that the employer could be in so these are the 2 states we should consider when funding a scheme.

This is unfortunately not how UK pensions regulation works. The Pensions Regulator lives in a quantum mechanical world of scheme funding and sees a continuum of schemes from those with strong employers to those with weak employers. Trustees are told1 to set their funding target taking into account this strength with higher targets required for weaker employers.

There are two key problems with this. Firstly, what happens when a strong employer becomes weaker? In this sort of scenario it is unlikely it suddenly has more money available to increase the funding level. Such demands could even make the employer weaker still and be a catalyst for its demise. Secondly, and related to this, strong employers can fail too! Who predicted the fall of Lehman Brothers and failure of Woolworths? Is it acceptable for members to receive a lower proportion of their benefits because we thought the employer was stronger than others?

Taking this approach to pension scheme funding is as nonsensical as a dead and alive cat!

So what approach should be used? To answer this we need to go back to the 2 possible outcomes for the employer and look at what this implies for the pension scheme…

Assume the employer is insolvent

In this case there is no additional money available to fund the pension scheme and, to wind it up and secure benefits with an insurance company, the full buy-out insurance liability will be required. On the assumption that the employer will be insolvent, we need to ensure the scheme is funded to this buy-out level.

BUT….

If this was the approach taken for funding defined benefit pension schemes then no schemes would ever be setup. The cost of funding the benefits at this level would significantly outweigh the perceived benefits from employees. An employer may as well just pay extra salary.

This approach to funding, although appealing from a security point of view, does not ultimately lead to an efficient way of providing pensions.

Assume the employer is solvent

If the employer is solvent until the last pension benefit is paid then (ignoring unfunded arrangements that would be even better!) it is most efficient for it to hold the best estimate of the amount of money it needs today to pay benefits in the future as and when they fall due i.e. taking into account best estimate expectations of returns on assets.

By doing this there is no opportunity cost of tying up capital. Benefits can also potentially be provided cost effectively meaning employees are able to access something they really value.

BUT…

If the funding regime took this approach then if an employer did become insolvent, there would not be enough money to secure benefits for all members leading to reductions. We therefore need a mechanism to address this and provide protection to members.

Interestingly enough, at the same time as introducing the current funding regulations such a solution was also launched:

Pension Protection Fund

Summary

To sum up my conclusions:

– The way schemes are currently funded does not make sense
– There are only really 2 ways to tackle scheme funding as an employer can only be solvent or insolvent
– Working on an insolvency assumption leads to no pension schemes
– Assuming solvency and funding to a best estimate level is therefore the answer
– Security needs to be addressed and the PPF is perfect for this

I will write more on why the PPF is perfect for this (or at least why it should be) another day!

1 – Notably they are told this by the Pensions Regulator rather than UK pensions law – see more here: Taking things too far