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 This is despite the fact that it will be immediately superceded by the valuation that had already been done with an effective date just 1 month later.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.

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.

Reduction in the annual allowance – an opportunity

I read Josephine Cumbo ‘s article on pension tax relief being back on the agenda for Osbourne’s Autumn Statement in Sunday’s Financial Times with interest. The suggestion was that the annual allowance, the maximum amount you can put into a pension and claim tax relief on, may be reducing to as low as £30,000 a year.

I actually see this as an opportunity. I blogged just recently on my view on how long term savings can be improved and a reduction in the annual allowance for pensions makes such a scheme even easier to implement. Combine this fall in the pension annual allowance with an increase in the ISA allowance to same amount and you are well on the way to getting rid of pensions policies in place of flexible savings vehicles with incentives to keep money invested for retirement.

Industry interests

Someone commented earlier on a copy of my blog on Mallow Street that ISAs:

do not generate commission, and from the pensions industry point of view, this is a disadvantage. Indeed, they would compete for funds with conventional dc pensions.

Competing with conventional DC pensions is precisely the idea! This comment comes after comments from Michael Johnson that providers are holding back pensions reform. The pensions industry needs to stop worrying about change and have a good hard look at itself. It only has its self to blame for any industry wind-up.

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