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.


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.


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?

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.


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.


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


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

How to assess a pension fund’s health

Originally posted on IPE: How to assess a pension fund’s health

I read Jeroen Wilbrink and Jelle Beenen’s article on determining the health of a pension fund with interest, as this is an ongoing debate Wilbrink and I have had for the last two years. I therefore couldn’t resist writing a response to their arguments. They make the claim that Cools and van Nunen are confusing issues. I hope to show that it is actually Wilbrink and Beenen that suffer from this confusion.

Their article makes many references to arbitrage-free pricing and risk-free valuation, quoting many academics in this area. Of course, quoting many names does not make the theory any more appropriate to use. Risk free, or more appropriately, risk-neutral valuation is indeed the foundation of a huge market of derivatives. However, the clue as to why this is not relevant is in the name, ‘derivatives’.

Derivatives are products whose value is derived from other assets. A simple example is a forward contract and a more complicated one an option over an asset. Derivatives are valued using risk neutral, or arbitrage free, pricing because it is possible to create a perfectly replicating portfolio that will have the same payoff as the derivative from a portfolio of the underlying asset and cash. This means that no assumptions need to be made about the valuation of the underlying asset. Derivatives are about relative pricing. You wouldn’t, for example, use risk-neutral valuation to determine the value of an equity or property.

The theories quoted are powerful but not relevant for valuing pension schemes. A pension benefit is an asset in its own right, not a derivative of another asset.
Wilbrink and Beenen would perhaps like to suggest that pension benefits are a derivative of risk-free investments. Indeed, they quote the example of a member having no risk tolerance and that the pension benefit should be treated as being risk free. They have ignored a big part of what a pension benefit is, though, when making this assertion.

Let’s say there is a 20% chance of me dying over the next 10 years. You have a choice as to whether you buy Asset 1 that is a payment of £1,250 in 10 years’ time, provided I am alive, or Asset 2 that pays £1,000 in 10 years’ time with no risk attached – secured by the UK government, for example. The expected cash flow in both cases is £1,000 – i.e. 80% x 1,250 for Asset 1 and 100% x 1,000 for Asset 2. Which asset do you prefer? Which asset, therefore, has the highest value?

Asset 1 is, of course, very similar to a pension scheme benefit where the payment is dependent on the member being alive. To suggest that the ‘value’ of that benefit is the same as a risk-free bond of the same term is just plain wrong.

Wilbrink and Beenen give the example of a scheme changing its investment strategy and having better coverage. They write: “We would argue that the coverage ratio is still 100% for both funds; nothing changed in the value of the investments or the liabilities.” I completely agree with the second part of their sentence, that nothing changed in the “value” of the investments or liabilities. However, I disagree with the first part (assuming it really is in the pension context such that the cash flow was dependent on the member being alive). In line with my comments above, the coverage under both investment strategies is more than 100%, as the pension benefit is not worth as much as a zero-coupon bond.

However, I couldn’t tell you how much above 100% the coverage was, as I don’t know what the value of a pension benefit is. There is no market to tell me this, nor would it be desirable to have one. In fact, in the UK, we have specific legislation to prevent it. I could construct models to come up with a ‘value’ in the same way as I could value a company share or a property. It would only be a model, though, and highly subjective to my personal views. A market price would reflect everyone’s view. For these reasons, talking about ‘market value’ of pension liabilities is a pretty pointless and unnecessary exercise.

This brings me to the other two approaches to looking at the health of a pension fund. Moving away from ‘value’, we can think about the concepts of ‘budgeting’ and ‘reserving’. In many ways, these are the same thing and just reflect the level of prudence allowed for. Let’s look at budgeting first.

Budgeting is about answering the question ‘How much money do I need today to pay for things tomorrow?’ This is fundamental to what pensions actuaries call a ‘valuation’. In many ways, it is merely this confusion of terminology that has led to so much debate.

If we are to budget for something on a best-estimate basis, then we arrive back at the position Wilbrink and Beenen dislike, where different investment strategies suggest that less money is needed. There are two key points they make. First, that this is not appropriate when monitoring progress, and second, that this is extremely risky.

Dealing with the first, I’d like to return to the football analogy they used to dismiss the idea of allowing for expectations. They gave the example of a football team fooling themselves that it was OK to be a goal down, as they expected to score three goals. If you are the manager of a football team and expect to win a game but then go a goal down in the first 10 minutes, what is your reaction? I would suggest the reaction is that there is no need to panic, as there is plenty of time left to turn things around. The manager would be unlikely to change his tactics. He certainly wouldn’t give in and accept that 1-0 was the result.

If it got to half-time and it was still 1-0, then the manager might be a little bit more anxious and change things around a bit. Once it got to the last 10 minutes, the super sub would be on, and all-out attack might be on the cards. The manager of the team monitors the game against his expectations of what the team might achieve. Monitoring is, therefore, more appropriate allowing for expectations than without it. Without the expectations, the manager might make bad decisions early in the game.

The second point they make relates to the risk or variance of outcomes not being allowed for. They use an expected equity return over 200 years to demonstrate this. All they are really showing, though, is the power of compound interest. A similar picture could be shown with bond yields and large changes in interest rates. This is a completely unrealistic variance to allow for, though, as it effectively assumes that no monitoring or adjustments would be made throughout the entire 200-year period.

It is also suggested that interest rate risks can be hedged. This is true and, with legislation where it is, certainly worthy of consideration. However, if you are investing in other assets, all you are really hedging against is the way we choose to ‘value’ the liabilities.

Finally, this second point brings me to a third possible approach in considering the health of a pension fund – ‘reserving’. Reserving is merely budgeting with prudence. It is the backbone of how insurance companies operate. When Wilbrink and Beenen talk about a member’s expectations of benefits being risk free, it is reserving, rather than valuing, that makes sense. A large reserve would provide such certainty, whereas a small one wouldn’t. In this scenario, bond yields could be used as part of the measure. This is a choice, though, rather than a necessity and is certainly not the only answer. The level of any such reserve is open for substantial debate – the larger it is, the more certainty it provides. However, the larger it is, the less efficient the provision of benefits becomes.

The solution to this protection vs efficiency equation comes in the form of insurance, but that is a topic for another day.

I hope I have shown why risk-free is not always the answer and why pension benefits should not be confused with bonds. Ultimately, the decision on how schemes are funded is a political one. If good, efficient occupational pension schemes that share risks are to thrive, then the answer should lie at the budgeting end of the spectrum. I therefore hope politicians will take note and regulate pensions in a way that provides the best outcomes for all of us.

The Pensions Regulator’s statement – taking things too far

Towards the end of April the Pensions Regulator (tPR) released its first annual statement on the funding of pension schemes. Despite its reporting in the press, I can’t see how this gives any additional slack to employers. However, it does provide perhaps the clearest steer yet on how the Pensions Regulator expects The Occupational Pension Schemes (Scheme Funding) Regulations 2005 to be applied in practice.

It’s fair to say I’m not tPR’s biggest fan. This is largely because I strongly disagree with how they say we should do things (more to come) but also because when I’ve had to deal with them they’ve not been particularly effective (e.g. lack of guidance/help when asked by trustees or making comments that add advisor fees rather than any value). They have of course done some good things. The focus of this blog though is on the difference between the law and how tPR would like us to implement the law. A key quote from tPR’s statement:

“It is a requirement for trustees to calculate technical provisions based on prudent assumptions in relation to their assessment of the employer covenant”

Let’s have a look at what the law says on how schemes should be funded:

“(4) The principles to be followed under paragraph (3) are—

(a)the economic and actuarial assumptions must be chosen prudently, taking account, if applicable, of an appropriate margin for adverse deviation;
(b)the rates of interest used to discount future payments of benefits must be chosen prudently, taking into account either or both-
(i)the yield on assets held by the scheme to fund future benefits and the anticipated future investment returns, and
(ii)the market redemption yields on government or other high-quality bonds;”

No mention of employer covenant there. The whole notion of allowing for employer covenant in calculating the technical provisions has been made up by tPR. It is not law and therefore not necessarily a “requirement”.

Another key statement:

“In the regulator’s view, investment outperformance should be measured relative to the kind of near-risk free return that would be assumed were the scheme to adopt a substantially hedged investment strategy.”

This time they at least preface this with the comment that it is their view. It is quite clear from everything tPR has said over the last couple of years that their view of the future is that all schemes should invest in wholly bonds and be funded on a “self-sufficiency” basis. This is again a significant interpretation of the law and is inefficient, damaging to the long term future of pension funds and unnecessary.

TPR’s continued comments have pushed trustees to use more and more prudent assumptions and focus on short-termism instead of running schemes taking into account their long term nature. This has only accelerated further the trend of the closure and wind-up of both pension schemes AND employers. This goes completely against the tag line on their website:

Committed to increasing confidence and participation in work-based pensions

If this really is what they are committed to do then shouldn’t they be encouraging good pension provision rather than pushing funding so high that it puts employers off (any that aren’t already that is) for good?

A look at tPR’s mandate perhaps gives the biggest clue as to the why they have chosen to regulate pensions like this. From their website:

“The Pensions Acts of 2004 and 2008 give The Pensions Regulator specific objectives:

– To protect the benefits of members of work-based pension schemes
– To promote, and to improve understanding of, the good administration of work-based pension schemes
– To reduce the risk of situations arising which may lead to compensation being payable from the Pension Protection Fund (PPF)
– To maximise employer compliance with employer duties (including the requirement to automatically enrol eligible employees into a qualifying pension provision with a minimum contribution) and with certain employment safeguards”

The third bullet above around protecting the PPF is the only meaningful reason I can think of to allow for employer covenant when calculating technical provisions. It is nothing to do with the first bullet about protecting member’s benefits which would be better served with a significantly lower or significantly higher funding benchmark for all employers no matter what their strength*.

Isn’t this the biggest conflict of interest in pensions?

The difference between tPR’s approach to scheme funding and what the law says is huge. For me this is taking things too far as tPR is there to ensure that the law is abided by, not to write the law. It is after all an unelected quango.

* I will write a further blog on this but the higher level is obvious in that any funding level less than buy-out is not protecting members adequately and anything less than buy-out of PPF benefits provides no protection whatsoever. The lower level reflects the fact that protection already exists via the PPF and that capital can be better spent by employers than tying it up in the pension fund.

Fair and Sustainable Public Sector Pensions

Ahead of the planned strikes on Wednesday I thought I’d post a few thoughts on public sector pensions. I think of myself as being one of the few people that aren’t firmly on one side of the argument on this. I’m a taxpayer on one hand but defender of defined benefit pensions on the other. I’m therefore hoping that this post will perhaps dispel some of the various mistruths out there and perhaps get to the heart of the real dispute.

Why should the government provide good pensions to the public sector?

This seems a reasonable place to start in the debate. There are many shouting that they are too generous but is this just envy? The government should look to provide good pensions to those in the public sector for several reasons:

  • It is reasonable for a government to be paternal and want to look after the workforce in old age.
  • The government should lead by example, how can it expect others to provide if it doesn’t?
  • It reduces potential costs in means tested benefits.
  • Most importantly, it has a comparative example in doing so.

The government is much more able to take on the risk of defined benefit pensions than any other organisation. It can also provide them in a large scale efficient unfunded manner and is not subject to the horrendous number of legislative hoops that are in place for the private sector.

What is being provided? Isn’t it a gold plated benefit?

Public sector schemes generally provide benefits of either 1/80th of final salary for each year worked as a pension plus 3/80ths of final salary for each year worked as a lump sum OR 1/60th of final salary for each year worked as a pension. These benefits are generally payable at 60 or 65 with the majority currently still being payable at 60.

For example, if you joined at age 20 then retired at 60 you might get a pension of 40/80=half of your final salary plus a tax free cash sum of 1.5 times your final salary or, alternatively, a pension of 40/60=two thirds of your final salary but no lump sum.

Some schemes such as the police and armed forces are significantly different to reflect the nature of their roles.

Is this gold plated? Mostly it’s the same as what the private sector used to provide so arguably it’s not. However, retirement at age 60 without reduction is something that is very rare to see in the private sector and has been for some time. Arguably therefore the retirement age is the only thing that makes these schemes gold plated. It is often argued that the average pension is only £4,000 a year so how can they possibly be gold plated. The average pension is irrelevant. All it tells you is that there are quite a lot of low paid workers, quite a lot of part-time workers and quite a lot of people who don’t spend their entire career in the public sector.

What do these pensions cost?

Putting a value or cost on pensions is very difficult and there is no area in the pensions world that suffers quite as much in terms of bad calculations of cost as public sector pensions.

The “problem” with public sector pensions is that the majority of them are not funded. This means that the contributions paid just go to the treasury along with taxes raised and pensions are paid each year out of this pot as they fall due. This is instead of a funded scheme, which is the norm in the private sector, where contributions are paid into a pot that is invested and topped up as appropriate and pensions then paid out from this pot.

This “problem” leads to some horribly bad numbers being produced on the cost of public sector pensions.

The first is that the cost is often given as the pension outgo this year less contribution income this year. This tells us very little if anything about “cost”. If this was how we calculated cost then it would be more expensive to remove all public sector pension accrual than doubling their benefit accruals as the contribution income would fall to zero if accrual ceased.

The other awful number often quoted is when an attempt is made to “capitalise” into one number all future public sector pension promises. As it is an unfunded scheme this number is utterly meaningless. It’s as silly a number as putting a single figure on what we will spend on healthcare in the next 80 years! However, it is made even more meaningless by assuming that, if it were funded, the money would be invested in government debt i.e. the government would issue debt only to buy it back and that therefore the way to value the benefits is by using index linked gilt yields – nonsense!

Of course cost is also very difficult in the private sector. The problem with pensions in general is that they are paid a long time into the future, a future we know nothing about. Because of this, to determine the cost of benefits accruing we need to use a discount factor so that we can compare the value of money today vs money tomorrow.

Up until now this has been done for public sector pensions in the same way as would be done when evaluating any government capital project (e.g. building a bridge) by using a Social Time Preference Rate or, more specifically for pensions, the SCAPE (Superannuation Contributions Adjusted for Past Experience) approach (see here appendix D for more on this). This is a real (i.e. above inflation) discount rate of 3.5% pa. Following the Hutton Review it has been agreed to use a rate in line with expected economic growth agreed at 2% pa real. This drop in discount rate leads to a significant increase in the perceived cost of public sector pensions (see below).

In the private sector there are a myriad of different approaches used but the 3 main approaches are that: the actual expected cost is determined using rates in line with the expected return on the assets held; the funding cost is determined using a prudent expectation of the return on the assets held; and the accounting cost is determined using a corporate bond yield.

When considering the private sector we should also include defined contribution (DC) schemes as the majority of private sector pensions are now DC. A DC scheme being little more than a tax advantaged savings scheme with strings attached. In determining the cost to an individual of replicating a DB pension in one of these schemes we can again use the expected return on the assets likely to be held but also need to factor in the fact that they will need to buy an annuity from an insurer at retirement.

The chart below shows an approximate comparison of the cost as a percentage of salary of providing a pension of 1/60th of final salary payable from age 60 in the public sector and private sector (including an individual in the form of a DC scheme). It allows for above RPI inflation salary rises of 1% pa, CPI inflation increases in payment and makes many other assumptions (available on request) – it is not designed to be definitive. It does however potentially under rather than overstate the private sector costs (particularly at the moment with bond yields so low).

pension cost comparison
[Click to see a larger version]

The chart clearly shows the “comparative advantage” I mentioned earlier that the government had over the private sector in providing pensions with the SCAPE method discount rate. However, it also shows that this has largely been eroded when compared with private sector DB with the discount rate change. Finally, it shows where the problems stem from as the costs, on a DC basis which is the setup of most private sector schemes now, are substantially higher. This is an even bigger problem because the contributions being made to DC schemes are substantially less than were/are made to DB schemes. Workers in the private sector doing similar jobs to public sector counterparts on similar salaries are therefore looking across with some envy about where they perceive their taxes are being spent.

The change in public sector discount rate will increase the cost of benefits by around 50%! But private sector funding costs in the short term are around 10% higher still and for an individual in DC the cost is about 25% higher on average. When people talk about pension apartheid this is what they mean.

What’s proposed to change?

Very broadly:

  • Contributions are to increase by 3% (but with little or no impact on lower earners)
  • The accrual rate will be set at 60ths
  • The new scheme will be based on average salary earned increased by average national earnings rather than final salary
  • Retirement age will be linked to state pension age (65-68 depending on date of birth) rather than 60

However, a transition period is to apply such that those within 10 years of retirement at April 2012 will not be impacted and those within 14 years will have a lesser impact.

Additionally, this is a cost envelope only and benefits can be amended for each scheme provided the revised benefit is no more costly.

Why is this happening?

There is much talk about fair and sustainable pensions. Both fair and sustainable are pretty difficult concepts though when it comes to pensions.

I think there are 3 points to address separately about why this is happening: the contributions rise, the benefit changes and the transition period.


I’ll deal with the latter of these first as it’s easiest. The transition has been offered as members do not understand the proposed reforms/how they will operate and the government has inadequately communicated this. In my eyes they’ve taken something that had an automatic in built simple transition and suggested a complicated “transition” that has introduced potential cliff edges.

So if you are due to retire before 1 April 2022 you no longer need to worry about your benefits provided agreement is reached before the year end and the deal isn’t revoked. (So no need to strike!)

Even if the transition weren’t in place if you only had e.g. 5 years until retirement then you will only have 5 years on the new benefit structure. Your old benefits would be protected on the old structure! For example if the new benefits were worth 20% less (not necessarily the case) and you already have 20 years service then you’d still get 96% of your original entitlement. If you are 1 year away then you’d get 99% and 10 years away 93%. Automatic transition!

Conclusion: The transition period offered is a bad idea and the money would be better spent elsewhere.

Benefit changes

When considering sustainability we need to note that the current benefits are sustainable – particularly as “cap and share” that was introduced following the last set of changes means members could expect to have to increase contributions in the future if the cost rose. However, what we really mean when we talk about sustainability is what level of benefit are we prepared to sustain?

What do we mean by fairness? Well the definition being applied seems to have 2 parts attached to it. Firstly that for it to be fair the changes should have greater impact on the higher rather than lower paid and secondly that pension benefits accruing should be fair to the tax payer. The first aim is I think achieved by the career average structure which for a given total cost should ensure greater benefits for the lower paid who generally don’t have such high salary growth. The second is much more subjective but it’s worth referring to notes on costs above noting just because it costs the government less doesn’t mean it should provide more as it should be using the comparative advantage to reduce costs.

One point that has clear sustainability merits is linking retirement age to state pension age as this should help ensure stability of cost going forward. I think it’s also reasonable to suggest that taxpayers aren’t getting the best value out of providing pension benefits as they stand. The number of opt outs suggested due to contribution rises shows that member value is nowhere near as high as cost on any measure. This is partly due to the mistrust members have with pensions and governments.

Conclusion: much of what is proposed is perfectly reasonable but much work needs to be done on communicating the value of benefits to members.

Contribution rises

There is an element in this that is about fairness and attempting to address the fact that the perceived total reward in the public sector is too high. Increasing member contributions has the effect of addressing the balance without talking about salary cuts. By ensuring the lower paid are affected less, the approach to increasing contributions is also arguably fair. However, I get the feeling that the increase in contributions is probably the overwhelming problem with the proposed reforms. This is the one that hits members pockets directly today and, assuming the government does want to encourage membership, is exactly the same as a pay cut.

However, we are in a financial black hole. As well as being the only thing that hits member’s pockets today, it’s also the only think that provides extra income to the government today. This is why it is being done. The contribution rises have very little to do with fairness and sustainability but everything to do with the deficit that exists in public finances. There is nothing wrong with this but it needs to be communicated as such.

Higher contributions or lower salaries
Higher contributions or redundancies

If the contribution rise doesn’t go ahead then the finances need to be filled by something else. This is why this area of change is not negotiable. This message has not been communicated though.

Conclusion: it’s going to happen but needs to be communicated why.

Other points of note

  • Just because your normal retirement age is 68 doesn’t mean that’s when you have to retire.
  • After the changes public sector schemes will still be very good and the envy of private sector workers.
  • We need to think hard about our ageing workforce. Some jobs just can’t be done at 68. Is it time to introduce positive age discrimination to get older workers into jobs they can do?
  • We need to attack things from the other angle and remove the barriers to private provision so that DB schemes can once again exist for private sector workers – much of the problem is due to bad regulation.

A socialist tory in pensions

Following my outing as a “tory” I feel empowered to use the word again within a blog title!

I mentioned last week to a colleague of mine, one Henry Tapper (all round nice guy and someone I’ve grown to like a lot over the last year), that I recently stood for election. “Really?” he responded, “For what party?”. I thought about just telling him but wondered where he thought my views stood given what he knew about me. “Have a guess!” I therefore retorted. It then went as follows:

“Liberal democrats?”
“Certainly not”
“Surely not the conservative party?”
“But you’re a socialist!!”

I firmly believe that we’re all socialist – nobody would ever suggest a complete removal of taxation and public services no matter how “right-wing” they were! I had a suspicion Henry would guess as he did though given my views on pensions; a defender of collective defined benefit schemes and maintaining these in the public sector.

My underlying political views are of minimal government interference and simplicity. The world should have as little regulation as possible and markets will automatically solve many problems. The government is there to step in where things don’t work as efficiently as they should and pensions is a great example of this. However we currently step in at the wrong place. As such we have ended up with a combination of over regulation and an encouragement of market principles in something where there isn’t really a market!

Remove the regulatory burden and the crazy bond market principles and occupational pensions can thrive once again.

Mark-to-Market, 24th November debate

A fantastic debate was held last night with the motion:

“This house believes that mark-to-market accounting is inappropriate for pension liabilities and should be abolished.”

My piece from the debate is reproduced below:

“I was sitting in Subway at the weekend thinking about what I might say today, staring at my “foot long” sandwich – yes I know I’d be better off with the 6 incher. It made think how bizarre the world would be if instead of having a universal measure for a foot we all put our own foot on the counter and demanded the sandwich was re-measured as 10 inches, 11 inches or 13 inches as appropriate. The length of that same sandwich would then be different depending on the last person to enter the shop and their view on what a “foot” constitutes.

But this is the bizarre world we live in when it comes to pension scheme liabilities. We regularly change our tape measure and value liabilities based on the opinion of the last person that day’s preference for bonds.

How can this be classed as a “true and fair” way of measuring liabilities. Just as the measured length of an unchanged sandwich varies in this fantasy world, the expected cost of paying pension benefits as and when they fall due could be unchanged in the real world but the value disclosed dramatically different. It also means that at measurement dates just a few days apart, large differences can result in balance sheets making 2 companies difficult to compare.

As well as the overarching principle of accounts being true and fair, there are 2 other accounting principles that mark to market valuation does not follow: “continuity” and “consistency”.

Continuity relates to accounting on the assumption that a business is ongoing. For this reason, assets do not have to be valued at “disposable” value. Yet this is exactly the basis on which marking to market works. I watched an entertaining debate on mark-to-market and regulatory capital on you-tube a few weeks ago and one comment stood out: “how much would your house be worth if you had to sell it in the next 10 minutes?”. This is what mark-to-market does for you.

The reason for this principle of continuity is clear. It avoids almost immediate losses being realised when a capital investment is made in assets that are valuable and profit making to the company, but have limited resale value in the “market”.

Consistency is another important principle. It is quite clear that a company’s balance sheet does not give its market value so why apply this inconsistent approach to the pension scheme? It is also worth mentioning at this point that accounting was never designed to give a company valuation and has never stated that as its intention.

As Simon has already stated there is no market for occupational pensions and nor would it be desirable to have one. We have specific legislation in the form of Section 91 of the Pensions Act to guard against this.

However, if we were to accept that marking to market was the right approach, and to be clear I don’t, then what would such a market look like? There is much evidence to suggest that it would have little to do with government or AA rated bond yields.
We can get some idea on the average member of the public’s preference for cash now over cash later by looking at loan and credit card rates. Looking a bit closer to home there are 2 areas where there is clear evidence that pensions are not valued in line with current views of mark-to-market rates.

The first is by looking at potential opt-outs. Recent research by the Department for Work & Pensions, Hymans Robertson and the Office for National Statistics, revealed that 62% of those in the public sector earning less than £25,000 a year were unwilling to make pension contributions of more than 6% and that widespread opt-outs are likely. The key point here is that by opting-out if contributions are increased members are saying they value 6% of immediate cash salary equivalent to 20% of salary worth of pension benefits. And this is based on a 3.5% real discount rate that I have no doubt those opposing the motion tonight would like to see significantly reduced! By my calculations this means the implied member discount rate is nearer 10% above inflation!

The other area to look at is enhanced transfer value exercises. Looking at the substantial difference in take-up rates for exercises where the enhancement is given in pension or cash again shows the reduced value members place on pension compared with cash.

Now both of these examples reflect a significant mistrust and misunderstanding in occupational pensions and only apply to a proportion of the membership. A market, if one existed may actually improve this, but I still believe that it provides some clear evidence that pension benefits are not valued by members in line with traditional mark to market theory. It also highlights why a market is SO undesirable as information asymmetries would be rife.

In addition to the obvious reasons for this e.g. the need for cash now, living for today not tomorrow, concerns of dying before retirement etc. a key reason for the increase in discount rate is the risk of default. Despite how those on the other side may protest, pensions are still not guaranteed, and they certainly weren’t setup to be guaranteed. Employers can still default on their obligation. When talking about guarantees, RPI to CPI also adds an extra dimension to the debate. In the future it is unlikely that the pensions industry will ever be able to persuade members that accrued rights cannot be reduced.

I therefore suggest that it is difficult to take seriously the views of those opposing the motion when they can’t even apply their own approach correctly!

The effective discount rate at which members value their pension benefits is important. Unless this rate is lower than the rate underlying the cost to the sponsoring company, the pension scheme has no value to the company and it may as well pay additional salary instead. This combined with the volatility driven by mark-to-market leads to another great undesirable behavioural change, in addition to those already mentioned by Simon, the end of defined benefit pensions.

Taking a more holistic view. What mark-to-market is doing is stopping companies taking on, pooling and smoothing risk and instead forcing every ill-equipped individual to take on the risk themselves – this is wrong!”

The economics of free wifi

I’m writing this post on the no longer free wifi service offered by East Coast trains.

I travel from Leeds to London a fair amount and have always been very pleased with the service. It’s been on time, clean and offered free internet access.

The internet was always patchy but it was free so who could complain.

However, on connecting today I was told that it was now only free for 15 minutes and I would have to pay £4.95 for an hour or £9.95 for 24 hours (+ the free 15 minutes!) The reason for this apparently was that they’d had comments about the patchy service and so made improvements to the service that meant they needed to charge.

This is perhaps all very well if it were true but having paid my £9.95 the service was notably no different to how it used to be. In my 2 hour journey I was disconnected no fewer than 20 times! Each time required 30-45 seconds of hitting refresh before it came back to life. So, not exactly value for money.

If you consider the economics of the move it’s also difficult to see how the pricing works. Even the 1 hour cost is higher than the daily rate on a pay as you go 3G card. I for one will just be getting a sim for my laptop rather than using the on train service again.

So the end result is:

a) one less incentive to like/choose East Coast over another operator
b) very little new extra income for them

This doesn’t seem like great economics to me.