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?

Statutory nonsense

We had internal training this week on the latest bit of legal loophole nonsense threatening to cost pension schemes a lot of money in legal costs. The issue is that of the Statutory Employer and has come about following the Pilots case (and others).

Essentially it seems that depending on where you look in pensions legislation there is a different definition of “employer”. The differences are subtle but enough to keep lawyers entertained for a while. The result of this is the bizarre situation that a company could believe it is responsible for the scheme, pay deficit contributions and levies but actually not be liable for any section 75 debt. Worse still the members of such a scheme could end up not being entitled to compensation under either the PPF or FAS!

So obviously rather than quickly tidy up the legislation it appears instead that all pension schemes will need to go through the process of identifying their Statutory Employer – often at significant legal cost. Then when all that money has been spent consideration will be given to extending FAS to catch those falling down the cracks.

Luckily I’ve saved everyone this trouble and drafted some new legislation. I call it the MJR Pensions Act 2011:

“For the purposes of xxx (list relevant acts/regs) in place prior to the effective date of this Act (the “Acts and Regulations”) the definition of employer is extended to include the other definitions included in the Acts and Regulations.”

Why can’t it be this simple for a change?

Guaranteed minimum price-tags (GMPs)

We’ve recently had the 21st anniversary of one of the most profound judgements in pensions, the Barber ruling. This was the judgement that meant that from 17 May 1990 pension benefits accruing for men and women had to be equal; the main impact being on retirement ages. Up until this point most schemes operated on the basis of a retirement age of 65 for males and 60 for females. As a result of the ruling they were forced to equalise downwards to 60 for both sexes until such time that the scheme adopted an equal retirement age. This period is unlovingly known as the Barber window. Unlovingly due to its added complexity to every calculation that is done!

21 years is a long time but the impact of this ruling is still being felt today in many ways.

In private sector occupational pensions, I still see schemes that are being caught by the ruling. This isn’t because they failed to do anything, but because they failed to cross every t and dot every i. The intention, and the understanding of that intention by all involved, It’s often entirely clear. However, legal advice says the scheme never equalised because it wasn’t done in quite the right way! Madness! This has resulted in schemes spending a fortune on legal costs and then administration costs of putting things right. Then to really ice the cake they end up with larger liabilities!

Recently in the news has been State Pension Age (SPA) for females. SPA was originally set at 65 for males and 60 for females. Since the Barber ruling it was decided that SPA would be equalised at 65. However, unlike in the private sector where this was done on accruals (i.e. it only impacted on pension accrued after the change date) it was decided that this would impact on all benefits but it would be phased in over a number of years. SPA for females is therefore currently being phased from 60 to 65 over the 10 years from 6 April 2010 to 5 April 2020. More recently it was decided that SPA should increase in phases to 66, 67 and 68 to control the costs of state pensions and it’s now been decided that the move to 66 needs to happen quickly. This is difficult to argue against from a theoretical perspective, as it should be a much greater increase if it were to represent a fair rise based on longevity statistics. However, a problem has arisen because the increase to 66 is planned to take affect during the pre-existing period of phased increase to 65. This means some females may see a significant movement in their SPA within in relatively short period (my mother being one of them!) and resulted in the protests seen recently.

The real madness is still to come though.

It is possible that later this year legislation will be introduced in relation to the equalisation of Guaranteed Minimum Pensions (GMPs). GMPs form part of pension benefits accrued between 1978 and 1997 for occupational schemes that “contracted-out” of state benefits. Contracting-out meant that you gave up your entitlement for accrual of SERPs (State Earnings Related Pension – now the State Second Pension) and in return paid lower national insurance contributions. The pension scheme then had to guarantee to provide you with a minimum level of pension designed to be in line with the state pension given up.

If you’re still with me this means that at retirement you then get:

Scheme Pension (includes GMP) + Normal State Pension – Contracted-Out Deduction (effectively=GMP)

The problem is that GMP is not an equal benefit. This was by design as the state pension it replaces is not an equal benefit. But despite this, it seems there are plans afoot to equalise GMPs such that at retirement you get:

Higher Scheme Pension (includes equalised GMP) + Unequal Normal State Pension – Unequal? Contracted-Out Deduction (COD) (effectively=unequalised GMP)

What a load of nonsense!

Another bit of nonsense is that, having reviewed the rules of perhaps over 250 pension schemes, I have never seen the calculation of GMPs specified in a scheme’s rules. It is legislation that govern’s their calculation and the National Insurance Contributions Office (NICO) that tells schemes what a member’s GMP is (scheme’s merely estimate them).

So if schemes need to equalise we will have a process of:

  • Pension scheme calculates scheme benefit
  • Legislation says provide a GMP
  • NICO tells scheme what the GMP is
  • Pension scheme equalises this and recalculates scheme benefit

If GMPs are ever to be equalised then NICO should do it and CODs equalised too so it makes some sense. If schemes are told to equalise GMPs then let’s all complain to NICO everytime it provides unequal figures!

The end result of all this will be slightly higher pensions for some members. The real winners though will be the advisers who will make a fortune out of doing it as, one thing is for sure, the equalisation of GMPs will have a Guaranteed Minimum Price-tag.

Nortel & Lehman Brothers Ruling

The ruling in this case has caused quite a few headlines. In summary the result of the ruling is that obligations arising from Financial Support Directions (FSDs) issued by the Pensions Regulator to insolvent companies are to be treated as an expense of administration rather than a provable debt. This means that such obligations have priority over all other creditors. The headlines are because this is seen as unfair on the other creditors.

The judge himself has said he found the result unsatisfactory as it could be “an impediment to the achievement of the objectives of the rescue culture” and “potentially unfair to the target’s creditors”. He also suggested that legislation might be considered to change this.

I generally disagree with the headlines and to understand why we need to look at what an FSD is and what it is used for.

A FSD falls under the Pensions Regulator’s (tPR) moral hazard powers. The idea is that if a company tries to avoid its pension obligations by “insufficiently resourcing” a company then tPR can issue a FSD to force them to contribute to the pension scheme. A simple example would be where a subsidiary pays a large dividend to its parent but then becomes insolvent with an underfunded pension scheme. A FSD would then be issued on the parent.

Given this, provided FSDs are issued in the correct circumstances, it seems only fair that the resulting obligations should have priority as arguably if the company had been run correctly in the first instance then the money would have already been paid to the fund.

As Simon Kew of Jackal Advisory put it:

“Should the Regulator focus its attentions more on bringing money into schemes whilst the employer is still trading and able to support the scheme? I would be sure that with appropriate regulatory pressure during the scheme funding negotiations, Nortel or Lehman Brothers could have either ‘written a cheque’ to clear deficits, mitigate deficits by providing security or certainly significantly increase their contributions to the scheme”

If this had happened then the money would have been spent already so wouldn’t be available now and the position would be the same as with the FSD.

Of course the one problem with this is the caveat I had above i.e. “provided FSDs are issued in the correct circumstances”. If this isn’t the case then further legislation may still be required but for now I don’t think we should get too concerned about the verdict.