Lower TVs and less DC saving…

…is perhaps an unlikely reaction to today’s budget consultation response. However, this could be the result of 2 of the measures announced today.

Locked away for too long

My first reaction following the budget this year was that DC might finally be something I have a real interest in saving money into. I am absolutely in favour of the reforms to give people more freedom with their pension savings. However, the reforms didn’t go far enough in my view. There was still the inflexibility of the money being tied up until 55, over 20 years away in my case. This is too long to tie my money up, there are so many scenarios I can think of in which I might need that money sooner whether it means I’m penniless in retirement or not.

Yet today it got worse still. Today it was determined that my money will be locked up until at least 58! That’s at least another 3 years before I can get at it and so another 3 years later before I START putting money into a DC pension. NISAs seem a much nicer way of doing things.

As an aside, the consultation response put “fairness” at it’s heart. It’s difficult to see why increasing the age at which you can access your own money is fair. Especially to the many people who don’t make it to retirement.

If all transfers are rational…

…then there’s some serious selection risk.

The area of most controversy in the consultation was on whether to ban transfers from DB schemes. Unsurprisingly following the reaction to this suggestion such a ban has not been implemented for all but unfunded public sector schemes. However, “safeguards” have been added such that independent advice must be obtained.

Given this, it perhaps reasonable to assume the majority of transfers will be rational decisions. But if this is the case then they must be better than average risks as far as the scheme is concerned. Should transfer values be reduced to take this into account?

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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?

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.

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?