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?

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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.

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.

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.