Introduction
The Department for Work and Pensions (“DWP”) has published its Green Paper: Security and Sustainability in Defined Benefit (“DB”) Pension Schemes. This is largely in response to reports issued by the Defined Benefit Taskforce and the Work & Pensions Select Committee.
While we anticipated the possibility of yet more major change in the regulatory régime surrounding private section DB schemes, in the event the Government has been quite circumspect. While pension scheme deficits have undoubtedly increased in recent years, largely as a result of low Gilt yields, the Government’s main conclusion is that there is no significant structural problem with the regulatory and legislative framework.
The evidence it has considered does not suggest that DB schemes are unaffordable on the whole. Many companies could afford to eliminate the deficit in their scheme if required and deficits are not, generally, driving companies to insolvency.
Thus there are no proposals for wholesale change to the current régime; rather the Government is seeking views on the advantages and disadvantages of suggestions made by other bodies.
Background
DB pension schemes were set up generally when life expectancy was shorter and pension increases could be discretionary. Increases in both life expectancy and regulatory requirements have increased pension costs.
In March 2016 there were 5,794 private sector DB schemes with total assets of about £1.5 trillion. Of these, 2,056 have fewer than 100 members and a further 2,563 fewer than 1,000 members. Only 4% of schemes have more than 10,000 members but they have 62% of the total assets.
Of the 11 million members of these schemes about 4.5 million are current pensioners. The average annual pension in payment is about £7,000. Some people have been members of more than one DB scheme, so the number of individuals involved will be less than 11 million.
At 31 October 2016 between 90% and 95% of schemes were in deficit on their ongoing funding basis, with an average funding level of 80%. It has been argued that increasing deficit reduction contributions (“DRCs”) reduces the money available for investment. However, this ignores the fact that those contributions are invested by the pension scheme. When looking at how affordable – or not – today’s DB schemes are, the Green Paper points out that:
- in 2015 FTSE 100 companies paid five times as much in dividends as in contributions to their DB schemes;
- the 56 FTSE 100 companies with DB deficits paid dividends totalling £53 billion, compared with an aggregate pension deficit of only £42 billion;
- of the FTSE 350 companies with DB schemes, 71% could afford to clear their IAS 19 deficits with the cash they generate every 6 months.
However, the paper notes that these are aggregate figures and that there is a significant minority of companies for whom DRCs may be unsustainable in the near future. These tend, on average, to be among the smaller schemes.
The Government regards the relevant issues as falling under four main headings:
- funding and investment,
- employer contributions and affordability,
- member protection and
- consolidation of schemes.
Funding and Investment
The Green Paper notes that the funding régime is not meant to eliminate all risk to members’ benefits. People have suggested that schemes are not making use of the flexibility available in setting discount rates for their funding valuations; however, the Government has found no evidence that this is the case.
Various commentators have suggested different approaches to actuarial valuations (or to communications to members on the subject):
- a stochastic assessment of a scheme’s ability to meet its liabilities,
- a comparison of the expected asset and liability cashflows,
- an assessment of the return required to equate the values of the assets and liabilities and
- the smoothing of market values and yields for Statutory Funding Objective purposes, rather than reliance on conditions at a particular date.
The Government’s view is that, while it may be helpful to use one of more of these methods to aid member understanding, it would be too disruptive to change the requirements for carrying out valuations.
On the question of the 3-yearly valuation cycle suggestions include:
- reducing the current 15-month period for completing the valuation,
- lengthening the cycle for low-risk schemes and shortening it for higher-risk schemes,
- introducing risk-based reporting and monitoring requirements that are proportionate for higher-risk schemes.
Next, the Green Paper questions whether trustees have the appropriate skills to make suitable investment decisions. It suggests that this could be addressed by requiring relevant trustee training or by requiring trustees to be “appropriate professionals”. It notes, however, that the latter option would have cost implications for sponsoring employers and that there might not be sufficient supply of such professionals.
The Government notes that equity investment has fallen from 60% in 2006 to 30% in 2016 and that bond investment has risen from 30% to 50% over that period. They conclude that most schemes de-risk for valid reasons. However, they believe that there may be cases where more risk could be taken and would like to explore the possible reasons why it is not. The Green Paper announces the Government’s intention to work on collecting more information on trustee decision making, particularly in relation to investment strategy.
Employer contributions and Affordability
Under this heading the Paper looks at ways of avoiding companies becoming “stressed sponsors”, for instance by:
- limiting extensions to recovery plans, especially for companies with significant resources available or
- setting interim funding targets for severely-underfunded schemes.
The Green Paper appears to entertain some relaxation for companies who, without the burden of their current level of DRCs, might remain solvent (but who would otherwise become insolvent). The first issue is how to define appropriate circumstances for such measures – and then to address the potential moral hazard of companies manipulating their circumstances to “qualify”. The definition would have to combine the scheme’s funding level and the affordability of DRCs. There is already the possibility of a Regulated Apportionment Arrangement (“RAA”) for companies deemed likely to become insolvent in the next 12 months. Other options include:
- widening the criteria for RAAs,
- cutting or renegotiating benefits,
- giving the Pensions Regulator (“TPR”) power to separate the scheme from its sponsor or to wind up the scheme, in certain circumstances,
- more intensive support from TPR.
It is envisaged that measures under the first two bullet points be available to only a “small proportion” of the potentially 450 stressed schemes.
The paper explores also the possibility of a scheme being allowed to run on without a sponsor, rather than buying out, giving the opportunity for an improvement in the solvency level over time (and the risk of a reduction). It notes also that there could be a case to suspend indexation for stressed schemes/employers, or to rationalise indexation to relieve the current “lottery” as to whether schemes can use CPI as opposed to RPI.
Member Protection
This section considers whether the funding régime needs strengthening to protect members’ benefits and looks at two options:
- setting out requirements in legislation or
- empowering TPR to set binding standards on a comply or explain basis.
Either approach would reduce flexibility for schemes, potentially taking us back to a minimum funding requirement. Furthermore, stressed schemes will probably be unable to meet the standards. It is not clear how such an approach would reflect contingent assets such as parental guarantees. The Government appears to envisage that TPR would dictate the level of risk appropriate in individual cases. In any event, the direction of travel would seem contrary to that of the Pensions Act 2004, which put power explicitly in the hands of trustees.
Under current legislation TPR can be notified of certain corporate transactions too late for it to be able to influence the outcome, other than by using retrospective moral hazard powers such as Financial Support Directions. The Work & Pensions Select Committee suggested that TPR should have powers to act proactively to prevent certain corporate activities; however, the Government is concerned that this could affect the competitiveness of UK business. An alternative would be to allow TPR to levy a fine in conjunction with a Contribution Notice or a Financial Support Direction, or to make it compulsory for companies to apply for clearance from TPR in certain circumstances. Government might also consider strengthening trustees’ powers, eg by requiring formal consideration before any dividend payment or by requiring employers and trustees to agree and publish a joint statement of objectives for their scheme.
Consolidation of Schemes
The Government seems keen to pursue the possibility of consolidation of schemes, on either a voluntary or compulsory basis. It notes the potential advantages:
- economies of scale,
- access to more investment opportunities,
- improved governance standards,
- more cost-effective buyout terms for smaller schemes and
- a potential solution for stressed schemes.
However, there are also challenges:
- the up-front costs of data cleansing and benefit alignment,
- vested interests of trustees, employers and advisers and
- the reluctance of employers to share information about their business with arms-length trustees.
The Paper sets out three types of consolidation that might be considered:
- ring-fenced schemes, with shared administration and advisory services – and potentially shared trusteeship and investment strategy – but with a segregated section for each employer,
- full consolidation of liabilities, leading to cross-subsidies between employers,
- “superfunds”, that would discharge the employer and the existing trustees. This solution would be aimed at smaller schemes that are close to 100% funded on a buyout basis (raising the question as to why they would not just buy out!); however, the Government stresses that risk should not be transferred to the taxpayer, so the question remains of who would underwrite such schemes if the employer has been discharged,
- a single “superfund”, aimed at stressed schemes.
Government might consider removing the regulatory and other barriers to consolidation. On the other hand, it might require schemes to report their running costs, presumably to attempt to drive down costs in general.
What might lead to compulsory consolidation? Potentially the Government might set out a standard for governance and costs and then require schemes to be consolidated if they cannot meet the standard. Alternatively they might set a threshold based on scheme size and funding level. However, Government remains unconvinced at present that consolidation is a proportionate response to the problems that exist.