The Department for Work and Pensions (DWP’s) Green Paper, released today, raises the prospect of measures being introduced to encourage sponsors with significant resources but substantial deficits in their schemes, to make faster progress in repairing those deficits. Our response agrees

Jon Hatchett, Head of Corporate Consulting said:

“While we agree with the DWP’s conclusion that the majority of employers should be able to continue to fund their schemes and manage the risk their schemes are running, the PPF’s modelling does suggest that in the worst 10% of outcomes around 1000 sponsors could be insolvent by 2030.

“The DWP recognises that the single biggest risk to DB scheme members is the collapse of the sponsoring employer. That’s why looking at sponsor covenant alongside contributions and investment strategy should be the cornerstone of any approach to risk management and scheme funding.

“While it’s important to debate how much cash should flow into schemes in current market conditions, throwing more cash at deficits could make schemes less affordable and redirect funds from valuable business investment. A strong business means a strong covenant. And, as a strategy, simply pouring more money into schemes hasn’t worked for the last 15 years so it is not obvious it will work over the next 15.

“Arguably the focus on deficit headline figures leads to significant cash calls on sponsors and distracts from what is important: meeting the interdependent objectives of ensuring there’s a good chance of paying benefits to pensioners in full and that there’s a healthy business sponsoring the scheme. A balance needs to be struck, and deficits are part of the picture. But to maintain a healthy business pension contributions need to be kept affordable both now and in future. And if we do that, schemes are less likely to fall into the Pension Protection Fund (PPF), where members lose £50,000 of benefits on average, employees lose jobs, and businesses are broken.

Commenting on potential measures to limit extensions to recovery plans he added:

“The overall regulatory framework should focus on managing risks, both for members and shareholders.  Focussing too hard on any single element is likely to lead to unintended escalation of risks elsewhere.  For instance, a limit to recovery plan lengths will encourage gaming of Technical Provisions and increased investment risk taking.  Neither has served DB schemes, members or UK plc well in the past 15 years.”

The DWP’s Green Paper on DB pensions has highlighted the need to find a better way to understand risks in the Defined Benefit (DB) regime. It effectively removed the possibility of across the board reductions in benefits – for example a wholesale abandonment of non-statutory indexation, which would have reduced the UK DB deficit on a buy-out basis by around £350bn, but it has kept the door open to the possible use of conditional indexation for schemes in distress or indeed ‘rationalising’ indexation, which could have a £175bn buy-out deficit reduction. 

Commenting Calum Cooper, Head of Trustee DB, said:

“We agree that more can be done by both Government and industry to help people better understand valuation and deficit data to provide an improved overall sense certainty and risk in the DB regime. Our recent survey of UK trustees found only 1% of trustees measure the probability of paying pensions. Paying members’ pensions in full is what trustees care about, so why not focus on that?

“When it comes to strategy, the industry still relies too heavily on volatile balance sheet deficits driven by ‘straight line’ discount rates. This is clouding how best to secure members’ pensions. The post-Brexit swing in deficits, from a record high of c£1trillion in August back to c£800bn in recent weeks, shows just how volatile deficits can be.

“As an advisory industry, there’s been too much focus on regulatory compliance or short term measurements, with a focus on deficits and discount rates. As a result, that’s what trustees hear about in meetings – gilts plus discounting, technical provisions, short term volatility and so on.

“The probability of paying pensions, with a decent chance of success and taking no more risk than is required, has got lost in the mix. That’s if it was ever in the mix. This needs to be a primary driver of strategy, so that trustees can regularly review their likelihood of ultimate success, i.e. paying pensions, and evolve it accordingly to further enhance the security of members’ benefits. There should also be a measure of benefit security in light of the chosen asset, contribution and covenant strategy to focus efforts on improving outcomes for members”

While measures to significantly water down pension promises across the board appear to have been abandoned, the Government is keen to consult on the possibility of members’ benefits being cut if schemes are in distress.

Calum Cooper also commented:

“There will be a sigh of relief from trustees and scheme members that measures to significantly water down pension promises across the board have been taken off the table, for example from a wholesale move from RPI to statutory minimum increases. However, rationalisation of increases that may involve a move from RPI-CPI for all schemes is not off the table and this would reduce member benefits by £20,000 on average.

“In addition, the door remains open to conditional indexation, which would be to enable schemes in dire straits to stop paying pension increases for a limited time, until scheme funding and business performance recover. This comes with a hefty risk warning and would need watertight safeguards.  For example, the suspension of pension increases should be temporary and with strict restrictions on employers (such as dividend freezes and substantial pension contributions) to align business and scheme members interests.  Another safeguard would be forcing schemes to reinstate lost increases before they could be wound up. These options should only be available to genuinely stressed schemes.

“While allowing struggling schemes to temporarily stop paying pension increases could help them get back on track while avoiding permanent cuts to members’ pensions, the scope for unscrupulous employers to game the system would be large.”

The DWP has also raised the prospect of requiring employers and trustees to agree and publish a joint statement of objectives for the pension scheme. It states there could be a role for Government in setting out a range of acceptable objectives such as buy-out, a reduction in balance sheet volatility, or reaching a certain level of funding by a certain time.

Further commenting, Calum said:

“This year, in our annual survey of DB trustees, while we’ve seen a positive shift towards longer-term goal setting, the majority are failing to put in place measureable plans to reach these goals. The number of trustees with no measurable plan to reach their goal almost doubled from 12% to 23%.

“We agree that working collaboratively with the sponsor to set goals is the right thing for trustees to do, and we have always encouraged this. Failure to set goals and put in place measurable plans to meet them may be putting members at risk. Trustees need to focus on the strategy, risks and metrics that matter, and it’s our role as advisers to help them do that.”