Funding DB in challenging times - part 1 | KPMG | UK

Funding DB in challenging times - part 1

Funding DB in challenging times - part 1

Mike considers the interaction of the regulatory and legal environments to draw some conclusions on pension scheme funding in the current environment.

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Following the Brexit referendum, subsequent Bank of England policy responses and PM comment implying that ‘hard Brexit’ is our most likely course, there have been significant falls in gilt yields and the pound. Although we have seen some small recovery in fixed yields, real yields remain stubbornly negative and inflation expectations have increased. The consequences for Defined Benefit pension scheme funding are material, with many trustees and employers facing substantially increased deficits that, in the absence of market change, will need addressing in their next valuation.

This position has led to market discussion around the validity of the most common funding models, which link liability discount rates to an ‘expected’ investment return, which are predominantly linked in turn to (falling) gilt yields. Commentators argue that, as gilt yields have fallen so far, the link to future investment returns is broken and actuaries should change their funding models to allow for higher future expected investment returns. It is assumed that by ‘taking a long term view’ of investment and acknowledging that the majority of assets don’t need to be realised for pension payments now, the risks of the approach are suitably mitigated.

In this circumstance, it is worth thinking through some of the issues around funding and why, apart from a regulatory duty, pension promises might be funded in the first place.

In the 1980s and early 1990s, pension promises were commonly considered to be deferred pay. Paternalistic employers withheld some of their employees’ earnings with a promise to pay them later, after retirement. Whilst there was generally significant flexibility about increases to benefits in deferment and payment, most Companies and their employees expected these increases to be paid. The removal of these flexibilities eliminated a company safety valve, changing the nature rather than the scale of the promise.

Similar defined benefit promises are seen around the world and the key risk to employees’ pensions is the insolvency of the company before pensions are received. Different approaches to protecting employees from the failure of the promise have developed in different countries, often reflecting different cultural realities.

In Sweden many schemes continue to operate on an unfunded, pay as you go, basis. Employee security is provided through a mutual insurance provider that steps in to pay the pensions when companies fail. Interestingly, the insurer is often effective in obtaining assets to support the pension promises of weakening employers, which then serves to reduce the impact on the insurer solvency and helps to maintain affordable premiums for ongoing companies.

In the UK, where we separate the pension promise from the company and then fund the promise over time, some different considerations are relevant:

  • To the extent that the trustees can rely on the company’s ongoing existence there is no urgency or need for any funding. However, companies do fail and the trustees’ duty is to make arrangements to pay members their benefits in full.
  • In the Swedish system, there is a robust safety net that allows unfunded operation. In the UK the PPF exists to provide a safety net, albeit at less than full benefits, but trustees are legally obliged to not consider the PPF protection when making funding decisions, i.e. to consider their fund as the sole protection mechanism.
  • Further, legislation broadly requires schemes to either enter the PPF or to be bought out with an insurance company on company failure.

For trustees these facts create a hard target – to aim for full ‘buyout’ funding by the time the company fails. Given that it is not possible to have certainty over company survival for a long enough timeframe and that insurance buyout costs are tied, by reserving requirements, to gilt yields, this makes a move away from a gilt based valuation approach risky and potentially inappropriate from a trustee perspective. Trustees should be seeking to work closely with their sponsoring companies towards a more robust, insurance type, position before failure becomes a likelihood, rather than afterwards, when the necessary cash will almost certainly not be available.

This conclusion doesn’t imply that trustees should not take any risk or that alternative funding approaches are not possible. However, working within the current framework, there is a clear tension between these 'alternative' funding approaches and the trustees duty to pay benefits in full.

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