Getting defined benefit pensions back on track

Getting defined benefit pensions back on track

The UK’s DB pension schemes are in trouble. David Fairs shares his thoughts on the green paper and on how we can get defined benefit pensions back on track.

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How can we get pensions back on track?

The UK’s defined benefits (DB) pension schemes are in trouble. Of the 5,700+ DB schemes funded by UK employers, over 4,250 are in deficit. They’ve been caught between ultra-low interest rates, now the norm for almost ten years, and increasing life expectancy, which has extended the number of years scheme members spend in retirement. As a result, the deficit for the UK’s DB schemes stands at just under £200 billion.

Beyond funding levels, there are other problems in the sector too, drawn into sharp relief by the fate of the BHS and British Steel DB schemes. What should be done about those schemes where the pension scheme is threatening the very existence of the sponsoring employer? These cases also highlighted concerns that The Pensions Regulator doesn’t have enough resources to spot problem schemes early and has inadequate powers to intervene forcefully enough to make a difference. There is also disquiet about the quality of governance for many schemes and variability of trusteeship by both lay and professional trustees.

Change ahead?

The Government’s green paper brings forward ideas for dealing with these challenges. Measures under consideration include allowing some schemes to switch from the Retail Price Index (RPI) to the Consumer Price Index (CPI) for pensions increases, a shift that can reduce liabilities by 5-10%. 

We can also see renewed scrutiny of trusteeship standards. Do we need measures to enhance trustee training, or should trusteeship be increasingly professionalised?

There are proposals looking at the frequency of and approach to valuations. Employers with distressed schemes, or with a weak covenant, could be required to conduct valuations more frequently and with greater levels of oversight on corporate activity where schemes are significantly in deficit. But, with the Government keen to see businesses investing in growth rather than pensions after Brexit, any proposals on this front will have to be finely balanced.

All these ideas hold promise, but a key focus of the green paper are proposals that pave the way for the consolidation of DB schemes. Combining thousands of small schemes into fewer, bigger trusts could be an important step to getting pensions back on track.

Big is beautiful

Consolidating the UK’s DB pension schemes could reduce administration costs dramatically. In fact, we estimate by more than two-thirds. It would also help to reduce fund management charges and facilitate buy out or liability hedging.

In addition, reducing the number of schemes would cut the regulatory burden, allowing the Regulator to operate more effectively with existing resources. The Regulator would have to oversee fewer schemes and could demand higher levels of governance. In effect, enabling current small schemes to benefit from the economies of scale and strong governance premium enjoyed by larger schemes.

How to make consolidation a realistic option

Consolidation, however, is not straightforward. The paper considers some high-level alternatives for consolidation but we believe the government will need to address three key challenges to make it a realistic option.

Create simpler benefits structures: One of the biggest barriers to consolidation is the complexity of benefit entitlements that have developed over the past 30 years. Schemes will have tranches of benefits with different retirement ages from the impact of equalisation, different pension increase rates and potentially an amalgam of structures where scheme mergers have taken place. This complexity confuses members and is expensive to administer.

To make consolidation possible, legislation will be required to allow schemes to convert all the different tranches to a commonly agreed benefit structure; a single later retirement age but with fixed early retirement factors and a single rate of pension increase. If schemes started to move to a simpler, standard structure, it would be likely that consolidators would enter the market willing to take on the administration, management and investment of these simpler arrangements.

Give employers, trustees and advisers an indemnity:  It would be an important principle that members would have at least the same value of benefits after simplification as they had prior to simplification. An actuary should be required to provide certification that this was the case for each and every member. But although value would be preserved there could be particular circumstances, potentially years in the future, where the actual amount of pension could have been higher if the benefits had not been simplified. For this reason, it would be necessary for the employer, trustees and advisers to be indemnified against any claims provided the simplification was done in the prescribed way.

Fix the tax system: Whilst simplification can have benefits for both members and schemes, there can often be unintended tax consequences of changing benefits. Converting a lower pension payable from 62 to a higher pension payable from age 65, could use up significant amounts of a member’s Annual Allowance and their Lifetime Allowance. Perfectly sensible simplification could be unworkable if members end up with additional tax charges. Simplification should therefore be transparent for tax purposes.

What about you?

If your organisation is funding a DB scheme, what does all this mean for you? The green paper could provide some relief, potentially allowing reduced benefits for schemes in severe stress and a reduction in the administrative burden but there could be requirements for stricter governance and more restrictive funding measures.

But the sheer range of options being considered mean that it will take some time for the various options to be refined into a white paper and eventually passed into legislation. With Brexit imminent, there may well be a shortage of Government legal resource further delaying when the proposals could become effective.

In the meantime, you should continue to manage your liabilities under the current system, paying particular attention to strong governance, ensuring an integrated risk management approach at the next valuation and de-risk liabilities through appropriate liability management.

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