The UK’s “just about managing” pension funds need a radical rethink of how to tackle widening pension deficits, mounting costs, and volatile markets, according to leading industry experts.
Ahead of last year’s Autumn Statement, the government’s first post-EU-referendum budgetary update, the focus was on prime minister Theresa May’s new term: “just about managing” families – abbreviated to JAMs for the sake of a soundbite. However, there was hardly any mention of the “just about managing” in the pensions world.
As Mark Wilkinson, a principal at consulting firm Mercer, describes them: “These are some of the smaller defined benefit [DB] schemes in deficit, essentially managing on a valuation to valuation basis – a hand to mouth existence, you could say.
“They cannot magic up more money as their sponsor employers are also struggling. So there is a real challenge about the options available to these kinds of schemes.”
According to the Pension Protection Fund (PPF), the aggregate deficit of the 5,794 DB schemes increased to £224 billion at the end of December 2016, from a deficit of £195 billion a month earlier. The number of schemes in deficit also increased marginally to 4,339, representing three quarters of all schemes.
Richard Murphy, a partner at consulting firm Lane Clark & Peacock, says the key challenge for the industry is to avoid adding to the number of JAMs.
“Over the next few years, some schemes will fail and end up in the PPF, and others will struggle – it will be more realistic for industry to work with trustees and employers to ensure that a wider group of schemes avoid ending up as JAMs,” he said.
Schemes in deficit have to submit a recovery plan to the Pensions Regulator. This can be tailored to meet the specific needs of the scheme and sponsor, including the employer’s plans to invest in sustainable growth.
“We are committed to working closely with employers and trustees that are facing significantly challenging circumstances,” a spokesman at the Pensions Regulator confirms.
One way forward, Murphy says, is rethinking investment strategy to target higher-returning assets, as well as improved diversification.
“It is clear that if pension funds invest defensively, they will never achieve the return they require,” he says. “It is also clear that old style mix of equities and bonds are being replaced by hedging of interest rate and inflation to a much higher level.”
Murphy adds: “We are seeing strong interest in a much more diversified range of assets such as private equity and absolute bonds.”
Collaboration and consolidation
Another radical plan is to consolidate the smaller schemes along the lines of the industry-wide pension schemes in the Netherlands and Australia. The UK already has seen some consolidation with the pooling of local government pension schemes and multi-employer funds such as the Railways Pension Scheme and the Universities Superannuation Scheme. The pensions market has also seen the launch of new DB master trusts, such as TPT Retirement Solutions (formerly The Pensions Trust), which provide services such as management, administration, and governance as well as investment.
The Pension and Lifetime Savings Association (PLSA) – the UK’s retirement funds trade body – published an interim report from its DB Taskforce in October 2016. In it, the association called for an investigation into the potential for scheme consolidation to achieve greater economies of scale.
Joe Dabrowski, head of governance and investment at the PLSA, said: “We have found that, with the smaller schemes, they have fewer resources and much more limited access to the right advisers or investment strategies. In some cases, we found that schemes at the bottom end of the size spectrum are paying proportionately more for their services, in comparison to larger schemes, due to their limited bargaining power and typically lower expertise.”
This was backed up by recent research by consultancy Spence Johnson, which found that schemes with less than 100 members typically struggled to secure fund prices below the UK’s 75-basis-point price cap.
The PLSA will publish its final report at its investment conference in March, outlining what it says will be the best way forward and the risk to members’ benefits of maintaining the status quo.
Richard Butcher, managing director of independent trustee firm Pitman Trustees (PTL), agrees that there is a sound argument to be made for consolidation, but argues there are constraints to this happening.
“In principal it is the right thing to do, but in practice it’s not workable without compulsion,” he says. “The idea of consolidation is that you can definitely drive economies of scale. So while the argument is sound, there are a number of barriers not least from employers and trustees who fear their influence will be reduced.”
The other proposal the PLSA is examining is conditional indexation, whereby struggling schemes could temporarily stop paying pension increases, or pay low increases, to help bring them back on track. The body will make its recommendations on conditional indexation in March.
Dutch pension schemes have conditional indexation rules. A number of funds have fallen below the funding threshold required to increase benefits, and this year 10 pension schemes will cut payouts to pensioners in order to address funding difficulties.
Mercer’s Wilkinson adds that, while DB benefits are in theory ‘guaranteed’, there should be some flexibility about payment of those benefits.
“There is a case for changing the law so that you can go back to members to ask them to accept a lower level of benefit – for example, conditional indexation – in exchange for greater security and a lower risk of ending up in the PPF. As long as properly communicated and explained, members could well be in favour,” he says.
However, Steve Delo, chief executive of independent trustee firm PAN Governance, warns that any “tinkering” with members’ benefits would be impossible to do without strong governmental intervention and such flexibility would introduce a new “moral hazard”.
“There is a need for some creative thinking around this whole issue surrounding the JAMs,” Delo says. “But all parties involved need to know that there is no magic bullet solution – and it is very much a case of the stable door having been left open a long time ago.”
UK pensions minister is expected to publish a green paper with proposals for DB reform in the coming weeks.