The “superfund” consolidation model proposed by the UK pensions trade body risks creating a moral hazard for the country’s defined benefit (DB) schemes, industry commentators have warned.

The Pensions and Lifetime Savings Association (PLSA) yesterday published a report making the case for consolidation as a solution to stresses in the UK’s DB system. It argued for the creation of “superfunds” for weaker schemes to join as an alternative to securing full insurance buyouts or “limping on” with attempts to plug deficits.

Kate Smith, head of pensions at Aegon, said the superfund proposal “needs to be treated very carefully by government and regulator”.

Under the PLSA task force’s proposal, a pension scheme entering into a superfund would cut its link with the sponsoring employer, with trustees also discharged of their liabilities for benefits.

Smith said allowing employers to “walk away from their DB schemes” created a moral hazard.

“Removing the link with a sponsoring employer also removes DB schemes’ financial back-up plan, and could weaken members’ positions,” she added. “It’s absolutely fundamental that the funding and solvency of any superfund is robust with clear rules on who makes up the shortfall.”

Stefan Lundbergh, head of Cardano Insights, said “letting the employer off the hook” would mean there was no backstop in the form of an employer, “which basically makes the superfund a mutual insurance company”. The PLSA suggested that providing superfunds might be preferable option for insurance companies under Solvency II rules, rather than taking schemes on via a buyout.

David Fairs, pensions partner at KPMG UK, said the complexity that has developed in the DB system would mean the PLSA’s efforts to simplify and standardise DB funds would be welcome across all schemes, regardless of size.

However, he added that the suggestion that the PPF stand behind a superfund – as proposed by the PLSA – “begs the question of who will pay the levy to the PPF to support the arrangements”.

“This is a particularly potent question as the PLSA is predicting that up to half of DB pension schemes might otherwise fail,” he said.

The task force acknowledged the issue of the PPF levy, but said it had “not sought, at this stage, to speculate about how that might be done, nor how the creation of superfunds might reduce the likelihood of claims on the PPF”.

“Equally, we have not considered the levels of protection that superfund members could receive from either the PPF or an alternative public superfund,” the task force said.

It suggested there could be a role for protection such as that provided by the Financial Services Compensation Scheme and noted that the PPF is consulting on a levy for schemes operating without a sponsor.

Regulatory arbitrage

Cardano’s Lundbergh also argued that superfunds could benefit from regulatory arbitrage and weak risk management principles if implemented as the PLSA proposed.

He criticised some of the thinking laid out, or omitted, from the task force’s report. He claimed the task force had not acknowledged the effects of poor risk management on the problems facing some schemes.

Lundbergh said it was “shocking” that risk management was not listed as core element of DB schemes. The PLSA identified eight core elements in the report, which the task force then used to describe different consolidation models.

Lundbergh said “the unique selling point of the proposed superfunds is that they will benefit from regulatory arbitrage and weak risk management principles”.

Without good risk management, consolidating implementation of asset management will not generate benefits, he argued: “If the consolidated building blocks are not based on sound risk management principles, then it is near impossible for trustees to change the investment strategy since they don’t even have access to proper tools.”

KPMG’s Fairs also saw the superfund proposed by the taskforce as being premised on regulatory arbitrage.

“The PLSA paper assumes the underwriting of that risk is being carried by the PPF,” he said. “So the superfund has lower reserving requirements than an insurance company – the PPF being expected to underwrite a higher degree of risk than the Financial Compensation Scheme but at a lower price.

“In effect, the PLSA is setting up a regulatory arbitrage between the insurance company reserving requirements and the reserving requirements of superfunds.  But there is no free lunch – a lower price means someone is bearing more risk at lower cost.”