More pain than gain
What we are seeing is a great step forward for defined benefit schemes in the construction of a safety net which I hope will prove to be much more effective than the minimum funding requirement that was introduced in the last decade.”
These are the words of Lawrence Churchill, chairman of the new Pension Protection Fund (PPF) which is due to launch next April. Words of optimism, spoken at November’s Pension Show in London. Shared by some, rejected by others. But the strength of the opposition gives some cause for concern, if not alarm.
Much of the criticism has centered around the method of funding the PPF. Taxpayer or business? Or both? How much should each be expected to pay? What is fair? What is workable?
The government has decided that business will meet the bulk of the cost via a levy. Initially the levy will be a flat fee which will, after a certain period, be largely superseded by a risk-based levy accounting for 80% of the total charge. This will take into consideration the level of under-funding and, except for small schemes, the risk of insolvency of a scheme’s sponsoring employer.
In a written statement to IPE the minister for pensions Malcolm Wicks explains that a risk-based levy “will keep costs down for good employers with well-funded schemes”.
But what about the schemes that do not enjoy such robust financial health? John Ralfe of John Ralfe Consulting highlights the problem: “There are many big, weak companies with big pension scheme deficits, which are up to their eyeballs in equities,” he notes. “If the PPF charges a proper commercial rate weak companies would be paying a very large premium.”
Stephen Yeo, a partner at Watson Wyatt, takes a similar view. “You can never raise enough from the risk-based levy to replicate the true risk,” he says. “For example, if Turner & Newall do make it to April next year, what is their levy going to be? It obviously can’t bear any relation to the true risk, which inevitably it means that if there is a risk base to the levy good schemes will end up subsidising bad.”
The government’s view is that because no scheme is completely risk free, any scheme could need PPF compensation in the future, so it is reasonable that all should pay the PPF levy. “The US experience shows that good firms are happy to participate because you never know what’s around the corner, especially 30 or even 60 years down the line,” says Wicks. “Pensions are a long-term commitment, which is why the PPF is taking a long-term view.”
The trouble with citing the example of the US is that its own pension protection fund, the PBGC (Pension Benefit Guaranty Corporation), is mired in deficit – some $23.3bn (e17.5bn) in November.
Furthermore, there are some
that question the long-term thinking of the government. The heart of the matter is the adequacy of the levy as a means to finance the fund’s liabilities both now and in the future. Deborah Cooper is senior research actuary at Mercer Human Resource Consulting. “There is no question that the PPF will be able to pay the benefits that it says it will be able to pay but maybe only for the next five
to10 years. Pensions are a long-
term product but what the government is setting up does not
seem to be a long-term solution.”
The view that the levy will prove inadequate has been fuelled by a last-minute decision by the government to extend eligibility to the PPF to schemes whose sponsors had already had an insolvency date prior to the introduction of the PPF. The minister considered that it would be “unfair” to exclude such schemes, provided they have “not commenced wind-up before the introduction of the PPF and have a ‘qualifying’ insolvency event after that date”.
Many feel that the government has simply reacted to the woefully inadequate funding of the Financial Assistance Scheme (FAS) by moving a chunk of the risk burden to the PPF. The FAS is taxpayer-funded and is intended to assist the members of schemes who lost all or part of their pensions when the sponsors of their schemes became insolvent up to the PPF launch date. The total funding of £400m (e579m) sounds generous until one realises that it is in fact the total allocation for the next 20 years.
“Ministers are so worried about the pressures on the FAS that they are getting the PPF to prop it up,” argued David Willetts, opposition spokesman on pensions, while speaking recently in London. “They are shifting some of the risk towards the PPF because, as we warned, £400m is nothing like enough to deliver anything like the level of assistance which the victims of pension wind-ups thought they were going to get.”
Adrian Waddingham, chairman of the Association of Consulting Actuaries (ACA), is a vocal opponent of the government’s policy of billing business for the cost of the PPF, particularly now that eligibility has been extended to companies that have already experienced an insolvency event.
“The government put £400m into the FAS and went round with a begging bowl seeking contributions. But they raised nothing because the consensus is that the problems faced by pension funds are much more down to the government than to anyone else. The £400m is clearly not enough for the existing claimants never mind Turner & Newall. So the government said: ‘Dear me, how do we get out of this hole? Oh we’ll just dump these new liabilities into the new PPF and hope nobody notices.’ And that is not fair bearing in mind the actions which the government has taken to stop others dumping liabilities, and its refusal to guarantee the PPF. Some cheek – exclamation mark!”
So has the government rendered the financial position of the PPF untenable? “Yes, from day one,” says Waddingham. “It seems incredible that at the eleventh hour the government has made it much harder for the PPF to succeed by dumping liabilities. None of this was debated. What the government has done is a kick in the teeth to its chances of success.”
He concludes: “It is disappointing that the government throughout the passage of the pensions bill have been deaf to the constructive advice from pensions experts.”
And yet, as Minister Wicks puts it, “the government wants to take action to increase member protection without overburdening employers.” How do we reconcile this with the additional last-minute burden of the retrospective insolvency cases?
With some difficulty, as Stephen Yeo, a partner at Watson Wyatt, explains: “There is no doubt in our mind that the levy is going to rise,” he says. “Faced with the choice of raising the levy or cutting benefits the politician will always raise the levy. At the moment the levy is capped at twice its initial value at £600m; if it turns out to be inadequate something has to give. But not for a long time – the problem will be handed down to the next generation.”
Minister Wicks attempts to provide reassurance. He explains that “if under-funding does exceed our expectations, the PPF board will be able to increase the levy up to a fixed maximum. In this way, and over a number of years, the board will be able to reduce any deficit that occurs.”
But the “fixed maximum” levy suggests that other measures will be used to balance the books – as far as such balancing is achievable. The legislation does contain provisions for the reduction of benefits should the financial pressures on the PPF become too great. However, says minister Wicks at a recent conference that “the PPF will have recourse to a number of measures before reduction of compensation.” These measures include commercial borrowing.
But consultant Ros Altman is sceptical. Speaking at the Pensions Show she stressed: “Everybody should rush to get into the PPF at the beginning because the benefits can only go down from here.”
As it stands the PPF is supposed to guarantee 100% of the pensions already being drawn with no cap and 90% of the pensions of those who have not yet reached retirement age. Yeo thinks this level is too high. “The main problem with the PPF is that the benefits are much too generous,” he says. “Which means that they have underestimated the levy. I predict that the first time a six-figure pensioner gets paid out of the PPF there will be uproar.”
But while the level of benefits and other components of the legislation governing the PPF are potentially negotiable – if not now then perhaps at some stage in the future – it could be that the concept of a PPF has more fundamental flaws than those discussed so far. Ralfe notes: “The Pension Protection Fund can only work if the defined benefit pension system it is underpinning is fundamentally sound. But the UK defined benefit (DB) system is fundamentally unsound - there are huge structural deficits and a huge mismatch of assets and liabilities because pension schemes are holding equities, not bonds.”
He stresses that the PPF cannot work unless it has the power to require companies to inject cash into their pension schemes over a specific number of years to plug the deficit against the PPF liabilities. “Risk management is about getting the risk down to an acceptable minimum and then charging an appropriate levy on the residual risk,” he says.
So long-term funding is key, yet there are no specific provisions to force pension schemes to strengthen their funding base. Churchill seeks to reassure: “Through the dynamics of how the risk-based levy is set it may be that companies decide for themselves that adopting the stronger funding basis for the fund is a smart thing to do and if that were to be the outcome then one would applaud it.”
Reassurance or laissez-faire? The two may be irreconcilable in this context and a similar approach is evident in the line adopted by the government. Wicks explains that “the risk-based levy will discourage trustees from underfunding and therefore reduce the call upon the PPF’s funds.”
But what about schemes that are already under-funded? Such companies may find themselves in a vicious circle, as Mercer’s Cooper explains. “If a scheme is underfunded and has a weak employer covenant it might be difficult for the sponsoring company to recover its own finances and that of scheme if it has to pay whopping great levy to the PPF. That is a double whammy, but arguably it is the fairest way of doing it.”
The cost of funding the PPF has raised the issue of whether more public money should be used to cover the cost of failed schemes, especially in view of recent increases in the potential size of the liabilities that the fund will have to meet.
Waddingham of the ACA believes that there is a clear case for using some government funding to ease the burden on the PPF. Referring to the extra cost imposed by the retrospective inclusion of schemes whose sponsors have had a prior insolvency event. “Since 1997 the taxman has taken £40bn out of pension schemes. We suggest that if he gave £2bn to £3bn of that amount back into the FAS we wouldn’t have this problem.”
He adds: “Why is it any more inequitable than the government bailing out foot and mouth?”
Businesses and their pension schemes can argue with some legitimacy that they have been overtaken by events. Some of these events, such as the ups and downs of the markets, are ultimately down to the businesses and their schemes to put right. Where certain others are concerned, notably those effected by legislation, there may well be a case for government funding.
Jeremy Dell, a partner at consultants Lane, Clark & Peacock notes: “Companies set these schemes up voluntarily based on the best information at the time. Bailing out the employees of other companies was not part of the deal. It is not a satisfactory situation for the industry, on its own, to have to dip in to its pockets.”
He explains the importance of another key component when deciding fault: information. “If the government has told people that their benefits are guaranteed when they are not and never have been it swings the argument away from the industry funding these things to the government,” he argues.
Another issue which strengthens the argument for government funding is that confidence in the system, which has been lacking for so long, is a matter of national interest. Ken MacIntyre, pensions policy adviser at the National Association of Pension Funds notes: “This issue affects the whole nation. If we lose confidence in DB schemes we lose confidence in all forms of retirement savings. If that is lost it will take a generation to get it back – and we can’t afford to wait that long.”
Meanwhile the concern felt by employers, for whom the provision of a DB scheme is a significant financial commitment on its own, never mind of any further levies, was voiced by John Cridland, deputy director-general of the CBI, in a recent statement: “Employers have got more concerned as the bill has travelled through the House and the government has added extra costs onto companies,” he says. “Amendments made late in the day introduce a whole new cost that firms did not know they would have to bear.” He adds: “it has become unnecessarily burdensome and still has no government financial backing.”
It is the weaker companies and their schemes which will be hardest hit. While we have seen that the issue of cross-subsidy, which arises because the risk-based levy is unlikely to replicate the true risk of a scheme, exists up to a point, the less financially robust companies will nonetheless end up paying more. “It will be difficult for a company to recover its own finances and that of scheme if it has to pay whopping great levy to the PPF,” says Mercer’s Cooper. But arguably it’s the fairest way of doing it.”
So does the additional financial burden of the PPF mean that employers will flee DB pension provision like rats from a sinking ship? Willetts is unequivocal: “no company is going to open a DB scheme after this pensions bill.”
In fact the sentiment is quite mixed. Those who fear for the future of these schemes cite the financial burden of the PPF. Altman is pessimistic: “The problem for corporate UK is that anyone running a DB scheme is at a severe competitive disadvantage,” she says.
Yeo cites the financial uncertainty arising from PPF membership: “the unknown size of the levy will not encourage companies to share in the risk. So there will be a bigger push to DC where all the risk is passed on to the member.”
The more upbeat soundings come from those that stress the importance of the PPF in injecting confidence to a system of pension provision that has failed so many people in recent years. Minister Wicks notes: “The PPF is just the reassurance employers need to continue their valuable defined-benefit schemes.”
And it seems that employers do appreciate this benefit. Cooper: “A lot of our clients understand the need for the PPF because they have made a conscious effort to retain their DB schemes and want their staff to value them because they are a very expensive benefit.”
She adds that communication is key: “If the government is not open about what the PPF can achieve there will be no change in the level of confidence in DB schemes.”
The possibility that benefits will be cut does not make the communication challenge any easier. Altman: I don’t think people will have the necessary confidence that this safety net won’t get snatched away, just as people were failed by the system in the past. We have to be very careful how we explain this.”
What we may well end up with is more hybrid schemes, where the costly DB element is smaller, and therefore less costly, and is topped up by a defined contribution (DC) element. Cooper suggests that a DB element with an accrual rate of 1/100 may be appropriate, and with its - albeit imperfect - PPF guarantee it may be more saleable as an option for employees than a more generous but less sustainable DB scheme.
In view of the recent history of vanishing safety nets and the resulting misery the guarantee maybe the preferred cornerstone of pension provision for millions of scheme members.
But whatever the merits of the various arguments in respect of sources and levels of funding one of the principle complaints is that the legislation has left too much uncertainty in an area that is critical to financial planning.
So how do we reconcile Lawrence Churchill’s claim of a “great step forward” with so much uncertainty? Again we respond: With some difficulty.
PPF: the facts
The Pension Protection Fund (PPF) is being introduced as part of the new legislation forming the Pensions Act, which finally became law in November.
Due to launch in April, the PPF is intended to protect members of private sector defined benefit schemes whose firms become insolvent with insufficient funds in their pension scheme to meet the pension promise.
“In this situation, members can be reassured they will still receive most of the benefits which they were expecting,” noted Andrew Smith, then secretary of state for work and pensions, who outlined the aim of the PPF when the Pensions Bill was published in February.
He added: “The government wants to increase protection for scheme members in the future to ensure that they are confident in saving for retirement, as well as to give employers the reassurance they need to carry on providing valuable pension provision.”
The PPF will provide 100% compensation for people who have reached the scheme’s normal pension age and for those under the scheme’s normal pension age who are either in receipt of survivors’ benefit or already in receipt of pension on the grounds of ill-health; 90% for people below that age, subject to an overall compensation benefit cap. It will also include indexation of pensions in payment on rights built up from April 1997.
To help some of those who lose out on their occupational pension prior to the launch of the PPF, the Pensions Act also provides for a Financial Assistance Scheme (FAS), which was announced in an amendment to the pensions bill in May. Government funding has been committed to the FAS and totals £400m over 20 years.
The government came in for much criticism in November when it announced that eligible schemes, whose sponsoring employer has already entered insolvency proceedings may be able to receive PPF compensation.
Many felt that the government had privately acknowledged that the funding of the FAS was inadequate, and that to counter this it was shifting more of the financial burden onto the PPF – and hence onto business.