Most defined benefit (DB) schemes in the UK are presently under funded, following falls in bond yields, increases to projected longevity and the equity market falls of earlier this decade. Scheme members have become more aware of the risk of deficits, following publicity around schemes which failed due to under funding when their employers became insolvent to provide the original promised benefits. There is no insurance market to protect an individual member from these benefit reductions.

The Pension Protection Fund (PPF) is the UK Government's answer for providing protection for members whose companies fail - and leave behind a DB scheme that is under funded.

The PPF is a central fund which receives the assets and liabilities of failed schemes which are unable to provide a specified level of "protected liabilities", and then aims to provide these specific benefits itself. It was launched in April 2005, and by June 30 2006 already had over 90 schemes being assessed for entry to the fund including some high profile names such as MG Rover and Heath Lambert.

The protected benefits do not represent the full benefit entitlements for most members, hence the PPF's nickname; the ‘Partial Protection Fund'. Despite being a UK government initiative it is not funded or backed in any way by the government. It is funded by levies on the potentially falling population of ongoing DB schemes.

The PPF describes its mission as: ‘Promoting increased confidence in and setting reasonable expectations for members of UK defined benefit pension schemes by:

❏ Paying the right people the right compensation at the right time

❏ Prudent and effective management of our investments to meet future obligations

❏ Setting and collecting a levy which is appropriate and proportionate; balancing employer and member interests

❏ Communicating clearly what we do and why.' The UK's Pensions Regulator has a wider focus, increasingly entering into a dialogue with DB scheme trustees, and with one of its objectives being to protect the PPF from future claims by encouraging higher funding levels.

The US solution to this problem - the Pension Benefit Guaranty Corporation (PBGC) - was established in the mid-1970s. As with the PPF, its purpose is to take control of the assets of the schemes where the sponsoring employer is insolvent, and to pay a limited level of benefits to its employees.

Unlike the PPF, the PBGC is backed by the US government and as a result suffers from direct political interference (and delayed reactions) as Congress sets the risks taken on by the PBGC and the premiums it can charge companies. Initially, its calculation of premiums did not allow for the funding of the scheme or the risk of the scheme sponsor's insolvency. This, combined with PBGC investment in equities (which performed poorly over recent years) and improving longevity, lead to a massive $23bn (€17.8bn) deficit at 30 September 2005 (compared with assets of $57bn).

The PPF looked carefully at the problems the PBGC encountered and has tried to avoid a similar fate.


What does the PPF pay out?

The protected liabilities represent broadly the following benefits:

❏ 90% of benefits for members below the scheme's normal pension age (at entry to the PPF), up to an overall limit which is currently £26,050 a year at age 65, and

❏ 100% of benefits for pensioners who are over the scheme's normal pension age;

It may appear that only people with larger pensions would face significant reductions to their full scheme benefits. However, the protected liabilities include less generous terms for post-retirement increases and death benefits than many members will presently enjoy in their scheme, and so the level of protection for a member's benefit package will often be much lower than these headline figures would suggest. A typical member under their normal pension age might only get about two thirds of their full scheme benefits protected, and many would get much less.


Safety valve

Given that the government says that it will not underwrite the fund if it gets into financial difficulties (which might only require a couple of large heavily under funded schemes to enter the PPF), the PPF's options would be to increase levies (such increases are subject to restrictions), undertake short-term borrowing, or reduce the protected benefits further.

There are concerns that the PPF has been perceived by the public as a ‘guarantee' but most do not realise the limits to the protection available.

The PPF describes when a scheme will enter the PPF in the chart below:

It takes a significant amount of time (we expect at least one year) to get through assessment. During this assessment period the trustees continue to run the scheme but under close supervision of the PPF who impose various controls on the scheme.


What gets paid in?

The PPF's funding comes from:

❏ an annual levy on eligible UK DB pension schemes; and

❏ the assets of a scheme which enters the PPF;

❏ any further assets recovered from the insolvent employer;

❏ in some cases, a continuing equity stake in the employer's business if it is able to recover.

The levy is based on a scheme's risk of claiming on the PPF and on scheme size. The risk is measured based on the extent to which PPF benefits are funded in the scheme, and on the assessed probability of the employer becoming insolvent in the next year.

The insolvency measure is of necessity subjective and is based on a ̔failure score' assessed by Dun & Bradstreet (a credit rating agency). This has proved controversial, with some scores fluctuating regularly in response to new information about the employer which sometimes appears to be relatively insignificant.

The Government predicted before the PPF was set up that the levies would need to be about £300m per year. However the PPF says it needs the 2006/07 levy to raise £575m. There are concerns that this figure is also too low, as it has been assessed after applying various restrictions to the theoretical ̔risk-based' levy calculations that the PPF derived. These restrictions significantly reduce the levies payable by some of the higher risk schemes - this can be justified on the basis that the PPF does not want to create additional insolvencies purely from the size of the levies set, but the possibility of politics affecting the levies is hard to dismiss.

DB schemes are increasingly closing to accrual and some of the healthier employers are even starting to contemplate the option of securing scheme liabilities in the growing UK annuity market.

This could remove some of the healthier schemes from the PPF's remit, and so eventually increase pressure to levy more from weaker schemes. The PPF is very aware that the levy calculations - however complex - still ignore one major risk factor, schemes' investment strategy.

This may eventually change and is another political issue - most UK schemes still invest predominantly in listed equities and bonds, and a move by the PPF to reward greater bond investment would be at odds with a UK government objective to encourage financial institutions to invest in equity, particularly private equity.

In June 2005, the PPF appointed Insight Investments and PIMCO as fund managers. Their remit was to invest in government bonds, corporate bonds, cash and derivatives related to these markets. The PPF seeks, in the long run, to match assets to liabilities as closely as possible (in contrast to the average UK pension scheme which invests the majority of its funds in equities).

The PPF is therefore taking a lower risk, lower return investment strategy than most pension schemes. In terms of its investment strategy it is behaving more like an insurer - which is probably no bad thing given its objectives.

Lynda Whitney is a pensions consultant at Hewitt Associates