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Impact Investing

IPE special report May 2018

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UK: A chink of light

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  • UK: A chink of light

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A small compromise in the treatment of accrued rights might signal a more flexible approach to benefit indexation in the future, finds Liam Kennedy

The UK may retain Europe's most inflexible and employee-friendly regime for defined benefit pensions, with guaranteed retail price inflation indexation of both accrued benefits and pensions in payment. But the 2008 Pension Act, which received royal assent at the end of November last year, provided for a small compromise in the treatment of accrued benefits for early leavers. Too late to halt the shift from defined benefit perhaps, but at least a sign that the government is willing to compromise on issues such as indexation.

So from April this year, retail price index (RPI) linked increases for the accrued benefits for those no longer contributing to a DB scheme have been capped at 2.5%. Joanne Segars, chief executive of the National Association of Pension Funds (NAPF), welcomes the measure, which her organisation had lobbied for. She adds that the NAPF has been pressing hard for a number of years for more employer flexibility in the area of deferred rights indexation.

"We have a very rigid regulatory framework," comments Segars. "We are only one of two countries in the OECD that has mandatory inflation proofing for pensions in deferment and pensions in payment. This becomes a driver for behaviour, because with rising longevity, providing those benefits becomes more and more expensive and you end up with the tail wagging the dog."

She says the NAPF is working on a concept that it terms optional indexation, whereby employers would not have to provide indexed benefits but would have to provide the employee the right to buy that indexation. DB would work a little more like DC, where individuals can purchase an indexed annuity but are not compelled to do so.

"This would be a good way of introducing an element of risk sharing into the equation, where the employee takes on some of the longevity risk and the employer still holds the investment risk. It seems to us that this is the direction in which we should be moving," says Segars.

Despite the extent of the UK's pension assets, there has been little innovation in the area of pension benefits, and little debate about the form good supplementary pensions need to take in a modern but ageing society. There is very little between the twin poles of DB and pure DC, and few employers offer hybrid benefit systems, such as cash balance pensions.

DC has also been treated as something of an afterthought by trustees in the UK, for whom defined benefit arrangements have been much more time consuming - the introduction of the Pensions Regulator, the Pension Protection Fund and the issue of deficit funding have all consumed trustees' time.

Most DC schemes in the UK are microscopic in size, however. In June the Pensions Regulator published DC Trust - A Presentation of Scheme Return Data, which analysed 100,000 current and wound-up schemes. It found there were only 5,800 trust-based DC schemes or hybrid schemes with more than 12 member out of a total of 56,619 trust-based DC and hybrid schemes, meaning that 90% of trust-based DC schemes have fewer than a dozen members.

The Pensions Act 2008 also provided the framework for Personal Accounts, a new state-sponsored trust based defined contribution scheme, that will come into effect from 2012. From then, automatic enrolment will apply once more to occupational pension schemes - and the Personal Accounts system may act as a standard setter for DC design. If its contribution projections are met, it is also set to become a world class-size institutional investor pretty quickly.

May saw the publication of a consultation document on investment by the Personal Accounts Delivery Authority (PADA). According to PADA's investment director Mark Fawcett, the system is likely to use target date funds. "The advantage of target date funds is that you can actually be quite flexible about your retirement date," says Fawcett in the current issue of IPE. This is despite the fact that target date funds have come under the scrutiny of the Department of Labor and the Securities and Exchange Commission in the US this year following average 2008 losses of around 20% for 2010 target date funds, with extremes of 40%.

The results of PADA's investment consultation exercise are likely to be published by the end of this year, and a tendering exercise will take place in time for the launch of Personal Accounts in 2012. In time, adds Fawcett, the Personal Accounts system is likely to develop its own in-house investment expertise.

Last year's Purple Book, the annual risk assessment of DB pension funds, and published jointly each December by the Pensions Regulator and the Pension Protection Fund, found that only 31% of its sample were open DB schemes, compared with 36% a year previously. Deferred members of DB schemes (42%) also outnumber current members (22%) by a factor of almost two to one. The remainder are pensioners.

Latest figures from the Pension Protection Fund's PPF7800 index show that the aggregate deficit of 7,400 pension funds has improved from £200.1bn (€232.1bn) at end-June to £158.1bn to end-July, in part thanks to improved government bond yields as well as improving equity markets.

John Ball, head of defined benefits consulting at Watson Wyatt, points out that 85% of pension schemes would not have enough assets to provide their members with benefits above PPF compensation levels if their employer went insolvent tomorrow.

In June this year the Pension Regulator published a statement emphasising the necessity for prudent funding levels for pension funds. The aim is to encourage pension fund trustees to be flexible in their demands from sponsors and not to push sponsoring entities into insolvency by insisting on pre-agreed funding commitments. This would simply lead to more pressure on the Pension Protection Fund and lower benefits for all members.

Mindful of the burden on business, the PPF also announced at the end of July the appointment of a steering group consisting of business leaders to assist it in developing proposals for the future of the pension protection level. This follows the PPF's November 2008 proposal to tailor individual funds' levies to a greater extent to the overall risk they present.
 

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