Summary
The Defined Benefit (DB) Taskforce has released its interim report. Its key findings are:
- DB schemes matter to the economy – £1.5 trillion invested through DB schemes supports the UK economy through investment in businesses and infrastructure and by providing income for pensioners that turns into consumer spending;
- schemes’ funding deficits have been growing and one of the reasons is the effect of Quantitative Easing, that has led to very low long-term interest rates prevailing for a prolonged period;
- the drive to reduce deficits, through higher contributions, reduces the funding available for job creation and investment by businesses (although we note that these funds are still available for investment more generally by the pension schemes that receive them);
- schemes have been de-risking over recent years, leading to their having to rely on the sponsor covenant for longer, meaning that overall risk is moved around rather than reduced;
- members risk a reduction to their benefits if their scheme has to be rescued by the Pension Protection Fund (PPF);
- there are nearly 6,000 DB schemes in the UK, many of which are small schemes which tend to have lower levels of governance and cannot access the economies of scale that are available to larger schemes.
The taskforce recommends the following actions to address these points:
- investigate the potential for scheme consolidation, to allow more sponsoring employers to benefit from economies of scale;
- remove regulation that adds cost but has little or no tangible benefit;
- allow a more flexible approach to benefit design to help sustain schemes;
- develop better measures of the risk to members’ benefits.
DB schemes today
Today, 27.3 million people are current or former members of a DB pension scheme, of whom around 13 million are in private sector schemes. However, the number actively accruing benefits in private sector schemes has fallen, from 4.6m in 2000 in to just 1.6m in 2015.
At the end of August 2016 over 5,000 schemes were in deficit on the PPF levy (section 179) basis. Total deficits on this basis have grown from £22.5bn in 2006 to over £400bn in 2015. “Mark-to market” valuation bases (as required by legislation) – used for accounting for schemes in the sponsoring employers’ financial statements and for funding – lead to volatility in scheme deficits. This leads in turn to difficulties for companies trying to budget and has been one of the drivers in schemes de-risking, in order to reduce the level of volatility. One aspect of de-risking has been a move from equity investment toward investment in Government bonds – which have a lower expected return which must be topped up by higher contributions to the scheme.
The report notes that, while there are almost 6,000 private sector schemes in the UK, the Netherlands and Australia have just 308 and 232 respectively, although their pension systems are similar in size to the UK’s in terms of assets under management.
As schemes mature, many are becoming cashflow-negative, that is they pay out more in benefits each year than they receive in contributions. In this environment, underfunded schemes face an increased risk of having to disinvest assets at inopportune times to meet benefit payments.
The impact on the economy and on employers
Deficits are growing even though sponsors have been paying more in deficit contributions. Having said that, it is estimated that, in 2015, FTSE 100 companies paid around five times more in dividend payments than they paid in deficit reduction contributions. It appears, therefore, that many employers could afford to reduce their deficits more quickly by reducing dividends to afford additional contributions to their pension scheme.
The report suggests that there are potential downsides to such a course of action:
- pension schemes rely to an extent on dividends, so would suffer as a result – however, this ignores the fact that many schemes would have received additional contributions instead;
- a reduction in dividends might result in the employer being downgraded – however, since the employer will have reduced its pension deficit, we consider that the positive effect arising from that will more than offset the prospect of such a downgrade;
- by not being paid as a dividend to shareholders the money involved will not be available for investment in the economy – however, the money will have been paid into the pension scheme and, as the report noted earlier, pension schemes are major investors in the economy.
The risk to scheme members
This section of the report explores the risk of members not receiving their full benefit entitlement, as a result of the scheme sponsor becoming insolvent when the scheme has insufficient assets to secure benefits in full. While the Pension Protection Fund (PPF) exists to ensure that members do not lose all their benefits in this situation, the benefits it pays are lower than the member’s full scheme benefits, so members still suffer some loss. This loss is greatest for members below normal pension age whose scheme pension exceeds the cap on PPF benefits (currently £37,420 pa at age 65). As might be expected, members of schemes with weaker employers are more at risk of not receiving their full scheme benefits than members of schemes with stronger employers.
Efficiency and value for money
There are 5,945 DB schemes in the PPF universe. The majority of these schemes are small: two thirds of them have fewer than 1,000 members and the average scheme has just over 1,800 members and £200 million of assets. The report notes that running so many small schemes independently of each other is unlikely to be the most effective and efficient way to mitigate risk, optimise investment returns and attain high-quality governance.
Smaller schemes are less likely to be able to negotiate lower fees or to access certain asset classes.
The report notes also evidence (from the Bank of England) of “herding” in investment which, in the case of investment in index-linked Gilts, has led to the suppression of yields.
Regulation and legislation
The report notes the significant volume of regulation affecting pensions, pointing out that 850 new pieces of regulation and legislation affecting DB schemes have been introduced since 1995. This has added significantly to the cost and complexity of operating schemes and the Taskforce attributes this to regulation having to be targeted at the schemes with the poorest governance – predominantly smaller schemes.
Next steps
The Taskforce expects to publish its final report, including more detailed recommendations, in March 2017.