UK pensions, we are often told, are in crisis. But what lessons can be learnt from defined benefit and defined contribution systems around the world?
In such times analysis tends to turn inwards, picking apart the flaws of a system or industry in minute detail. But might we instead learn lessons by looking outwards, at both the struggles and successes of the many and varied pensions industries around the globe?
At this level of fragmentation you can’t possibly have the right level of expertise on these pension schemes
Stephen Soper, PwC
That would seem to be the implication of recent research by index and analytics firm MSCI, which shows the UK’s defined benefit funding levels lagging behind our neighbours.
“The average underfunding ratio is the highest in western Europe,” says Agnes Grunfeld, vice-president at MSCI.
The data show that while the underfunding ratio of schemes not flagged as being in the worst quintile of their regional peers is broadly normal, the UK has a much wider spectrum of funding than others in Europe. Flagged schemes are underfunded by 15.6 per cent on average.
The US tops the leaderboard of poor funding ratios, with MSCI also saying that its underfunding ratio has deteriorated by 23.4 per cent from 2015 to 2016. In comparison, Britain has pared back losses during the year, amounting to a 2.8 per cent change in the funding ratio.
Is consolidation the answer?
Experts often turn to the fragmentation of the UK’s DB system as a factor that hinders its efficiency relative to its peers. The UK has just under 6,000 DB schemes, managing £1.4tn of assets, according to the latest 7800 index, published by the Pension Protection Fund.
That high number of small schemes, says Stephen Soper, senior pensions adviser at PwC, prevents the UK from achieving the economies of scale seen in countries like Canada.
There, co-investing and consolidation have taken place naturally, out of the belief that it is better for members. Meanwhile in the Netherlands, consolidation has been achieved through regulatory pressure.
“At this [UK] level of fragmentation you can’t possibly have the right level of expertise on these pension schemes,” Soper, who is also the former interim chief executive of the Pensions Regulator, adds.
However, the UK’s standards of covenant monitoring, and lifeboat provision in the PPF, are superior to the Canadian system, he concedes. There, core industries are expected to continue to pay pensions, despite large insolvency events such as Nortel and Stelco.
Beware oversized funds
But consolidation alone is unlikely to solve the DB problem for corporate sponsors.
“[Cost savings] would not be that significant in the context of the overall cost of the benefits, or indeed in terms of pension scheme deficits as a whole,” says Frank Oldham, global DB risk leader at Mercer.
At its extreme, consolidation could even hamper the investment activities of UK schemes.
Even at £36bn in assets under management, the largest of the proposed Local Government Pension Scheme pools will pale in comparison to US municipal giants like the California Public Employees Retirement System, which manages some $300bn (£240bn).
At that size, notes Al Pierce, managing director of SEI’s institutional advisory team, the investment options available to schemes begin to narrow.
He argues that the access offered by pooled solutions means consolidation is not an obvious answer: “If you look at the large plans here in the US [...] they’re getting out of certain asset classes just because they are either too big, or they can’t really get the appropriate diversification.”
The issues with valuation-driven investment
If scale and good investment practices are not enough to remedy poor funding levels, the UK may instead have to look for international lessons in its approach to liabilities and valuations.
Some might argue that the valuations used by pension funds in much of the developed world paint an unrealistically gloomy picture of scheme funding in a low-rate environment.
Suitability of a risk-minimising strategy depends on how strictly liabilities are defined and also on the availability of long-dated index-linked bonds
Certain US state and municipality schemes use best estimate valuations techniques instead of the prevailing mark-to-market methodology, and the same is in theory permitted by the UK regulator.
“You’ve got to be pretty prudent in that,” says Pierce. “When a plan gets underfunded using that methodology, it’s pretty hard to catch up.”
But valuation techniques are not merely two ways of looking at the same picture; they have a significant impact on the investment strategy a scheme can pursue. Liability-driven investing can be argued to have been born out of the need for pension funds to discount liabilities according to bond yields, which move up and down with interest rates.
“Suitability of a risk-minimising strategy depends on how strictly liabilities are defined and also on the availability of long-dated index-linked bonds,” says Lucas Vermeulen, managing director of consultancy Ortec Finance.
He notes that strict LDI is not possible in many European DB systems, and that the cost of hedging, and the potential for a sponsor to tire of funding low-return strategies, could now become an issue for some UK schemes.
Some countries, of which the Netherlands is the most notable, ease the strain on corporate sponsors through DB by allowing a discretionary approach to benefits.
But Vermeulen notes that trustee freedom in this area has had to be scaled back by ever more prescriptive regulation: “The pension deal has become much more explicit, but it has not yet restored trust in the pension system.”
Flexible retirement age: Another lever for trustees?
Given that increasing longevity is often cited as a major challenge in the continued provision of DB, it may be more appropriate to take a flexible approach to retirement age.
Sweden and Norway have largely eliminated the concept of a single retirement age, instead allowing people to retire at any age after 61, with their state pension linked to actuarial assumptions.
In occupational pensions this becomes more difficult, as older workers may drive up youth unemployment rates.
But Brigitte Miksa, head of international pensions at asset manager Allianz Global Investors, maintains that it is imperative.
“Today’s work realities demand that we must rethink the retirement income mix from being binary: income from employment until age x, income from state and/or occupational pension afterwards,” she observes.
Miksa points to Estonia as an example of an economy where a lifelong learning programme allows older workers to remain a valuable asset to their employers.
Compulsion yes, employee contributions no
While such measures may well ease the burden of DB pensions on companies, it is unlikely they could revive them without resorting to extremes.
Increased contributions vital to continue AE success story
The real tests of auto-enrolment are still to come, one of the architects of the initiative has warned, as an adequacy report found many defined contribution-reliant members of Generation X are already beyond auto-enrolment’s help.
As such, it would only seem appropriate to include a lesson from Australia, often cited as an example of an advanced DC system.
There, compulsory employer contributions are at 9.5 per cent, with no employee contributions, meaning the system is not facing the same adequacy problems as the UK.
“The best advice for the UK was to start 25 years ago,” says Peter Nicholas, managing director of communications firm AHC.
The UK can learn from Australia’s rebranding of pensions as the more attractive “super” and increased provider competition, he says, but ultimately compulsion is necessary to drive better member outcomes.
