In the acclaimed novel, The City and The City, by China Miéville, residents of Besźel and Ul Qoma spend their lives “unseeing” half of the city around them. They avoid walking into people and cars that they consciously don’t see, but in their mind half of the city does not exist.
Many defined benefit pension schemes, perhaps half of all schemes, operate in a similar way. The focus is on hitting the technical provisions target, while at the same time recognising but not acknowledging their genuine destination, which for most is buyout.
They understand that is their likely endpoint in the future, but this is not documented in any formal way. The expectation is increasingly that this approach, with an ‘unseen’ long-term objective, cannot continue.
I expect some sponsors to back away and claim that running the scheme in its current form for the long term is their intention
A new funding regime will be consulted on during 2019 and come into force in 2020. The white paper issued in March 2018 clearly indicated that schemes will be expected to have an appropriate long-term objective, and then also to reflect that in their technical provisions.
With political pressure to do something about failing schemes, it seems unlikely that direction of travel will change. But there are implications to deal with, as well as details to establish.
Sponsors may cool on buyout
The first issue is that sponsors and trustees will disagree on the long-term objective. Many trustees expect buyout to be their eventual aim, and when it is just an aspiration many sponsors will agree.
But if it is formalised then I expect some sponsors to back away and claim that running the scheme in its current form for the long term is their intention.
Of course, that could be overridden by legislation that dictates that buyout or self-sufficiency must be the aim. But that changes the role of funding regulation from oversight to direction, in a way that has not been seen since the minimum funding requirement regulations.
Perhaps more likely is a middle ground where the regulator determines whether a long-term objective is ‘appropriate’ or not, with guidance supporting their position, and powers to intervene.
Will employers have to fund to higher targets?
An important question is whether a new regime will change the measurement only, or real behaviour. Disclosing a higher deficit changes nothing, and the politicians, civil servants and regulators know that. It needs to change behaviour.What does that mean in practice? Whether you’re a ‘fully funded’ scheme expecting to reach buyout by investment return alone, or a scheme expecting to never target buyout but just keep running indefinitely, the pressure will almost certainly be to continue contributions (if affordable) to move towards a more secure target earlier.
Another behaviour that could change is around investment strategy. In the past, both accounting standards and MFR have stood accused of leading schemes into investment strategies that they would, and should not, otherwise not have adopted. A new funding regime needs to avoid that if at all possible.
There are wider implications to be managed, and unexpected consequences that need to be avoided. Managing the reaction of stakeholders will need some work, whether that be members, shareholders or analysts. But all of that is doable.
Embedding a long-term objective in the technical provisions is not the same as funding for that objective today
We also need to be sure that changes in funding approach do not inadvertently change payments to members. Commutation factors and transfer values are both often calculated by reference to the cost of benefits, and paying members more just because the scheme is more secure, just increases costs further.
Scaremongering will not help
Finally, from a technical perspective it needs to be recognised that embedding a long-term objective in the technical provisions is not the same as funding for that objective today.
For example, the way to check whether a scheme is on track to buyout in 10 years’ time is not to look at the buyout funding level today. If the new regime wants to recognise long-term aims without scaremongering, then this is important to get right from the outset.
If the proposed changes go ahead (and with Brexit and the possible fallout from that still unknown it is by no means certain that it will) then I expect long-term objectives to be part of our funding regime within the next 12-18 months.
As a principle I think it is the right approach, rather than ‘unseeing’ the long term. But that does not mean it is going to be an easy or agreeable change.
Paul McGlone is president of the Society of Pension Professionals and a partner in Aon’s retirement practice
