Trustees and their actuaries must consider the impact of deficits and funding negotiations on struggling defined benefit sponsors, the president of the Society of Pension Professionals has warned.
Hugh Nolan, who is also a director at consultancy Spence & Partners, and colleagues pointed to short recovery plans, “herd mentality” investment in gilts-linked securities, as well as lack of flexibility on valuations as aggravating factors in the question of DB affordability.
Whether there are systemic problems with UK DB has been a matter of intense debate for some time now.
The Department for Work and Pensions stated in its green paper in February that it did not believe this was the case. While Nolan agreed that many of the sector’s problems are due to industry rather than legislative failures, he did call for a reconsideration of indexation rules.
You’ve got a long-term pension scheme here where you can be invested in equities and take risks
Simon Cohen, Spence and Partners
One such industry failure is seen as undue pressure being put on sponsors to fund deficits within a short period of time, either because schemes feel they should push for as large contributions as possible, or because of the current political atmosphere.
“We see situations where the actuary has said to the trustees, ‘This is how big the deficit is, and that means you have to pay this much over the next 10 years... because Frank Field said so',” he said. “It puts the company under unimaginable pressure.”
The Work and Pensions Committee recommended that recovery periods be shortened in a paper released in December, ahead of the Department for Work and Pensions’ subsequent green paper.
The Pensions Regulator abandoned the previous 10-year requirement in 2014 in response to the introduction of a duty to consider and protect sustainable growth of employers.
Shorter not always better
Nolan welcomed the DWP’s decision not to repeat the select committee’s recommendation. Increasing the length of recovery plans does increase the amount of time the scheme is exposed to the sponsor’s solvency, but also lets sponsors invest in their own business, and allows more time for market conditions to improve.
At the weaker end of the covenant spectrum, the decision to squeeze a cash-strapped sponsor could deliver insolvency “not in five years but in six months”, he said.
The calls met with some opposition from others in the industry. David Felder, director at professional trustee company Law Debenture, agreed that inappropriate recovery plans can harm sponsors, but said many schemes already take sponsors' financial health into account.
“That’s why in nearly all cases you need the agreement of the sponsor,” he said.
Flexibility is key
In an effort to lighten the load on sponsors, Nolan and colleagues called for actuaries to encourage greater use of asset-backed funding, and to be less cautious in their use of assumptions.
That might mean allowing for some investment returns in setting discount rates, where the scheme’s allocation is appropriate to do so, and explaining to sponsors and schemes the possibility that such assumptions might be wrong and need to be updated in future.
If too much faith is placed in 'gilts-plus' valuations, they said, schemes will be drawn into investing in short-term, low-risk assets, increasing funding pressures.
Simon Cohen, head of investment consulting at Spence, said that while leveraged liability-driven investment products had helped to a certain extent, “really, you’ve got a long-term pension scheme here where you can be invested in equities and take risks”.
Mind your risk
However, others were more wary. “Investing your way out of deficits never works, and it exposes the trustees and the sponsor to too much risk,” said Felder.
Calum Cooper, head of trustee DB at Hymans Robertson, said using deficits at all should be avoided when setting funding and investment strategy.
“It’s a bit like driving a bus and looking out of the right-hand side window to see what’s [up] the road,” he said, recommending setting a strategy in response to goals-based modelling, ideally including covenant risk.
Industry behind indexation change
Nolan also argued that schemes providing pensions increases in line with the retail price index or other expensive measures should be allowed to change to the statutory minimum of the consumer price index.
Noting the somewhat arbitrary nature of the way in which scheme rules tie them to RPI, he said: "I don't believe that there's any member in the world who's relying on an RPI increase rather than a CPI increase."
The industry seems to back him, with a recent survey of delegates at a Baker McKenzie event finding 87 per cent were in favour of the move.
But he did not think that awareness of the limitations of deficit measures should stop schemes from derisking.
“I think most pension schemes wouldn’t have a lot of conviction that they’ll be rewarded for taking interest rate risk,” he said.
With many schemes a long way from buyout and wide variations in assets held by insurance companies, Nolan and Cohen suggested there was no clear-cut case for schemes to prematurely tilt towards low-yielding bonds.
But Cooper said schemes should continue to derisk, adding that gilts and corporate bonds would continue to be priced fairly by insurers. Schemes should “scan the market” carefully for firms whose particular asset portfolio allows them to price attractively.
