The Pension Protection Fund, the lifeboat for failed defined benefit pension schemes, is facing a looming iceberg known as ‘PPF drift’, says Lincoln Pensions' Richard Farr.
PPF compensation is typically lower than the full benefits promised by a scheme, mainly because once the scheme enters the PPF benefits of members who are below the scheme’s normal retirement age are capped, and all benefits often increase at a lower rate.
The cap does not apply to members above the NRA, so resisting PPF entry helps secure a greater pension for members approaching NRA. However, this delay can cause a material upward drift in the size of overall PPF compensation.
The Pensions Regulator and PPF need to acknowledge and clearly define the drift, while actuaries should regularly estimate it for trustees to include in annual scheme returns
While the PPF’s exposure to all DB schemes currently stands at around £220bn, the drift will see it steadily increase towards their combined buyout deficit, worth a staggering £1.5tn – unless sponsor contributions or investment returns are sufficient to compensate.
Drift must be minimised
This is a significant problem that needs to be addressed. The drift incentivises trustees of failing schemes to delay either a restructuring or PPF entry, to increase the total compensation for their members.
If the drift could be reduced or slowed down, trustees would explore restructuring options more readily to try to prevent employer insolvency and perhaps extract greater value from the sponsor.
Secondly, if the scheme’s PPF funding level is below 100 per cent, then allowing such schemes to limp on increases the compensation payable by the PPF upon entry.
As this is ultimately funded through the PPF levy, this means viable and well run schemes are effectively subsidising those that are failing.
Even if a scheme has a PPF surplus, there is a risk transfer from older to younger members as the uncapped benefits of those above the scheme’s NRA increase over time.
If these members’ benefits are not lowered through a scheme restructuring, the PPF drift would draw a greater proportion of scheme assets to fund full benefits for members above NRA.
This unfairly reduces the assets available to secure benefits for deferred members.
A raft of drift remedies
PPF drift must be tackled, and there are a number of steps that should be taken now.
First, the Pensions Regulator and the PPF need to acknowledge and clearly define the drift, while actuaries should regularly estimate it for trustees to include in annual scheme returns.
Trustees should also ensure that they reasonably expect to obtain sufficient investment returns or employer contributions to offset PPF drift over the next triennial period.
This would allow TPR to perform better-targeted regulatory interventions into the schemes that pose the greatest risk to the PPF in future.
Second, the annual PPF levy should be based not just on the current PPF deficit, but also expected PPF drift over at least the next three years. This would ensure that the levy reflects both the risk to the PPF today and over the longer term.
Third, the process for approving regulated apportionment arrangements should be streamlined. Earlier intervention would reduce PPF drift and may be sufficient to prevent a call on the PPF altogether.
This could create a moral hazard for the sponsor, but robust covenant advice and increased anti-embarrassment protections should offset it.
An unpalatable choice
Most controversially, the PPF’s compensation structure should be reviewed to consider whether the cliff-edge nature of the compensation cap could be removed, or retained at higher ages.
Full benefits should only be guaranteed for those members who are no longer capable of meaningful employment.
It is becoming increasingly clear that people are generally capable of continuing working until later in life, meaning many recent retirees could continue working to offset an unexpected decline in pension income.
While PPF drift cannot be stopped entirely, these steps will help to slow it and improve the outcomes for members in aggregate.
They will also help the pensions lifeboat avoid the iceberg and continue to provide adequate compensation to members, without being a burden on solvent schemes and their sponsors.
Richard Farr is managing director of covenant advisory Lincoln Pensions
