There are two fundamental issues I want to highlight with regards to the defined benefit crisis: the measurement of liabilities, and what should be done to prevent promises being broken (and how best to spread the burden if they are).
The measurement of liabilities is a fundamental issue because it is the results of our measurement system, which indicates whether there is a funding deficit. There are two basic approaches to Valuation – mark to market and mark to model. Around the turn of the century both theoreticians and practitioners were inclined to support mark to market and accounting standards were set that way.
The theoretical underpin was “The Efficient Market Hypothesis” which argued that the price of an entity on a deep and liquid market between two knowledgeable traders was the best indication of Value. The theory asserted that markets absorbed every imaginable piece of information in establishing value and price, and it became the leading valuation technique. However, it produced unwelcome results for DB schemes in two ways.
Firstly, to produce a current valuation for a steam of long term cash flows, Government Bonds became the reference point of choice (some advocated taking some credit risk in return for greater yield by investing in corporate bonds, while others argued that additional prudence was required to cover re-investment risk). The yield on Gilts (or AA corporate bonds) has become the default standard for a discount rate. And of course, as the ILC-UK has pointed out, deficits yo-yo around as bond yields change – while the actual liabilities, namely how much pension is due on a certain day, have not changed at all. It’s just the measurement system.
The second inconvenient truth for those who support mark to market is that the market which does exist for the bulk purchase of pensions liabilities costs even more than the deficit – implying that the deficit is an understatement of the real cost. There are two principal reasons why ‘buy-outs’ are more expensive – first they represent a transfer from a non-regulated entity to a regulated entity, where standards of risk management and capital adequacy are much higher – and second , the insurer needs to make a profit and so builds in a profit margin.
As a consequence, it has become fashionable in the Pensions industry to advocate a move away from mark to market and adopt a policy of mark to model, to try to smoothe out some of the volatility. The measurement issue then becomes – who’s model, and how is it calibrated and governed?
This is important because if the model goes too far away from the market, we may lose transparency of the true underlying cost of funding, as eventually market assets will need to be purchased to fund the liabilities. Warren Buffet, the Sage of Omaha, disparagingly referred to a third valuation technique – mark to myth!
As a pragmatist, I would suggest a possible way forward could be to acknowledge that no valuation technique is perfect and therefore to permit supplementary disclosures on different bases, perhaps using GDP as a discount rate, on the grounds that the growth in the wealth of the nation as a whole is a relevant reference point, or using the anticipated yield of the actual asset mix as a discount rate. Some argue that this is equivalent to incorporating future, as yet unearned and speculative, profits into the financial statements, so would have to be supplemented by a statement of liquidity strength – for example disclosing the length of time current assets could discharge known liabilities.
The second fundamental issue (which sounds like a questions from a moral philosophy paper), is, what should be done to prevent promises being broken and how should the burden of a broken promise be spread? In Pensions parlance, what is the framework for deciding how to supervise schemes in deficit, and what is the balance between forcing companies to stronger funding or asking members to accept less than they have been promised and have been planning for?
This question reveals a minefield of special pleading and unaligned incentives!
Stereotypically, the Employer asserts that the money would be better spent re-invested in the business, while the member would claim that the quality of life in old age depends upon the promise being kept! There are two ways, and combinations of these ways, of making up shortfalls in individual schemes.
The Employer can be forced to use its resources to fund the deficit as a priority to the point of bankrupting the business, and the member can be asked to accept less than was promised. A limit has been set by parliament in the UK as to how much of a ‘haircut’ the member should be asked to take – the PPF level of compensation. This is the level captured in the s.179 valuation, and, broadly speaking, equates to 100% pension for anyone over scheme retirement age, and 90% of the pension for anyone under the scheme retirement age, with an overall cap of around £37k pa and with limited indexation. We should also note that both the UK courts and the European courts have indicated restrictions to the size of the ‘haircut’ in individual cases.
There is not much more that can be done to ask the member to accept less. Individual schemes frequently run a variety of ‘liability management’ exercises in which a member is offered accelerated cash in a way which reduces scheme liabilities by a greater amount, and, post “pensions freedoms” we may see more of these.
But we could potentially set expectations on the Employer side, for example by tightening up on circumstances where a firm can pay dividends (or pay increases in smaller companies) while in deficit. At the moment we allow a strange inversion of the normal credit hierarchy by allowing equity holders to subordinate the providers of debt without any consultation. Should Trustees be allowed to limit or block dividends? We could also insist that schemes which remain open to new members or new accruals should be fully funded on a self- sufficiency basis for the additional liabilities.
And, following the current debates about regulatory powers, we could potentially allow PPF to take over the investment strategy of schemes (subject to conditions). PPF has won numerous awards for its investment strategy and it would also improve governance and reduce costs simultaneously. We could allow PPF to take over schemes before the Employer formally defaults – perhaps for the category of schemes never likely to be able to discharge their liabilities.
Extreme care would be needed to align incentives (I am certainly not suggesting a free put option, but more of a ‘buy-out’ model). Such a development would socialize the residual cost of deficits to the broader base of PPF funders. Finally, we could allow TPR to intervene without such a great burden of proof. Recent cases have confirmed my own experience of how incredibly complex individual cases can be – and how creative and subtle the advice industry can be.
One final point. Current generations of workers also need to secure a comfortable retirement, and the adequacy of contributions into DC is one of the hottest topics around. In ‘The end of the beginning’, the ILC-UK points out that average Employer contributions into a DB plan is 16%, compared to 2.5% into DC.
That’s over 600% more into DB than DC!
This is beginning to look like a transfer from DC contributions to DB, and is a topic that should be made more transparent. If within a single Employer, the notion that those workers in the DC scheme were subsidizing those in the DB scheme took hold, it would surely result in more strident calls to correct the inequity – and could itself sow the seeds of another Pensions crisis and a demand for political and regulatory action, some potential components of which I have already suggested.
So in summary, we should clarify how much of the current problem is largely a measurement problem and for the real problems, we should explore a tougher contribution regime for open schemes and a pathway to a DB hospice for those who are unlikely ever to pay their liabilities.
I do not underestimate the difficulties in crafting a framework which most aligns the incentives on all parties, but I believe we are more likely to find a good answer if we start to look for it. As Talleyrand says in his first law of politics ‘Anticipate the inevitable, and facilitate its introduction’.
Lawrence Churchill CBE
Chair, Pensions Policy Institute
This blog is based on the comments delivered by Lawrence Churchill at the launch of ‘The end of the beginning? Private defined benefit pensions and the new normal‘.