Making Sense of Pensions

Brian Spence

Complete the jigsaw to reveal a new Christmas themed Spence logo. The timer will start from the moment you click on the first piece and will stop when you have all the pieces in place.

Good luck, it’s just for fun but if you complete it in under 1 minute you are doing well!

Alan Collins

The 2017 Purple Book, the Pension Protection Fund’s stat-fest on DB pensions, has landed.

The document, can be accessed here.

The main headlines for me are as follows:

  • The transition of schemes from “closed to new members” to “closed to future accrual” is continuing – if the trends continue, more schemes will be closed to accrual than closed to new entrants by 2018 or 2019. The number of fully open schemes is relatively stable (but only accounts for 12% of schemes);
  • The funding levels of schemes (as measured on a S179 basis and a buyout basis) rose over the year to 31 March 2017, in spite of significant market turbulence which occurred around the EU Referendum Vote in June 2016;
  • The average length of recovery periods for valuations submitted to the Regulator dropped slightly, from eight years to seven and a half years;
  • The average insolvency rate of companies who sponsor DB schemes is around 0.3% a year – this has been relatively stable over recent years having dropped from around 0.8% in 2013/14). So, if you are a member of a scheme, your employer is (on average) significantly less likely to become insolvent than was the case four or five years ago;
  • Asset allocations to equity and property are relatively stable. There is a modest switch from cash and “other investments” to “bonds”.
    • I have a hunch some of this may be a re-classification of assets rather than a sign of strategic shift towards bonds.
    • The relative steadiness of allocations indicates little evidence of asset allocation changes during a year which contained some shocks.
    • It will be interesting to see if there is a greater shift towards bonds in 2017/18 as funding levels have improved and as there may have been some profit-taking from equity stocks. I suspect those hoping to have seen “peak bond” will be disappointed.
  • The number of schemes in assessment for PPF entry has continued its steady decline, both in terms of the total number of schemes and as a percentage of the DB universe. 78 schemes were in assessment during 2017/18 (around 1.4% of the total number of schemes); and
  • There is a large concentration of liabilities for schemes in assessment (around 80%) amongst schemes whose liabilities exceed £100m.
Brendan McLean

Autumn for me represents two things: colder, darker days, and a new budget. I wait excitedly for the budget in the hope of fewer taxes, but it seldom happens – however this year, something else exciting happened. Philip Hammond, Chancellor of the Exchequer, declared the Government wants to see pension funds invest in patient capital as a way of financing growth in innovative firms as part of his mission to unlock over £20bn of new investment over the next 10 years, ensuring the UK economy is fit for the future.

This move follows a government consultation that closed in September 2017 which discussed lowering barriers to patient capital investment, such as long-term illiquid investments in start-up companies, for defined benefit (DB) and defined contribution (DC) schemes.

This change won’t take place overnight – The Pensions Regulator will still need to provide guidance on how trustees can increase patient capital investment, which both the regulator and HM Treasury has not yet provided a timescale on. However the Treasury has said they will establish a working group consisting of institutional investors and fund managers with the goal of increasing access to patient capital for innovative firms, and removing barriers to investment for DC members.

Investment-Pension-Budget-2017

In this current low yielding environment with various asset classes valued at record highs the thought of allocating to alternative long-term investments such infrastructure and venture capital which are less correlated to traditional asset classes offers a hope of a higher level of future returns for DB schemes. This could help decrease funding deficits. I believe over time illiquid long-term assets which are currently more accessible for larger schemes will become available for smaller schemes, as previously occurred for LDI.

Investment in long-term patient capital represents an opportunity to encourage younger DC members to get involved with investing in their pension.  As they are unlikely to retire for decades the benefits of long-term patient capital will be more visible to them. However most DC pensions’ assets are currently daily priced and normally offer daily liquidity. These two factors make it extremely difficult to make illiquid assets available to DC investors.  On a technical point, DC funds are offered in life assurance wrappers and the rules around those wrappers typically prohibit investment in illiquid asset classes.

Removing barriers to entry can only be a positive thing as it will help investors allocate capital more appropriately. These new changes will benefit DC members as they currently have a greater challenge accessing long-term illiquid investments. DB schemes will also benefit as they will have a greater opportunity to allocate to diversified less correlated assets.

For more information or to discuss the content of the blog please get in touch.

Brendan McLean
t:/ 020 3794 0193
e:/ Brendan_McLean@spenceandpartners.co.uk

Alan Collins

I read an interesting comment piece by Peter Smith in the ever-reliable FTfm section of yesterday’s Financial Times.  It concerned a possible upcoming change in the investment strategy of the Bank of England’s own defined benefit pension scheme.

So, what have they been doing and what might be next?

Around 2007, the fund switched investment strategy from one with a mix of gilts and equities to a “portfolio exclusively focussed on index linked-gilts”.  Having checked the most recent fund report and accounts (as at 28 February 2017), the actual split is around 60% index-linked gilts, 30% index-linked corporate debt (issued by the likes of Network Rail) and 10% fixed-interest gilts.   The point being is that the scheme has been wholly invested in debt-based securities for over ten years.  This has served the scheme very well over many years, with the funding level now reported to be 101%, an improvement from 96% in 2011.  I would take issue with the contention from Marc Ostwald of ADM investors who rather uncharitably suggested that the scheme has “been an OK performer more through luck than judgement”.  Many schemes will look back and wish they had achieved the same “luck” over the last ten years.

The really interesting bit is what might come next.

According to recent meeting minutes, the Scheme’s Chair of Trustees (John Footman) has stated that the Scheme was considering “alternative approaches” and “taking more investment risk”.  This is being taken as a sign that gilts are “relatively less attractive” and that “defined benefit pensions are not necessarily best served by gilts”.

Gilts may not be hugely attractive, but they remain an important tool (perhaps the most important tool) in a trustee’s armoury for tackling the biggest pension scheme risks of interest rates and inflation.  While many of our clients are rightly seeking higher yield where they can get it (through multi-asset credit, illiquid assets and other growth assets), gilts (and instruments such as Liability Driven Investments) will remain core to a scheme’s investment strategy.

In my view, this potential change in tack may actually be more about dampening the expected cost of future benefits than managing the risk of benefits built up to date.  With ongoing accrual costs at an eye-watering 50%+ of pensionable salary, perhaps it has been decided that more investment growth is needed to mitigate this (broadly speaking, the more investment growth that is assumed, the lower level of contributions are expected to be needed to pay for future benefits).

There is no suggestion that wholesale change is on the horizon.  I would expect the vast majority of the £4 billion plus fund to remain invested along current lines.

So, what can we learn from the Scheme’s approach:

  • It is important to regularly review your Scheme’s investment strategy – a strategy that is right today won’t be right forever;
  • Diversification (and here I agree with Mr Ostwald) should be an important consideration for scheme trustees –even the smallest of funds should be considering how different asset classes can add to overall performance and reduce risk;
  • The nature of defined benefit pensions means that the ongoing build up of benefits is hugely expensive if the investment strategy is wholly gilt based.  To sustain benefit accrual (where the risk can be sustained), growth-seeking assets are likely to be a necessary part of the portfolio; and
  • The search for yield in the current environment may point towards alternatives to government bonds.

For more information or to discuss the content of the blog please get in touch.

Alan Collins
t:/ 0141 331 9970
e:/ Alan_Collins@spenceandpartners.co.uk

Quick Summary

Andrew Kerrin

The first three quarters of 2017 truly flew by, with only two thirds of 2017’s last quarter left to go too.  We never do things by halves, and we have kept a close eye throughout the whole of the last quarter, to bring you the hottest topics in the pensions industry, divided up into bite size pieces.

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David Davison

An Unwelcome Inheritance

Mostly when people are told they have an inheritance it’s good news. A long lost relative or friend has bequeathed some money to you which opens up the opportunity to do all (or at least some) of those expensive items on the bucket list. Unfortunately an inheritance in an Local Government Pension Scheme (LGPS) is usually every bit as much of a surprise and shock, but far from as welcome for the recipient.

Many organisations, having become a participant in the LGPS were blindly unaware that to do so meant that they automatically inherited all the past liabilities for any staff transferring to or continuing with the organisation. Frequently this can mean that charities inherit hundreds of thousands of pounds of liabilities and in some cases many millions.

This anomaly arises because LGPS is unable to identify and allocate past service liabilities between employers, apparently only being able to allocate all of the liabilities to the latest employer. This is undoubtedly incredibly unfair as it means local authorities can deftly transfer the funding risk to an unsuspecting charity. Even where guarantees are provided tend only to protect charities on insolvency and not on voluntary exit or on increases in contributions.

The approach used by the Fund (in most but not all cases) notionally assesses the liabilities as being fully funded at outset so even if the funding level is only 90%, for example, it is assumed to be 100%. However this is far from a perfect solution for a number of reasons:-

    • The value of these liabilities will vary over time. If a further shortfall arises the funding costs for this will have to be picked up the new employer in full even though they did not employ these individuals at the time they accrued the benefits.
    • Where liabilities should have been notionally uprated frequently this has not been actually carried out or the exact terms have been lost ‘in the mists of time”.
    • Even if the benefits were fully funded this would have been on an on-going basis and not on a cessation basis. This means that on an ultimate exit the latest employer would pay a cessation debt on all these previously accrued benefits.
    • Should members benefits be subject to strain costs such as on redundancy or ill health early retirement these additional costs would have to be met in full by the latest employer.

These issues can come in to sharp focus where the latest employer has been admitted as part of an out-sourcing exercise. Procurers can inherit past service liabilities which dwarf any future service benefit which can be accrued over the term of the contract and become responsible for variations in the value of these liabilities over the contract duration and at the contract end date. Attempting to deal with these issues, usually very imperfectly, is achieved via contract negotiation and terms which again adds unnecessary complexity, inconsistency and frustration. A worked example showing the issues is available here.

Funds should really be dealing with this issue properly by segregating liabilities, as is the case in most other large multi-employer schemes. The costs related to past service liabilities would be fairly retained with the employer who accrued them with future service only being the responsibility of the new employer.

Frustratingly many Funds continue to deny the issue of inherited liabilities. It is totally inequitable to expect a small charity to pick up a cessation liability for benefits they previously inherited from a public sector body on an on-going basis, or even in many cases a funding basis well below this. I’m surprised more fuss hasn’t been made of this!!

Some Funds however have sensibly identified this and looked to deal with it fairly and I can only hope that all others will follow. Indeed these liabilities should just be re-allocated to public sector ownership, which is totally possible, and would mean that the Fund has them guaranteed with no cessation debt requiring to be paid. I can only think the reason for not doing this is the LA’s know they’ve dodged these liabilities and don’t want them back!!

The recent ICAS report made recommendations how this issue could and should be addressed. I would recommend that any charity that have witnessed significant contribution increases or have been provided with a cessation debt consider this issue and have it properly investigated as it could have a material impact and it seems an issue which when outlined would not be easy for funds to reject.

 

David Davison

A Landmark Judgement

The objective of bringing LGPS funds more in line with all other UK pension schemes and forcing them to invest in the best interests of members came a little closer after the government suffered a major defeat in the High Court at the end of June.

The government had issued guidance in September 2016 requiring LGPS funds to have environmental, social and governance (ESG) policies but added a requirement that funds could not “pursue policies that are contrary to UK foreign policy and UK defence policy”.

The Palestine Solidarity Campaign (PSC) launched a bid in the courts to overturn the regulations via a judicial review. It contended that the government had acted outside its powers and it was “lacking in certainty”. It also cited Article 18.4 of the EU’s directive on the Activities and Supervision of Institutions for Occupational Pension Provision (IORP) that states “member states shall not subject the investment decisions of an institution…….to any kind of prior approval or systematic notification requirements”.

Judge Sir Ross Cranston only agreed with the first argument citing that he couldn’t see “how the secretary of state had acted for a pensions’ purpose”. He therefore granted the judicial review.

A spokesman for DCLG said that the government would consider whether to appeal.

While the judgement was broadly welcomed it may not be quite the end of the issue as trade unions encourage the government to implement EU IORP directive into LGPS.

The judgement does however mean that Funds will have more freedom to take positions on ethical investment focussed wholly on the best interests of scheme members which must be a benefit.

David Davison

In April this year the DWP launched the snappily titled public consultation ‘The draft Occupational Pension Schemes (Employer Debt) (Amendment) Regulations 2017’. The consultation, which closed on the 18th May, was looking to make suggestions to deal with the perennial issue of Section 75 debts. A Section 75 debt triggers when an employer ceases to have active employees in a multi-employer scheme while other employers still do.

All very interesting (or not) but what does this have to do with LGPS you may ask, especially given neither the Section 75 legislation nor the DWP consultation actually cover LGPS? However while Section 75 legislation may not specifically apply to LGPS the principles on exit / cessation and the issues the consultation is looking to address are pretty much the same. In fact some of the specifics of LGPS actually make the options for employers even more restrictive than in other ME schemes.

The consistent issue is that neither multi-employer defined benefit schemes (MEDBS) or LGPS have a mechanism to allow participants to cease building up benefits for all members without automatically trggering a debt at that point. This is a mechanism available in standalone and segmented multi-employer schemes allowing employers and trustees to more effectively manage risk. The lack of this option encourages participants to continue to build up additional benefits for staff way beyond the point where they are affordable, placing their very existence at risk, reducing the covenant of member benefits and risking placing an additional burden on other organisations who participate in the scheme. Legislation as it sits at the moment not only limits an employer’s ability to manage this risk but also ties the hands of those running the pension scheme.

Many employers are now facing a cliff edge as their membership numbers fall. Many recognised the risk and associated costs of DB provision and closed their schemes to new entrants. This just makes a movement towards ultimate cessation inevitable as eventually they will run out of active members. Research recently carried out by the Scottish Government in relation to Scottish LGPS has highlighted this wall of risk and Funds throughout the rest of the UK will be no different.

A way that many private sector MEDBS have looked to deal with the issue is either to close to future accrual for all employers simultaneously or to add a defined contribution scheme under the same trust as the defined benefit scheme thereby allowing employers to have active participation but to have stopped accruing further DB liabilities. Unfortunately neither of these solutions is open to LGPS employers.

In one of my previous Bulletins ‘An Alternative Approach’ I highlighted the potential impact of the timing of this debt trigger and how this was effectively a one-sided equation stacked in favour of the Fund and unfortunately an equation that many admitted bodies are unaware of until it’s too late.

The DWP Consultation sought comments on a potential solution called a deferred debt arrangement (‘DDA’) which would allow employers to cease further DB benefit accrual and continue to fund the scheme without triggering the S75 debt. Employers would retain all the same obligations towards the debt and scheme to protect members and the Trustees but it would permit a more practical and orderly exit from DB accrual.

There does seem to be consensus at this stage that something does need to be done, though some variation in the mechanism to achieve it. I can only hope that we get some practical and workable proposals out of the consultation and that it is more widely applied covering LGPS. Action needs to be taken now but given our current political environment and the Governmental focus on Brexit it would be a brave man to predict we will see anything substantive in terms of legislation in the short term, let alone seeing it extended to LGPS, even though in my view it quite clearly should be.

David Davison

There is now a greater acceptance of the issues charities face through their participation in local government pension schemes however it has been difficult to identify the quantum of the problem and from there arrive at logical and implementable proposals for change…until now!

Over the past couple of years the Institute of Chartered Accountants in Scotland (ICAS) via its Pension Panel has been engaging with the Scottish Government and the Scottish Public Pension Agency (SPPA) to look to better understand the scope and impact of these issues to allow recommendations to be made.

Helpfully, following an initial engagement with Scottish Deputy First Minister John Swinney in the middle of 2015, he helpfully issued a communication to all Scottish LGPS at the end of October 2015 requesting that Funds did not push charities to insolvency as a result of their pension liabilities pending a review of the Regulations.

In addition at the same time he requested the Scottish Scheme Advisory Board (SSAB) to carry out research amongst the Scottish LGPS to look to identify the quantum of the problem. This research was carried out and delivered to SSAB mid 2016 although it was not released more widely until mid 2017. Following its publication ICAS have commented on the key findings and made some recommendations for change in a report issued on the 25th September 2017.

Whilst based on the research carried out on Scottish LGPS it is important to emphasise that this research and the resultant ICAS recommendations have a UK wide application.

Key findings from the SPPA Data Collection Exercise

  • All data supplied was as at 31 March 2017.
  • There were 530 employers with at least one active member. Of these 422 were admission bodies (covering both transferee and community admission bodies) of which 223 had no guarantor and so were at some point likely to be liable for a cessation payment. Of these 102 had 5 or fewer members where a cessation payment could be deemed to be payable in the short term.
  • Worryingly of the 102, 60 remain open to new members and are therefore building further liabilities. Of the 121 with no guarantor and more than 5 members 94 remained open to new members.
  • There are 41 employers at greatest risk as they have fewer than 5 members and are closed to new members which mean that a cessation is imminent.
  • The cessation deficit associated with the ‘at risk’ group of 41 was estimated to be in the region of £12m-£15m (i.e. and average of around £300,000 per body).
  • The total liabilities for the 223 admitted bodies with no guarantor were in excess of £350m and the cessation liabilities could be in excess of £150m.
  • The cessation position could be materially worse now given falls in gilts yields since 2014 which highlights the issue with the cessation basis being adopted.

A summary of the recommendations

  • Admitted bodies should not be burdened with gilts based cessation deficits for liabilities inherited from all public service bodies. It is wholly unreasonable for a member of staff to transfer from the Council, for example, and then have the admitted body pick up the cessation cost of liabilities built up while the individual worked at the Council.
  • The treatment of these inherited liabilities should be consistent across all LGPS Funds and should apply to all benefits transferred in from public bodies.
  • Organisations carrying out out-sourced arrangements for public bodies should have their pension liabilities dealt with on a ‘pass through’ basis with them being able to be transferred back to the public body at the end of any contractual term. This would avoid local authorities seeking to walk away from their liabilities, leaving them with the out-sourced contractor.
  • It should be compulsory for LGPS Funds to provide all admitted bodies with an annual update on their cessation amount.
  • The LGPS Regulations should be amended to prevent the automatic trigger of a cessation debt on the exit of the last exit member. This would allow employers to continue to pay contributions on an on-going basis and manage their contributions and ultimate exit.
  • LGPS should provide admitted bodies with greater flexibility in payment amount and term.
  • There should be a maximum level of prudence applied to cessation calculations with a gilts basis not being used as the default.
  • Where it is clear that an admitted body cannot afford to exit the scheme and settle a cessation debt they should be allowed to exit based upon affordability and a payment plan agreed.

Many of these measures have already been implemented in some Funds so the proposals are wholly achievable. There are however huge inconsistencies in the approach taken by Funds and everyone would benefit from having access to a consistent series of options. The report provides a good template and it’s now up to government to implement much needed change.

David Davison

Beware, beware, beware!!

Charities rightly have a reputation for adopting a more paternalistic attitude towards staff than is generally the case, and I’m sure they would be concerned if it was felt that their actions were exposing staff to unnecessary risk. However, the approach taken to retirement benefits could in many cases be inadvertently doing exactly that.

Charity employers make a commitment to help staff fund for their retirement provision throughout their working life. They closely monitor contributions, look to ensure that the scheme they provide offers staff the best choice and benefits possible, and that they have access to information and advice when they need it. However, coming up to and at retirement, just when members have accumulated their largest benefit, and have the most difficult decisions to take about their retirement, and when they are at their most vulnerable to scammers and unscrupulous individuals, is the point at which little, if any, support is available.

I was struck by a recent case highlighted by the Pensions Regulator (the full press release and related notices can be found here) where £16 million was invested, and this was made up of transfers from other, reputable schemes, the value was reduced to approximately £991,000. This is all before any tax penalties are considered in respect of liberation payments. Any return to members is likely to be a tiny fraction of the transfer value they paid in. Assets had disappeared in a myriad of suspect investments and those affected have been consigned to a retirement considerably less comfortable than the one they might have expected.

The statistics are frightening. According to research carried out by Citizens Advice:-

  • 10.9m pensions consumers received unsolicited contact since April 2015;
  • 8.4m consumers were offered unsolicited pension advice/reviews in the last year;
  • Action Fraud – in first six months of Pension Freedoms the average pensioner affected by pension fraud lost £163,000;
  • The average consumer has difficulty in spotting scam offers.

Nobody knows exactly how much has been lost to pensions fraud, but some estimate it could be as high as £3bn.

Recent research published by Retirement Advantage has shown that 35% of savers over 55 years old have been targeted by scammers offering free pension reviews, or investment opportunities.

This is an increase from figures released in June 2015, showing that one in five people over 50 had been approached by would-be scammers. As the people being approached here are over 55, this is not about pension so-called liberation, it’s about separating individuals from their retirement pots.

The Pension Regulator press release outlined classic elements of scam behaviour including:

  • Potential scheme members were cold called and text messaged by introducers, who were paid on commission for the introduction.
  • Without their knowledge, members’ funds were invested in exotic sounding, unregulated investments overseas, such as tree plantations in Fiji, a Brazilian teak plantation land and fund shares based in the Cayman Islands.
  • The scheme appeared to have been a vehicle for pension liberation and that the trustees were aware of this. TPR found that some scheme members (below the age of 55) received cash advances or loans via introducers with, in at least one case, a scheme member receiving a loan directly from the scheme assets.

Never has the old adage “if it seems too good to be true it probably is” been more apt.

So, what should employers be looking to do to protect staff from these unscrupulous individuals?

People need to be made aware of the risks and what to look out for. Snake oil salesmen promising guaranteed returns and buy now while stocks last investments are unlikely to be genuine. The illusion of high growth with the promise of low risk in a time of low inflation and interest rates is unachievable.

A good start as a minimum would be to supply all staff with a copy of the Pension Regulator’s Guide on what individuals should be on the look out for. Charities could supply this to staff via e-mail or letter, or it could be included as part of an annual update. Additionally employers could ensure that any staff presentations from your pension provider / independent financial adviser on pensions include some warnings about scams. It is also certainly well worth considering having access to an independent financial adviser available for staff, as they reach retirement age.

In addition, we need to stop the scammers getting hold of the money and, if you can’t stop people giving it away, you need to save people from themselves. All hail the Nanny State!

In August the Department for Work and Pensions (DWP) / HM Treasury published “Pension Scams: consultation response.”

The response suggests:-

  • a ban on cold calling in relation to pensions, to help stop fraudsters contacting individuals;
  • limiting the statutory right to transfer to some occupational pension schemes;
  • making it harder for fraudsters to open pension schemes.

This is excellent news, however, it is nothing more than a statement of intent at this stage and will remain so, until legislation in enacted. In this regard, rather worryingly, in the consultation response it does say that “the government will bring forward legislation when Parliamentary time allows.” Given the parliamentary timetable is currently congested with Brexit issues, I have a concern that many more people will be exposed to risk before this legislation is enacted, making remedial action in the interim all the more pressing.

Hopefully the simple steps I’ve suggested here will keep more people out of the clutches of the scammers, and have their pension savings protected to provide for the safe and comfortable retirement they were always intended for.

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