Posts by David

David Davison

David Davison

Specialist consultant on pensions strategy for corporate, public sector and not for profit employers
David Davison

What pointers does the SHPS Valuation provide for employers in SHAPS

In early October the results of the Social Housing Pension Scheme (‘SHPS’) actuarial valuation at 30 September 2017 were published and are available here. I’ve provided a full commentary on the impact and options for employers in the scheme here.

Given that the SHPS results are 12 months ahead of those in the Scottish Housing Associations Pension Scheme (‘SHAPS’) which are due at 30 September 2018 I wanted to consider if the results would provide a good barometer for what Scottish RSL’s might expect when they get their results next year.

The SHAPS scheme is much smaller than SHPS with a smaller number of employers but the two schemes do share many similarities in terms of employer covenant, trusteeship and investment methodology so the results should certainly identify trends.

If we start with the actuarial valuation assumptions for SHPS and SHAPS these are shown in the table below.

Assumption SHPS Valuation

30 September 2014

SHAPS Valuation

30 September 2015

SHPS Valuation

30 September 2017

(Equivalent basis)

Price Inflation RPI – 3.1%

CPI – 2.2%

RPI – 3.1%

CPI – 2.2%

RPI Curve (3.4%)

RPI Curve less 0.9% (2.5%)

Discount rate

Pre-retirement

– Post-retirement

 

5.9%

3.3%

 

5.7%

3.1%

 

Gilt Curve plus 2.4% (4.2%)

Gilt Curve plus 0.45% (2.25%)

Pensionable earnings growth (annual) 4.2% 3.7% CPI+1% (3.5%)

You can immediately see that the SHAPS assumptions at 30 September 2015 are very similar to those adopted by SHPS in 2014 with only a slight reduction in the discount rate pre and post retirement from 5.9% and 3.3% to 5.7% and 3.1% respectively and a salary increase assumption of 3.7% versus 4.2% to reflect different market conditions. The inflation assumptions were identical.

The changes to the SHPS valuation assumptions reflects changes in market conditions and a strengthening of the assumptions being used and these changes accounted for almost all of the identified deficit.

In a commentary I wrote on the 2015 SHAPS Valuation results I expressed some surprise/shock at the funding assumptions used. At a time when all the market indices were indicating a reduction in gilt yields the trustees decided to increase the discount rate used pre retirement from 5.3% p.a. in 2012 to 5.7% p.a. in 2015. This was apparently to reflect a strengthening in employer covenant. This decision had the effect of reducing the scheme liabilities and therefore the on-going deficit by around £100m. This would have been positive news for the employers but was this improvement real or some funding smoke and mirrors. Comparing the on-going deficit in 2012 of £304m to a cessation deficit of £732m compared to an on-going deficit of £198m in 2015 and a cessation deficit of £937m highlighted the change in funding prudence. My expressed concern was that this approach may result in additional future prudence and therefore increased future deficit contributions being required.

Given the similarities in the covenant strength and investment / funding approach across both schemes it does not seem unreasonable to assume that a similar methodology will be applied to the SHAPS valuation, though this would be something of a backtrack from the 2015 position.

If the trustees are adopting the same commitment “to both security and affordability” how can they not apply a consistent basis which would result in a materially higher deficit amount? If they do employers may reasonably question the approach taken in 2015.

We do not have the exact details of the SHPS change but from the information provided it looks like the discount rate has been reduced by 0.6% p.a. which alone could increase liabilities by around 5%. There may also be a further increase in liabilities to move the SHAPS assumptions in line with SHPS which could further increase the scheme deficit. Given that, as an example, the pre-retirement discount rate assumption in the SHPS valuation reduced from 5.9% to 4.2% this could be very material.

Like SHPS, SHAPS has deficit contributions based on proportion of salary and proportion of liabilities and a move to simplify contributions similar to SHPS could be attractive to the scheme. Whilst in my view the setting of contributions based purely on share of liabilities is a fairer distribution of cost it will mean that that there are some winners and losers in terms of contributions with potentially small numbers of employers seeing very material increases as a result of any change.

What would also be concerning for employers would be how the conversion from the existing funding basis with contributions reducing over the next few years to a level basis costed as a share of liabilities, similar to SHPS, would result in very material increases in future contributions and a linked increase in FRS102 accounting deficits just at the point where the scheme is promoting a move to a full FRS102 disclosure basis.

In terms of future service contributions the position may be less dramatic in SHAPS than in SHPS. Contributions increased materially at the 2015 SHAPS valuation to 27.1% p.a. for Final Salary 60th benefits and 25.8% p.a. for CARE 60th benefits. Both these figures include 0.7% p.a. death-in-service costs and reduced by 2% where employers offer DB to new entrants. These contributions are in my view more reflective of the costs of buying benefits and compare reasonably with the new SHPS rates. I would however still expect some increase to future service rates in SHAPS to reflect current market conditions, maturing scheme membership and costs being shared over a smaller membership population.

Given the more the material re-distribution of members in SHAPS away from DB I suspect we could also see an increase in on-going scheme expenses similar to that in SHPS.

Based on the above therefore I think it’s wholly reasonable to assume that SHAPS employers can expect similar bad news when they receive their results in 2019 as SHPS employers are currently dealing with. There could be something of a ‘triple whammy’ with negative movements in market conditions, a strengthening of valuation assumptions and increases in operational costs.

With DB membership numbers continuing to fall (now only around 1,000 compared to the 3,500 participating in 2012), only around 1/3rd of employers open to new DB members and huge increases in DC membership the scheme shape is changing. Any further increases in SHAPS contributions is likely to further hasten exits from DB and there must come a point where there will need to be a serious discussion about the future of the DB section of the scheme. Employers may also be once again questioning the approach adopted in 2015.

David Davison

The results of the Social Housing Pension Scheme (‘SHPS’) actuarial valuation at 30 September 2017 have been published and are available here. With new contributions due to be implemented from April 2019 RSL’s will need to consider their options and take any required decisions in the very short term.

The headlines from the SHPS Valuation are:-

  • The funding level has improved to 75% (from 70% as at 30 September 2014) but the monetary deficit has increased from £1.323Bn to £1.522Bn. While assets increased from £3.123Bn to £4.553Bn over the period (i.e. 46%) liabilities increased from £4.446Bn to £6.075Bn (i.e. 37%). A huge driver in the increase in liabilities, and therefore monetary deficit, was some material changes in the key valuation assumptions as shown in the table below:-
Assumption 30 September 2014
Valuation
% p.a.
30 September 2017
Valuation
% p.a.
Price Inflation RPI – 3.1%

CPI – 2.2%

RPI Curve – equivalent to 3.4%

RPI Curve less 0.9% – equivalent to 2.5%

Discount rate

– Pre-retirement

– Post-retirement

 

5.9%

3.3%

 

Gilt Curve plus 2.4% – equivalent to 4.2%

Gilt Curve plus 0.45% – equivalent to 2.25%

Pensionable earnings growth (annual) 4.2% CPI+1% – equivalent to 3.5%

 

  • The changes have been as a result of two main factors:
    • Changes in market conditions over the period (a reduction in gilt yields and an increase in the markets expectation of inflation);
    • A change in the assumptions used to value the liabilities (less allowance is being made for expected returns in the pre-retirement discount rate and inflation looks to have also increase by more than pure market movements, the assumptions have also been updated for recent improvements in mortality)
  • The effect of these changes has been to increased the liabilities by £1.395Bn. So effectively the vast majority of the scheme deficit is accounted for by these two factors.
  • As a result of the increased monetary deficit, increased deficit contributions will be required from 1 April 2019. Total contributions will increase by £14m from £147m to £161m in April 2019 with contributions then rising by 2% per annum to 30 September 2026. This means that by April 2026 contributions will be around £180m per annum. What may have been missed by many however is that the existing contributions were to begin to reduce from next year tailing off to 2025 however this will not now happen so contributions in the last year could be as much as £100m more than under the previous funding plan. The option was there to look to extend the funding plan to retain existing contributions or smooth increases but this hasn’t been pursued.
  • Historic deficit contributions had been set based on a combination of pensionable salaries and share of scheme liabilities however all future deficit contributions from April 2019 will be paid based on share of liabilities. Whilst undoubtedly fairer, particularly where there is a mix of open and closed scheme accrual, as in this scheme, but the change could result in very large fluctuations in contributions for a number of employers.
  • Clearly the new higher contributions will have a negative impact on the FRS102 accounting disclosures, which are likely to be changing from 2019 from a net present value calculation to a full disclosure, so there could be a material balance sheet implications for scheme employers.
  • Future service contributions (i.e. the cost to buy more benefits) have increased by around 32% across the Board. Final salary 60th contribution s are up from 20.6% p.a. to 27.2% p.a. and CARE 60th contributions are up from 16.7% p.a. to 22.1% p.a. These are really material increases and it wouldn’t be unreasonable to wonder if historic contributions had been under-estimated, particularly when you see the cost of similar accrual in other Final Salary / CARE schemes.
  • Scheme expenses have increased from £1,800 per employer plus £70 per member pa to £1,900 per employer and £75 per member so a 5.6% and 7.1% increase respectively. I suspect this is not only inflationary but also a reflection of falling membership in the DB section and the need for TPT to recoup costs over a smaller membership base.

The direction of travel is seeing more and more RSL’s move to DC provision and away from DB and it’s easy to imagine that these changes will further encourage that move. It will be interesting to see the full valuation report when available to see how the membership profile has changed over the 3 year period.

So what can employers do?

  • In terms of deficit contributions not a great deal!! There is an appeals process where if contributions are deemed unaffordable this can be raised with the Scheme Trustees. However time to pursue this is short as appeals need to be in by 30 November 2018. If not pursued, or unsuccessful, then employers just have to find the money for the deficit contributions.
  • For future service contributions employers have a few more options:-They can just accept the increases as proposed
    • They can pass all or a proportion of the increases on to members. With member contributions in the final salary 60th option already at 10.3% then potentially increasing this to something up to either 13.6% or 16.9% must be unwelcome and really raises the question if this remains a viable option. In addition to the above if the membership is closed to new entrants an additional 1.1% of salary applies.
    • Employers could move to a lower DB accrual basis. The total cost of the final salary 80th option is now 20.5% in comparison to the 20.6% which previously applied to the final salary 60th option. A move to CARE 80th would have total contributions of 16.7% with the reduction potentially available to help fund the increased deficit contributions. Clearly remaining in the DB option, even at a lower accrual rate, does continue to build DB liabilities, though at a slower rate.
    • Employers could move to the DC Option within the scheme. Employer and employee contributions could be set at a fixed monetary amount at, above or below the level currently being paid. DB accrual would cease for these staff thereby limiting liabilities. This move could be for new staff only or for all staff.
    • Historically it has almost entirely been the case that new DC contributions would be arranged via the SHPS scheme primarily to avoid a cessation debt trigger on the DB liabilities. The relevant Section 75 legislation was amended in April 2018 which would allow DB accrual to be ceased without an automatic S75 debt trigger however at this stage it is unclear how TPT might provide access to this option and so this would have to be explored in more detail.
    • Employers could also consider setting up their own scheme or if they have a scheme already in place look at moving their assets and liabilities to that. Such an option is likely to be complex and potentially costly though, particularly for larger SHPS participants, is well worth considering as it does potentially increase the options available.
  • Clearly it’s likely any of the above changes would require communication with staff as a minimum and potentially consultation.
  • Employers need to be aware and manage any revised balance sheet impact.

Revised deficit contributions are applicable from April 2019 and future service contributions from July so employers will need to understand how the changes specifically impact on them and then consider what strategy they want to employ. Once a strategy is set they’ll need to consult with staff if there are any changes to contributions and/or benefits. This process will all have to be addressed in a relatively short period so engagement with the scheme and advisers in the short term will be necessary.

David Davison

In June 2018 the Scottish Local Government Pension Scheme Advisory Board launched a consultation on the future structure of the Scottish LGPS. The Board’s consultation sets out four options for the future structure of pension funds in Scotland. The review provides excellent background for all LGPS in the UK as the range of scheme sizes provides a microcosm in which to review the options presented more widely.

There are 11 Scottish Funds with total assets of around £42Bn and liabilities of about £55Bn. Scheme sizes range from the largest, Strathclyde Pension Fund, with around £20Bn of assets and 210,000 members to the smallest, Orkney Islands, with only £335m of assets and just over 3,600 members. The four options being explored along with the key considerations are shown below.

  1. Retain the existing structure

Retaining the status quo is likely to mean that inefficiencies will remain as most funds will not achieve the benefits of scale such as improved bargaining power, access to greater resources and reduced duplication of efforts in administration, governance, spending on advisers and fund management. Larger funds are also likely to be able to better access infrastructure investments. Maintain the existing approach is therefore likely to mean that costs per member are likely to be higher than necessary.

A potential negative would be the loss of local input and oversight and the regional diversification of resource such as staff as it may be difficult to access specialist staff in a single location. However the existing structure does potentially also create a key person risk as there is less available resource to cover key roles as well as budgetary and staff risk due to other competing local priorities..

Clearly any savings made or improvements achieved would need to outweigh any initial transition costs but all research to date would tend to support a move away from the status quo.

  1. Promote co-operation in investing and administration

There have already been some examples of collaboration particularly in the investment area and around procurement. This approach would allow the current governance structure to continue, allowing for continued local oversight, although requiring some sharing of control. There would also have to be some adaptation of governance.

Approaches to date seem to have been relatively informal which results in a degree of uncertainty over their future persistence so a more formal structure may be of value to assist with planning as well as the distribution of costs and returns. To date this sort of co-operation has been pretty limited despite its obvious benefits which would suggest that without strong vision and direction it will remain  something of an outlier. I can’t help feeling that greater structure and compulsion is needed to really drive change.

  1. Pool investments

This option would see all assets pooled in one or more asset pools managed centrally on behalf of a number of Funds. Schemes would retain their governance, administration and back office functions and continue to appoint and manage their advisers. This is very similar to the approach currently being adopted in England and Wales.

A single pool would double the asset size to about £42Bn over the largest Fund which has assets of just under £20Bn. At this size it would be of a similar size to 3 of the English pools and larger than the 3 others.

Fund assets and liabilities would still be allocated in the same way to ensure specific employer responsibility for liabilities.

A move of this type would be likely to result in lower cost investing though subject to some initial cost increases to manage a transition. It would also be likely to mean that the asset pool was of a significant enough size that more of the investment and administrative tasks could be undertaken in house.

From a governance perspective each Pension Committee would retain responsibility for asset allocation and managing the legislative structure however day to day investment management would be delegated to the pool. Each Fund would also maintain its Pension Board.

As has been shown in England and Wales this approach is very achievable and its hard to deny the value so would seem to be a minimum required step.

  1. Merge funds in to one or more funds

This option would see the creation of a Scottish ‘superfund’ which would manage all LGPS benefits in Scotland. Such a move would benefit from the asset pooling advantage s in 3 above but also allow for merging of the administrative and governance functions.

Such a move, whilst ultimately desirable from a cost and consistency perspective is not without its challenges. Each of the Schemes is funded at a different level and there would have to be a recognition of this and a mechanism to resolve it to ensure there was not a cross subsidy between different regions and even potentially employers. There would also have to be clarity in terms of governance, priorities and costs. There are also political drivers as well as a need to ensure that the right level of resource is available to the new consolidated scheme.

None of these challenges however are insurmountable and really just need commitment to achieve the objective and a clear plan to do so over a reasonable timescale.

The Funds all provide consistent benefits based upon a single regulatory framework. Consolidation would remove regional variations and inconsistency. Legacy arrangements would have to be clearly documented and honoured but future practice could be implemented on a wholly fair and consistent basis. Undoubtedly given the size distribution of schemes in Scotland a number of them would be likely to benefit from cost savings and improved governance very quickly. Market buying power in terms of services would be improved and greater investment possible in staff, technology and scheme communications.

Conclusion

Research carried out by Deloitte in 2011 suggested that costs per member in Scotland compared favourably with funds in England and Wales and that a single operating model and common administration system may have a greater benefit than formal administration mergers though research by APG concluded that administration costs decline with larger funds and certainly this seems to be the model being employed across UK defined contribution businesses.

It also needs to be considered that the number of employers participating in LGPS in Scotland is falling so less resources are needed and greater consistency of practice can be achieved. In addition with greater employer consolidation there will undoubtedly be increased demand for larger employers to have all benefits consolidated in a single fund rather than across multiple schemes.

In addition the benefits of having a single scheme which is not accountable to a local authority and can operate in an autonomous way based on its agreed priorities should provide greater flexibility in staff terms and conditions and therefore provide the opportunity to attract a much higher calibre of staff.

There are clear benefits which can be achieved through investment pooling and even further benefits through a consolidated single scheme for Scotland – it just needs vision and commitment to achieve them.

David Davison

If you’re one of the lucky admitted bodies who benefit from a council or other guarantee for your LGPS membership then this is likely to mean that you are currently disclosing a much more negative position on your balance sheet than actually should be the case.

In most cases transferee admitted bodies, and community admission bodies with guarantees, benefit from preferential exit terms should they leave the Fund, with the debt payable on exit calculated on an on-going basis (as per that used to calculate Fund contributions) rather than the more stringent cessation basis. This is good news of course as it means the likelihood of having a large debt on exit is much lower.

However, there is no correlation between the assumptions used in the calculation of the on-going funding position and those used when compiling the FRS 102 disclosures for company accounts. Under FRS 102 the discount rate must be set in line with the yield available on high quality corporate bonds. At the moment, corporate bond yields are low and so the discount rate used in the FRS 102 calculations is likely to be much lower than that used for the on-going funding basis, resulting in higher liabilities and a much larger deficit (all other things being equal), which therefore reduces balance sheet value.

I recently witnessed an example of this where, on an on-going basis, the organisation was in surplus but on the FRS 102 basis the organisation had a £100,000 deficit. The organisation had a guarantor and so was able to exit the Fund at any point paying off any on-going funding deficit (which in this case was nil). The FRS 102 deficit cannot be correct in this case as the worst case scenario is the on-going position. This meant that the charities balance sheet was £100,000 worse than it should have been, which, for the charity in question, was very material.

A further difficulty from a disclosure perspective are the recent changes to UK wide LGPS Regulation which now permit the return of surplus on exit from schemes. To date where a surplus has existed this has been discounted and a net neutral position assumed as any surplus could not be recovered. This however is no longer the case and the position will vary depending upon whether the organisation has a guarantee and whether their ultimate exit position is based upon an on-going or cessation position.

The disclosure position has therefore become much more complex and employers need to be considering their position well in advance of their company year end to leave enough time to take any remedial steps necessary. So if you have a guarantee or are very well funded on your exit basis, discuss this with your auditor. It may be possible to add a note to the accounts to provide greater clarity or better still, update your accounts with disclosures on a basis more consistent with the value of the liabilities actually owned.

David Davison

In an earlier Bulletin ‘A Landmark Judgement’ I provided some information on the welcome news that the Government had thankfully lost a case in the High Court which would have forced LGPS Funds in England and Wales to invest their assets (£263Bn in 2017) in accordance with UK foreign and defence policy.

Unfortunately my relief that common sense had prevailed on this issue was misplaced as on 6 June the Court of Appeal overturned the High Court ruling forcing schemes to comply with government policy, all this despite numerous warnings from pension experts about the negative impact and increase in pension scheme costs such a decision could have.

This whole saga started back in 2016 with the Government introducing legal guidance as it was concerned pension schemes could be taking actions which might “give mixed messages abroad, undermine community cohesion in the UK, and could negatively impact on the UK defence industry.”

The policy was successfully challenged by the Palestine Solidarity Campaign and an individual scheme member in 2017 when the High Court ruled it unlawful.

The whole approach smacks of state intervention and interferes with the ability of pension schemes to take decisions wholly in the interests of the members of the scheme. The Appeal ruling also seems to contradict proposed policy to require trustees of pension funds with 100 or more members to show how they have considered environmental, social and governance factors in their investment decisions.

The Government has refuted that its objective is to make pension schemes invest in line with government policy and has commented that it is not seeking to direct schemes investment decisions but despite the assurances the legal position seems to contradict this view.

It’s hard to see how the ruling won’t lead to schemes having to review policy resulting in increased complexity and additional costs which will be wholly unwelcome and not adding any value to scheme members.

Watch this space!

David Davison

On Friday 25th May 2018 new LGPS (Scotland) Regulations 2018 were published and came into effect from 1 June 2018. The Regulations are a result of a long and in depth consultation process focused on trying to assist with the difficulties faced by community admitted bodies (‘CAB’s), mostly charities, participating in these schemes. Charities are often trapped in LGPS unable to afford the contributions to stay in or the cessation debt which would be imposed to exit. The current approach offers CAB’s with only a threatening cliff edge and is inflexible, inconsistent and does not reflect the approach adopted across stand-alone or segmented schemes.

The new Regulations do indeed add some flexibility in a couple of key areas:-

  • The addition of the option for the administering authority (‘AA’) and the employer to agree a ‘suspension notice’ which would defer an employers requirement to pay a cessation debt. The employer would still be required to pay on-going contributions to the Fund as set by the AA. There is not really any specific guidance provided how such an agreement can be reached, which is a bit of a double edged sword. It does not therefore restrict the authority in terms of the approach it can take but as a result leaves the way open for a lot of interpretation. It is to be hoped that AA’s apply this flexibility pragmatically to arrive at reasonable outcomes for both parties.
  • The recognition that if an employer is over-funded then on exit they should have the right to the repayment of that surplus in full. The Regulations have therefore added a definition for an ‘exit credit’ which for the small minority of employers in this position will be welcome news and prevent Funds from just pocketing their surplus on exit.

Unfortunately however even with these changes the revised Regulations are a bit of an opportunity lost. In January 2018 the Pension Committee at ICAS provided a response to the Scottish Public Pension Agency (‘SPPA’) suggesting some additional items which would make these changes more workable and balanced. These recommendations included:-

  • a recognition that CAB’s should be able to make deficit contributions to Funds on a ‘closed on-going’ basis until the last member’s beneficiaries have ceased to receive payments.
  • A consistent basis for the calculation of these payments.
  • That CAB’s funding position be fully and consistently adjusted to recognise and reflect inherited liabilities from prior public sector employments. It is wholly unreasonable that CAB’s are expected to pay for benefits built up for staff who previously worked for public bodies.
  • It should be compulsory for all LGPS funds to provide CAB’s with a note of their estimated cessation value annually to allow both to better manage their funding position.

Scottish Government is to be commended for at least leading the way in trying to find a resolution to the difficult issues faced. A review of 3rd Tier employers in England & Wales is currently underway and it is to be hoped that the findings of this exercise will lead to similar changes to those implemented in Scotland but hopefully even taking a step further. It will be hugely interesting to see how these new Regulations are enacted in practice.

David Davison

Nearly three years ago I wrote an article praising Lothian Pension Fund in Edinburgh for an enlightened move they announced which protected organisations burdened with legacy LGPS debt. This is a huge problem, as outlined in a previous Bulletin, which unreasonable saddles admitted bodies with past Council liabilities without full compensation and usually without them even being aware. The process adopted is akin to someone buying a car but having to pay for the previous owners lease as well as your own!!

The logical and reasonable approach that Lothian Pension Fund took was to confirm that where participation in their Fund had effectively come about via an outsource from a local government entity that on exit from the Fund the exit debt would be calculated on an on-going basis rather than the much more penal cessation basis and I have been fortunate to witness a number of my 3rd sector clients benefit greatly from this wholly sensible change. Some of these issues are dealt with via transferee admission agreements but not all with many legacy arrangements still in place.

What however has surprised me is that other Funds have steadfastly refused to follow suit, a position highlight by four recent exercises I have been undertaking where all the organisations hold very significant amounts of legacy Council benefits under their membership.

How can it be reasonable for an individual to work for 35 years for the Council and then move to a small 3rd sector organisation with LGPS membership for a couple of years prior to retirement and for that small organisation to inherit the past liability in full. Patently it can’t be!

The Lothian approach recognised this and provided a clear policy statement so that everyone knew exactly where they stood.

Unfortunately, while hugely welcome, even Lothian’s approach doesn’t go quite far enough. I struggle to see the difference between members who transferred across at outset (which the policy covers) and those who transfer across at a later date (who aren’t covered). The historic liability is the same. Indeed the policy also doesn’t reflect transitions from other public sector employers and schemes which results in a similar inequity.

Scottish Government missed a huge opportunity to resolve this issue when they introduced their new 2018 LGPS Regulations but unfortunately it was absent from the revisions. This is an area which could have benefited from some prescription and a clear policy statement that it is unreasonable for public bodies to expect other organisations to pick up their liabilities and that any such liabilities should be excluded in the calculation of contributions and in the settlement of any cessation liability.

With the findings of the Tier 3 review due shortly to the England & Wales Scheme Advisory Board it is to be hoped that they will deal with the issue. In the meantime Funds have the opportunity to behave fairly and responsibly and deal with their own liabilities in full.

David Davison

The more I read about defined benefit (DB) consolidation, the more it appears to have a key parallel to Brexit, namely: everyone seems to have a different expectation of the outcome.

The DWP’s White Paper “Protecting Defined Benefit Schemes” was published in March and followed up last year’s Green Paper with further proposals on the benefits of consolidation.

There are multiple consolidation options. Each will have a different impact and will be complicated to achieve.

The suggestion is that bigger is better. Having larger schemes reduces cost and improves governance. Interestingly, however, the 2017 Purple Book suggests that smaller schemes (i.e. those with less than 100 members) are on average better funded than those with more members.

So, in considering consolidation, what options are possible, what are their potential benefits and what might be the associated considerations?

Investment consolidation

The potential to consolidate investments seems relatively simple, can reduce costs and provide schemes with access to a greater level of investment choice.

Access to investment platforms can provide cost and administrative benefits even without wholesale changes to underlying governance or administration.

Governance consolidation

Consolidating governance, for example, in the form of sole ‘professional’ trusteeship also seems to present schemes with a straight-forward path to governance improvements and can be achieved without upheaval to the schemes’ delivery services.

Going beyond the above there is further potential, but the benefit improvements are much less certain based upon the specific circumstances of each scheme and employer.

Operational consolidation

There may be operational opportunities to merge key scheme services such as administration and actuarial.

It’s far from clear cut, however, that such a move will result in cost savings.

There is little evidence that the provision of services within a DB Master Trust are provided at a materially lower cost unless some form of benefit consolidation can be achieved.

In addition, the likely scheme time horizon will have a huge bearing on the cost effectiveness of any move given the inevitable set-up costs of a service change. If, for example, the time horizon to buyout is within 5-10 years then annual savings may not outweigh initial transition costs.

Any move to a DB Master Trust must be reviewed in terms of flexibility. Such a move will require a scheme to fit within the DB Master Trust model where any pricing improvements which can be achieved are done so via some form of standardisation.

The timing of valuations or the approach to administration may not be something that suits all schemes or employers.

What is the Master Trust approach to employer covenant, member communication and benefit options and is any approach outside the norm likely to incur additional costs which may negate any savings?

This will be an important initial consideration as in my experience these schemes are much easier to join than they are to exit.

Benefit consolidation

This is even more problematic.

Converting one scheme benefit basis to another has long been fraught with difficulty given that ultimately a guarantee will have to be provided that members will be no worse off.

This will undoubtedly result in up-front costs that again have to be considered against any savings which can be made in future.

There have been calls for Government to standardise benefits to make consolidation easier, but it remains to be seen how this can be achieved.

Ultimately a Scheme Actuary will have to sign-off any benefit conversion to confirm that the change does not detrimentally impact on members’ accrued benefits, which is far from an easy hurdle to get over.

It is also difficult to envisage how consolidation can happen for schemes with unequal funding levels, as trustees would surely seek a “levelling-up” of funding. This has been an issue which has undoubtedly slowed the pace of consolidation in Local Government Pension Schemes (LGPS).

There must also be a concern that close links to key personnel in a scheme sponsor who can provide valuable insight from an employer covenant and operational perspective could be lost through consolidation.

Are ‘Superfunds’ the answer?

There have been proposals that a middle way between own-scheme funding and buying-out with an insurer may be possible.

This would be via what have become known as ‘Superfunds’ which would consolidate scheme benefits from multiple schemes. The suggestion is that sponsors would benefit from lower costs than that required to fund a buyout.

Proponents have been quick to highlight that any transfer in to Superfunds would need to be fully assessed by Trustees as being in members’ interests and that any agreement is likely to result in accelerated employer contributions over those paid under a funding plan in order to gain access.

An initial entrant to the market has suggested that revised legislation is not required as their scheme is just the same as any other occupational pension scheme and could run under existing regulation.

This, however, differs from proposals put forward by the Pensions and Lifetime Savings Association (PLSA) where it was expected revisions to the regulatory framework would be required.

Clearly we are at a very early stage in terms of this potential solution and it is likely to evolve over the coming months. Undoubtedly questions remain over this approach, particularly around the break in the link to the sponsoring employer and therefore the strength of the employer debt security.

Industry unconvinced by consolidation

The Association of Consulting Actuaries’ Pensions Trends Survey 2017 suggested that only 16% of sponsors would consider consolidation and only 32% thought that potential cost savings were real.

That would seem to suggest there are real concerns about how successful any consolidation might be and a high level of scepticism that promised improvements can be achieved.

It is interesting that LGPS schemes where the benefit basis is the same have primarily gone for investment consolidation. This may well be a first step, but where funds have merged for delivery services the impact in the end-user experience has been patchy.

There are undoubtedly efficiencies and opportunities for improved investment and governance available through some form of consolidation, however, the extent will be very much based on individual circumstances and requirements.

Those in favour of much greater reform certainly have a lot of convincing to do.

This article originally appeared in CA Today on the ICAS website here – on the 19th May

David Davison

The Security Obsession

In an earlier bulletin entitled ‘The Cessation Plot thickens’ I highlighted something of an anomaly in LGPS practice around security which I’d like to explore a bit further.

Firstly, I will consider an example of an admitted body looking to close off to accrual to better manage risk. Prior to doing this let’s assume that the organisation has £1m of accrued liabilities and £800,000 of assets covering them so a deficit of £200,000. The organisation is building further liabilities of £50,000 a year. Contributions for these new liabilities are £20,000 a year so each year the net position is worsening by £30,000 (excluding any investment return).

As an active employer the Fund has not taken any security so the Fund and therefore other participating employers are exposed to additional risk as liabilities continue to build.

If the admitted body was permitted to close to future accrual of benefits the accrued benefits are no worse pre and post the change (they will likely be lower afterwards if the link to salary on past benefits is removed), so why should security be required when none was previously in place. In addition a proportion of the contributions which were being used to build additional benefits in the Fund could be used to pay down the existing benefits rather than build up new ones. Let’s assume some of the £20,000 is needed to buy replacement benefits in another scheme so only £15,000 is available as a contribution. This will therefore reduce the deficit over time thereby reducing the risk to the Fund. This can only be good for all concerned and further supportive of the view that no security is needed.

So, why is there an obsession for Funds to get access to security on scheme change? It’s probably because they’re using it as an excuse to do so! A bit of a reality check is needed.

It’s potentially reasonable for Funds to look for security if some additional flexibility is being offered, such as access to a higher risk investment fund where the deficit risk could increase but without this the default position should be that additional security should not be necessary.

So if you’re being pushed for security by a Fund you may need to ask a few more questions, especially as any arrangement of this type is likely to be time consuming and expensive to arrange.

In my view there should be clear and consistent guidelines which Funds employ in relation to the provision of security. Some Funds are adopting a more pragmatic and indeed enlightened approach to the issue of security and it can only be hoped that others will begin to follow suit, especially if admitted bodies ask the right questions.

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