Making Sense of Pensions

Andrew Kerrin

Another year, another mixed bag for the pensions industry.  Looking back, with its final quarter now closed, 2017 was a year that threatened change (the Work and Pension Committee’s review and subsequent Green Paper on DB schemes, and the much-anticipated ban on cold-calling) but that ultimately saw pensions taking a back-seat to the political beast that has become the Brexit negotiations.

That’s not to say that pensions weren’t firmly in the headlines, with the collapse of schemes adorning household names, and some significant decisions coming from the courts (not least the Walker v Innospec decision on same-sex spousal benefits).  However, the final quarter of 2017 brought some significant announcements and stories that promise to keep trustees and sponsoring employers busy during the next 12 months.

So, we have collated all of the most important topics from the 3 months to 31 December 2017 into a bite size report, to let you sign off on 2017 and get ready for 2018. Enjoy your Quarterly Update!

The seasonal topics of this quarter include:

  • Anti-Money Laundering Regulations
  • Latest news from the PPF
  • VAT on DB scheme management costs
  • MIFID II and the regulation of investment firms
  • Bank of England interest rates
  • Transfer value redress
  • 21st Century Trusteeship

To download this report click here.

As always we love to get feedback from you. If you like what we do please tell us – it’s nice to get great feedback. If you would like things included, excluded or done differently please drop us a line too. The report is to help you, so help us tailor it to your needs.

And … if you find that you do have time to keep up with things, why not follow us on Twitter @SpencePartners and keep up to date as you go along.

David Davison

In past bulletins I have highlighted the lunacy of organisations in LGPS Funds being forced to continue to build pension liabilities beyond the point where they are affordable. Organisations are stuck, continuing to build more and more benefits for their staff, focussing contributions on new benefits rather than looking to pay down the legacy liabilities they’ve already built up.

Organisations have the Hobson’s choice of an unaffordable exit debt or continuing accrual driven by LGPS Regulations which are patently not fit for purpose.

At last there seems to be a glimmer of hope that the problem has finally been recognised and an acceptance that these Regulations need to be changed to better protect scheme employers as a whole, and indeed the Funds themselves.

In a previous Bulletin, I highlighted the work ICAS in Scotland had undertaken to encourage Scottish Government to review the Regulations and, as a result of this the Scottish Public Pension Agency communicated a commitment to review the Regulations and issue a consultation with their proposals. True to their word a consultation was issued on 6 November 2017 with a closing date of 15 January 2018.

The consultation proposes material changes to Regulation 62 (equivalent to Regulation 64 in England & Wales) which would allow ‘exiting employers’ to cease building up future benefits but without the imposition of a gilts based cessation debt, something which is unaffordable for most. This would be via the use of a ‘suspension notice’ where Funds could agree to let employers continue to participate, effectively on an ‘on-going’ basis, with a continuing contribution commitment to the Fund. Such an approach would assist in dealing with this ‘Hobson’s choice.’

I greatly welcome the SPPA’s approach although the detail still, in my view, needs some refinement.

ICAS has provided a response to the consultation which highlights some issues and makes further practical proposals how these may be resolved.

I can only hope that the proposals are implemented (with some pragmatic amendments) and that England, Wales and Northern Ireland look to follow suit. It can only be in everyone’s interests.

David Davison

I was reading through an LGPS annual report for 2017 this week (I know, I get all the fun jobs I hear you cry!) and was struck by a comment about the scheme membership continuing to grow and linking that to the health of the scheme and it’s relative attractiveness. This ‘positive spin’ wasn’t wholly in line with my experience so I decided to do a bit of digging to see if the statements actually held water.

Trawling through some old scheme records I identified that the scheme membership had indeed grown by about 50% over the 10 years to 2017. However, when you looked a bit more closely the increases were driven more by rising numbers of deferred members, which had more than doubled. The active membership had only increased by about 29% over the period.

So this meant that the active members, i.e. those actually contributing to the scheme, had fallen as a percentage of overall membership from over 52% in 2007 to less than 46% by 2017.

Over approximately the same period the pensionable salary roll for active members had increased by about 26% with deferred pensions increasing by around 80% and pensions in payment by over 88%.

This led me to look at a few other LGPS reports and the position is broadly consistent, demonstrating something of a trend.

So what this means is that the salary increase and active membership numbers have increased by a relatively consistent amount so the future accruing liabilities are broadly consistent. However it does mean that proportionately there’s a smaller number of those funding any deficit contributions related to deferred and pensioner members and paying for the costs of running the scheme.

So the picture isn’t quite a rosy as the statement would lead you to believe. It’s also a position that’s not wholly surprising.

Given that public sector pay rises were frozen for two years from 2010 and then 1% until this year the average annual salary rise in the public sector over the last seven years has been around 1.5%.

However, CPI over the same period has been 2.3% a year. So active member benefits (linked to salary have been going up at a significantly lower rate over the period than the increases on deferred benefits and for pensioners.

However, this isn’t the whole story. In 2014 in England, Wales & Northern Ireland and 2015 in Scotland the LGPS Scheme moved from a final salary basis to a CARE basis so this means that active participants are likely to have benefitted from higher increases on their pension benefits accrued after this date than they have their salaries, and this on a higher accruing figure (i.e. 1/49th per annum vs the previous 1/60th). So while salary benefits may have been losing value in real terms that’s not wholly the position in relation to pension benefits. A ‘healthy’ position for individuals but possibly not quite so healthy for the Funds! If we are to see salaries begin to rise in the public sector over the next few years then this will be something of a ‘double whammy’ for funds.

So, the claim of materially reduced costs as a result of the 2014/15 changes has proven to be something of a con, and indeed something that many admitted bodies will have witnessed first hand.

You may therefore not want to take the healthiness of your LGPS scheme funding from Fund comments about the growth of the membership as things are far from as simple, or indeed as positive, as suggested.

Alan Collins

My initial thought was to sum up the last year by describing it as being one where there was quite a lot of talk but very little action.  A sort of “Have I Not Got News For You” if you like.

Having reviewed matters further, I reminded myself of a number of issues that caught the headlines for justifiable reasons. There is also promise of some big stories as we look into 2018 and beyond.

Firstly, the quiet, quiet bit.

The political landscape was always going to be dominated by Brexit and so it came to pass. Things were “spiced up” when Theresa May called a snap election which took place on 8 June – her powers of predicting the future certainly made actuaries feel better about themselves. At least we can be fairly certain 2018 will be an election-free zone (if not, I imagine Brenda from Bristol will have something to say about it).

All the Brexit-ing gave rise to a pretty much pension-free political agenda.

The recommendations from the Work and Pension Committee’s BHS pensions review were converted into a damp squib of a Green Paper. Even the low-hanging fruit of allowing schemes to more easily adopt Consumer Price Inflation was not progressed.  I can imagine the Paper has since been gathering dust on a far-away shelve in the deepest recesses of the never going to happen cupboard.

The much-heralded cold-calling ban has been put into cold storage. First announced in September 2016, it had been expected that firms would be prohibited from making unsolicited sales calls on pension matters in an attempt to combat the prevalence of scams.   However, the packed parliamentary agenda prompted the government to announce that legislation will be delayed until 2020.

There was hardly a mention of pensions in Chancellor Hammond’s November budget. This was generally welcomed by an industry that has grown tired of tedious tinkering.

At the more technical end of the spectrum, the long-running saga of VAT on pension scheme fees finally drew to a close. The end result was….just leave it the same as you have all been doing, but with some possible extended areas for reclaiming VAT on investment services.  The problem was that, despite the industry being on tenderhooks for three years and with only eight weeks to go until the deadline for implementation, the HMRC forgot to tell anyone of the decision.

The Work and Pensions Committee strode forward again recently to announce an inquiry into Collective Defined Contribution schemes. After the early death of “Defined Ambition”, the industry is fairly split on this – many, like myself are in the “never going to happen” brigade while others sit in the “give innovation a chance” camp.

Now for the bang…

The standout legal judgment for 2017 was Walker vs Innospec, where the previous limitation of spouse’s benefits for same-sex partners to periods of service on or after 5 December 2005 was ruled to be illegal. The law is now clear and schemes are taking action where necessary to redress matters.

My inbox has been flooded this year raising questions about my “GDPR Readiness”. For the few of you who haven’t heard, GDPR stands for General Data Protection Regulations, which come into force on 25 May 2018 and is ramping up the level of scrutiny on the processing and treatment of personal data.  The implementation of GDPR is very much more stick than carrot, with fines for non-compliance and breaches being much higher than the current laws provide.  So, I have been getting ever more conversant in the language of legitimate interest, privacy notices, data mapping and subject access requests.  Much work has been done in this area and there will be plenty more of it in the coming months.

Despite the concerted and collaborative efforts of the industry’s “big three” (Willis Towers Watson, Aon and Mercer), the Competition and Markets Authority launched an investigation into the market relating to investment consulting advice for pension schemes. The probe, which will determine “if there are any market features which prevent, restrict or distort competition”, is expected to report back in 2019.

The year is ending with a flurry of consolidation in the advisory market. Firstly, Broadstone purchased Mitchell Consulting and their sister company 2020 Trustees Limited.  Then, the recently floated Xafinity deepened and raided their “war-chest” by purchasing the administration, actuarial and investment businesses of Punter Southall.  In the pension equivalent of a “player plus cash” deal, HR Trustees headed off in other direction to merge with PSITL.

So, an interesting end to the year with plenty of room for speculation on might come about in 2018. I can hope for a better balance between talk and action, but I fear the continued domination of Brexit is still likely to lead to more quiet than bang for pensions.

Matthew Leathem

The European Insurance and Occupational Pensions Authority (“EIOPA”) released the results of their Europe wide Occupational Pensions Stress Test last week.

The results show that pension scheme deficits can have a detrimental impact on the economy as a whole when companies’ future growth prospects are restricted by the level of contributions that they need to pay to schemes to plug their deficits. Businesses can fail as a result, bringing unemployment.
In this situation, it is also likely that members will not receive their full benefit entitlement in retirement.

What do the results of the stress test tell us?

The UK was one of three countries that showed a funding deficit on their current funding basis. It was also the worst performing country when measured using EIOPA’s common balance sheet approach, a method that broadly measures the ability of the scheme to sustain itself. The UK also fared the worst under the stressed scenario. This showed a funding level of just 45% for UK schemes.

EIOPA estimates that sponsors would only be able to cover 80%-90% of this deficit, meaning that the remaining 10%-20% of the deficit would fall on the PPF and the reductions in the level of benefits that members receive under the PPF than their scheme.

The report also highlighted the size of deficits relative to scheme sponsors. For 25% of schemes, the estimate of value of contributions required by the sponsor in the balance sheet exceeds 42% of the sponsors’ market value. This rises to 66% when the stresses are applied. For many schemes, the value placed on sponsor support in the balance sheet is greater than the sponsors’ market value as a business.
Such high level of contributions required would likely place a huge strain on scheme sponsors. This could affect their ability to continue to trade and when considered on a national basis could have a detrimental impact on economic growth and employment.

How do we plug this deficit?

There is no magic solution to fixing the UK’s pension funding shortfall. It will likely be a long process that will take into account a number of factors including scheme funding, investment and sponsor covenant within an integrated risk management framework.

The most important of these factors is to ensure that the trustee board has the expertise to be able to monitor and understand the funding position of the scheme.

There are a number of key take-away points for trustees:

  1. Ensure that you monitor your scheme’s funding level closely. These can be used to enhance your understanding of your scheme’s funding volatility.
  2. Trustees should work closely with the sponsors of their schemes to develop funding plans that will ensure the security of members’ benefits and minimise the impact on the sponsors business.
  3. It is important to take care when setting and reviewing your scheme’s investment strategy. Techniques such as stress testing and stochastic modelling can be used to assess how robust the strategy is under adverse market conditions.
  4. Make sure to review governance procedures regularly to ensure that decision making is effective and allows the scheme to react quickly to a volatile and changing market.
  5. Trustees can consider other options to secure members’ benefits such as securing benefits with an insurance company. Alternatively, they can look at options that can provide members more flexibility to take their benefits whilst removing risk from the scheme. This may include giving members the option to transfer their benefits prior to retirement so they can avail of flexible drawdown options.
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.

Read more »

Page 2 of 5612345...102030...Last »