Seven ways to improve Defined Benefit funding

14 September 2020

What do we want the new funding code to achieve? That’s the question we asked when we sat down to respond to TPR’s recent consultation, which closed on 2 September 2020.

The answer was clear. We want to help employers flourish, with a DB funding code that does nothing to hold back business growth. We want members to benefit from any funding changes. And we’re keen to minimise any regulatory change, as there’s not a great deal wrong with the status quo.

We came up with seven objectives which, if achieved, would bring about meaningful improvements to DB funding, benefiting schemes, sponsors and the members they serve.

1. Society should provide pensions efficiently

Providing pensions collectively is far more cost-efficient than an individual pot. Having both active members and pensioners in a scheme means contributions for current workers can provide for pensioners without the need to pay investment managers to sell and buy assets. And in collective schemes, members pool mortality risk, so there is no need to buy costly insurance, and no risk of running out of money.

Providing pensions efficiently is good for members, employers and society as a whole. So regulatory change should not result in more schemes closing or winding up.

For some employers that sponsor schemes open to pension accrual, the Regulator’s proposed funding code will result in higher contributions and cautious investments that will combine to make scheme closure the only realistic option. This doesn’t just mean a switch to less efficient individual pots; it also has a negative impact on employee relations, with a potential knock-on effect on business growth.

2. Schemes should invest productively

Investments in productive assets (i.e. assets that can generate profits and cash flows in line with inflation) play a crucial role in making the value of pension benefits higher than the original contributions made. By contrast, at the time of writing, every £1 invested in (non-productive) gilts for a 45 year old scheme member will be worth only 46p by the time that individual is an 80 year old pensioner.

The Regulator’s proposals push schemes towards more risk-averse investments, which guarantee that schemes will make a loss in real terms. That goes against the whole principle of pre-funding pension provision, by which we deliver on the pension promise to members with returns that make it affordable to employers.

3. A change in regulation should benefit members

The proposal introduces a real possibility of increasing scheme funding without delivering any additional benefit for scheme members. Yes, schemes may be funded at a higher level, but many would still end up in the Pension Protection Fund (PPF) in the event of insolvency, with no additional benefits for members. In the meantime, the employer would have less money available to fund pay rises, contributions to replacement DC schemes or investment in new jobs and production.

If employers are mandated to increase scheme funding, they should at least be able to invest those extra funds in productive assets, with some of the additional returns trickling down to members.

4. Build on PPF provision for all schemes

The introduction of the PPF marked a significant step forward in protecting DB pensions, and means schemes should be able to fund at a level where they expect to be able to pay all their benefits long term and to invest productively. If all schemes are required to overfund their benefits and invest scheme assets over-cautiously in bonds and to pay PPF levies at the same time, we are effectively requiring double insurance.

When DB members end up in the PPF, it is often seen as a disaster. In reality, however, members are often better off with the slightly reduced benefits of the PPF than they would have been with full provision from a typical DC arrangement. And if PPF compensation is considered insufficient, then the answer is to increase it.

5. Preserve the ongoing covenant between employer and employees in open schemes

We see a DB scheme that is open to new members as an ongoing covenant, or two-way commitment, between an employer and its past, current and future employees.

Employers provide their employees with pensions in an efficient way that allows them to attract, retain and retire staff in line with business needs. In return, members receive good quality pension benefits, while accepting the risk of PPF-level benefits if their employer becomes insolvent.

Deferred members who don’t want this deal can transfer benefits into a Defined Contribution arrangement, with all the risks and rewards that go with that. While pensioner members are unable to transfer, they face a much smaller reduction of benefits within the PPF.

6. Put an end to generational inequity in open schemes

All generations need pensions. Yet the proposal prioritises older generations (deferred and pensioner members) over current and future generations of workers.

Many schemes that close to new members are at the same time forced to make huge investments in loss-making assets to pay for the past pensions of active, deferred and pensioner members.

How can it be right to ask employers to divert significant resources into overfunding pensions for older generations at the expense of younger people?

7. Maintain the efficiency of open collective schemes

Every scheme closure makes it a bit harder for society to provide everyone with a pension.

A successful pension regulation system is one in which employers are willing and able to sponsor continuing accrual of benefits, i.e. keep schemes open to new entrants.

In the building industry, there is a role for demolition companies, but the principal task is construction. That the pensions industry and its Regulator have, in the main, been shutting down pension schemes for the past 20 years is a sign that things are wrong. We need to build both pension schemes and regulations that are fit for the future.