In the 1970s, the UK occupational defined benefit pension system was widely believed to be the envy of the world. Their scale and scope and importance to UK capital markets were widely lauded. While this may have been true, the system had some significant flaws; notably surrounding the loss of benefits for early leavers from a scheme, and the treatment of the dependents of a scheme member. The system penalised labour mobility. Members’ rights were really rather weak. Over two decades regulation was introduced to strengthen the rights of members, which raised the true cost of provision for most schemes by more than 100% as more pensions became payable to members and their dependents. These developments were not subject to further analysis or criticism in this paper.
However, the regulation we have seen since the early 1990s is different in nature; it is concerned with the perceived security of member benefits. Though widely spun as a reaction to the abuses of management and notably the Maxwell affair, the principal problem was actually regulation which treated active members inequitably relative to pensioners in payment. This was compounded by the fact that there is a genuine problem of corporate finance associated with sponsor insolvency and the financing of pension liabilities.
In this instance, funding a scheme to the level of the technical best estimate of liabilities is inadequate. If the scheme with insolvent sponsor is to be able to buy-out member benefits with an insurance company or to run off liabilities in a timely and orderly manner, even under adverse developments in the risk factors faced, it needs to be capitalised to far higher levels. The cost of buy-out is an indication of this required level – 130%- 150% of technical best estimate. This is the likely level of scheme funding which might become mandatory under the proposed application of Solvency 2 to DB pension schemes.
If funding to such levels is required, the pension proposition cannot be actuarially fair to either the plan sponsor or the scheme member. The value for money of contributions made would then be lower for a scheme sponsor than paying cash wages.
The effect of the new regulation has been to raise the cost of provision of DB pensions. The reality is that these increased costs have made little difference to the security of scheme members. Most schemes will be underfunded at sponsor insolvency, and members will receive only the reduced benefits of the Pension Protection Fund – and the long-term future prospects of that are suspect.
The regulations in effect are simply a new redistribution of the earlier problem of priority in the estate of an insolvent sponsor. They are extremely costly; far more so than the improvements in member security merit.
The result has been that employers have reduced or eliminated their provision of voluntary occupational defined benefit pensions. This has been done even though many of these actions, such as closure to new members, raise the cost of provision of the existing stock of pension benefit liabilities. The most evident of these actions has been the shift to offering defined contribution rather than defined benefit pensions, even though these will likely provide grossly insufficient retirement incomes. A defined contribution system is massively less efficient than an occupational defined benefit organisation. It will result is insufficient retirement incomes for most, and great income inequity among the retired population.
The current accounting standards are simply not fit for purpose, but regulation is based upon them. The problem for regulatory authorities is that the risk to member security lies in employer insolvency; this risk is the product of the employer insolvency likelihood and the level of a scheme’s funding shortfall at that time. It really is inappropriate for the state and its regulatory agents to involve themselves in the management of an employer’s insolvency likelihood, which means that pension regulation necessarily focuses upon scheme assets and the balance sheet. This is inefficient and leads to many paradoxes; for example, requiring additional scheme funding increases the likelihood that the sponsor becomes insolvent
This regulatory focus upon scheme funding and scheme assets has induced a further reaction among trustees; new and more complex asset allocation strategies are now commonplace. It is far from obvious that some of these are justified, such as the hedging of the accounting risk associated with interest rates and the discount function, and also far from obvious that these and many others are effective, such as longevity and inflation hedging.
It is now widely believed that defined benefit pensions are unaffordably expensive; this is a popular delusion, though widely encouraged by those with profitable vested interests. In this paper we have offered simple evidence that these beliefs are mal-founded, and that occupational defined benefit pensions are affordable at both the state and private sector levels.
Trustees are now encouraged to consider many risks which they are assured they face – for example, longevity, inflation and interest rates or discount functions – and to take costly action to mitigate these. This is reinforced by regulatory actions and statements. The reality is that an occupational defined benefit scheme faces just one risk – sponsor insolvency.
Through their role as the balance of cost underwriter of DB pension schemes, sponsors do face the risks inherent in their schemes, such as inflation and longevity. However, they also face these risks and consequences of them in their commercial activities; any hedging should, if desired, be conducted by them in this context, not by an isolated pension scheme.
This emphasis on perceived risk has distracted trustees from some fundamental issues which should concern them, such as the income generated by the assets in their care and the long-term prospects for financial markets and the global economy. These have direct consequence for their one genuine risk, sponsor insolvency.
It is clear that positioning the occupational pension issue in terms of financial analysis and markets is misconceived and costly. The genuine occupational problem, sponsor insolvency, cannot be solved by any form of regulation based upon scheme funding without incurring excessive costs. As demonstrated in this paper it can be solved efficiently by pension indemnity assurance, encompassing even entirely unfunded schemes.
It is time to rewrite regulation to accommodate and encourage such forms of pension provision. A society with deferred pay is more civilised than one without. It is time to restore the incentives for employers to sponsor defined benefit pensions schemes.