Defined benefit pension schemes: security and sustainability – Sackers’ response to DWP consultation
The DWP Green Paper on private sector DB pensions, “Security and sustainability in DB schemes”, sets out evidence about key challenges facing DB schemes and considers feedback from commentators.
In this response
- General comments
- Current valuation measures
- Funding and member understanding
- Investment choices
- Special arrangements
- Further protections for members
- Consolidation of schemes
We support the DWP’s initiative to review the security and sustainability of DB schemes.
As we explain below, we consider there to be unused potential in the current framework in terms of regulatory powers to take action in relation to schemes where there is a risk to members’ benefits and we would like to see these explored.
We also believe there are good arguments for introducing more flexibility into the current system to enable employers and trustees to reach better outcomes for members than PPF compensation where on the balance of probabilities the employer will be insolvent if pension liabilities cannot be restructured.
Are the current valuation measures the right ones for the purposes for which they are used?
We focus in this section on the scheme funding framework set out in the Pensions Act 2004, rather than the underlying methodologies, which, we are aware, are being considered by the actuarial profession.
In our experience, there is sufficient flexibility within the current funding regime to allow employers and trustees to agree funding strategies that are appropriate for their scheme. The key is that employers and trustees work together to achieve this aim.
In this regard, we consider that more active involvement from the Pensions Regulator (tPR) using its powers may be helpful. By using its existing powers in a clear and transparent way to target and manage, and, where appropriate make an example of, specific schemes, tPR can set precedents which demonstrate good practice.
In our view, the current timetable for completing actuarial valuations remains appropriate. For some schemes, for example, with a single employer that is based in the UK, with no particular issues on funding and experienced in the art of valuation negotiations, the 15 month timeframe is more than sufficient. However, it is necessary to bear in mind that the valuation process involves more than just number crunching – negotiation between the trustees and the employer(s) is a key element which can take considerable time (particularly in larger or more complex organisations) where input and engagement from various stakeholders is required.
For some schemes, such as multi-employer (and in particular, non-associated multi-employer schemes), a shorter timeframe would be likely to result in more schemes being in breach of their valuation obligations. It is necessary to take account of the fact that some schemes need to liaise with and obtain information from employers in different jurisdictions. Not only can this be time consuming, but turnover of an employer’s staff between valuations can also mean a loss of institutional knowledge of the valuation process and position reached at the last valuation, so that there is a need for full training and education in order to facilitate a smooth negotiation process between the trustees and the employer. Rather than reducing the 15 month timeframe, we believe that more proactive and consistent engagement by the Regulator in circumstances where there is a “failure to agree” would help make the valuation process more robust (see also our comments in relation to question 5 (Further protections for members) below) and minimise future delays.
Do members need to understand the funding position of their scheme, and if so what information would be helpful?
We agree that there is a widespread lack of understanding among members of the potential risks associated with DB pension scheme membership, in particular the level of reliance on the sponsor’s solvency and lack of any guarantee that members will in all scenarios receive their benefits in full. As such, we agree that it would be better for DB members to have more information on these risks.
More fundamentally, we consider that levels of financial literacy in the UK, both in general and in relation to pensions and retirement savings in particular, are poor. This is borne out in various research reports, including the interim report of the PLSA’s DB Taskforce, which identified that DB scheme members were generally unaware of the potential risks to benefits, as well as in research by the International longevity Centre – UK on “Making the system fit for purpose”, the Pension Policy Institute’s “The Future Book: unravelling workplace pensions”, and our own recent research with 11 Independent Governance Committees on member understanding of value for money in DC schemes. There is also limited understanding of the State Pension, and the introduction of the new flat rate State Pension in April 2016, something which was borne out in the Work and Pensions Select Committee’s report on “Communication of the new state pension”. We would therefore like to see the Government taking a much broader approach to financial education, of which DB pensions and their related risks would form part. Emphasis also needs to be placed on individuals’ understanding of the value of the State Pension, the gap between actual and perceived income in retirement, and the ways in which this gap can be plugged.
As to whether further information should be provided to DB scheme members, we note that risks can be explained in member communications, such as the annual funding statement. But, unless individuals have a broad base understanding of financial matters, providing more information on those risks in isolation is unlikely to achieve the desired aim of ensuring that members understand how risks to employer solvency affect their benefits.
Member understanding and giving consent
We note from the Kodak, Halcrow and BHS restructurings that there appears currently to be a policy preference to require members’ consent to changes that result in their benefits being restructured, and recognise (following the case of Pollock v Reed) that it is not currently possible under legislation and case law to bulk transfer members without consent to a scheme with lower headline benefits than the transferring scheme.
However, in practice member “consent” in restructuring circumstances is a difficult concept. Although the basic message can be clear, e.g. the benefits offered in the new scheme are overall higher than the member would get from PPF compensation, our experience in relation to Halcrow suggests that lack of understanding about financial matters, and restrictions on the information that can be disclosed for confidentiality reasons, can result in members being confused and/or distrustful of the message.
Also, importantly, the highest proportion of people you end up not being able to transfer are people you cannot contact for some reason. In our view it would be entirely proper to allow trustees to take decisions in the interests of members as a whole and restructure benefits without members’ consent (but recognise the law would need to change to allow this). Also, with reference to the proposals for consolidating schemes (see question 6), if it was considered appropriate from a policy perspective to permit the establishment of a consolidator for distressed schemes, we imagine this would need to work on a non-consent transfer basis to be effective.
Is there any evidence to support the view that current investment choices may be sub-optimal?
In general, our experience is that there is a good range of investment options available to trustees. That said, some trustees may have limited understanding of some options, as well as the way in which some of the more complicated investments work. In turn, low levels of understanding can lead to delays, for example, trustee boards acting slower than might be desirable to deal with any problems that arise which merit a switch of investment product or manager. In this regard, we welcome initiatives such as tPR’s new DB investment guidance, which is a useful tool to help trustees navigate their investment arrangements, objectives and strategy. Employers also require specialist knowledge, given the legal requirement to be consulted on a scheme’s statement of investment principles.
Given the role of trustees in relation to DB scheme investments, the focus of member understanding in DB schemes needs to be on factors such as risks to employer solvency (see our comments above in relation to question 2) rather than on the minutiae of investment decision-making itself.
In our view, it is right that trustees retain responsibility for determining an investment strategy that is appropriate for their scheme. It may also be appropriate, on occasion, for tPR to assist individual schemes in relation to the level of risk they are taking. But, in general, any effort by tPR to direct or determine the levels of risks that schemes should be take, could result in a narrowing of the investment options available to trustees.
We see investment as a key area in which consolidation could help schemes, for example through use of a common investment fund. In our experience, asset pooling can help schemes access more diverse investment opportunities (with an economy of scale) than would otherwise be available, particularly to smaller schemes.
However, we agree that care needs to be taken to ensure that trustees do not focus solely on risk averse strategies. Trustees need to choose a long-term investment strategy that is appropriate for the profile of the scheme in question.
In its interim report, the PLSA’s DB Taskforce points to “value leakage” in DB schemes as a result of “misaligned intermediation”, a theme picked up by the FCA in its interim report on its asset management market study. The PLSA notes that cost inefficiencies “will be borne directly by scheme sponsors […] and ultimately, borne by scheme members, the security of whose benefits may be put at risk by poorly operating and inefficient schemes”. Meanwhile, the FCA hones in on the potential for conflicts of interest on the provision of both advice and asset management services. Trustee experience in this area varies, and we welcome the focus by both the PLSA and the FCA with a view to enabling trustees to obtain value for money in DB schemes.
The consultation asks whether the professionalisation of trustees would help improve investment decision-making. While professional independent trustees can certainly strengthen a trustee board, in our experience, lay trustees continue to have a key role to play in relation all aspects of DB scheme management. For example, they bring diversity and balance to trustee boards, are an invaluable resource in terms of the knowledge and understanding they have of the history of their scheme and the employer covenant and can input on member communications. A lay trustee can also ask the “emperor’s new clothes” questions on investment matters that more experienced trustees may be reluctant to do. A good member nominated trustee or director can be a good check and balance on a board.
As such, we do not view mandatory professionalisation of the trustee role as the panacea in relation to investment decision making or DB scheme management more generally. But as issues for DB trustees become more complex, there are good arguments for having a balance of professional and lay trustees on trustee boards.
Investment committees can play an important role here, including for smaller schemes, as they can help to focus investment expertise (perhaps supported by a professional independent trustee) and report back to the full board with recommendations, and facilitate implementation of investment strategies between full trustee board meetings.
Is there a case for making special arrangements for schemes and sponsors in certain circumstances such as a different regime for employers who can afford to pay more, and/or new or enhanced flexibilities for stressed sponsors and schemes?
In terms of affordability of deficit repair contributions (DRCs), we believe that the actuarial and employer covenant consultancies are considering this further. However, we would just note that there is a potential danger in considering DRCs affordable simply because the cost can in theory be met, without evaluating the overall impact on the business of paying DRCs in full, and having to reduce spending elsewhere in the business (including on younger employees’ pension benefits).
In our view there are good arguments for introducing greater flexibility into the system to give more employers and trustees the ability to restructure pension liabilities to enable better member outcomes than PPF compensation.
However robust the PPF’s funding position is, in our view it is not appropriate legally, or from a policy perspective given the potential intergenerational impact, for schemes to be encouraged to continue in their current form if in reality they are not going to be able to meet their current benefit commitments in full, and on the balance of probabilities are going to end up in PPF assessment. Yes, more members may become pensioners over a period, and so receive closer to their full benefits in the PPF, but deferred members may well end up having their benefits cut back further in the PPF than if their current schemes had been able to restructure benefits for all members. Trustees, with their legal duty to consider the interests of members as a whole, are well placed to consider ways of restructuring pension benefits to enable outcomes that are better than PPF compensation for the membership overall.
We appreciate there are policy concerns about restructuring what are seen to be members’ property rights. We are not necessarily convinced that legally these are hard promises as referred to in the Green Paper. But we would of course accept that members have expectations about the benefits they will receive, and these must be respected as far as possible. We do not believe that allowing greater flexibility to restructure pension benefits would be removing property rights in a manner contrary to Article 1 of the First Protocol of the ECHR, particularly if the likely alternative is that members will receive only PPF compensation. That is, if pension benefits can be restructured to provide more than PPF compensation, when otherwise on the balance of probabilities they would only receive PPF compensation, their property rights would in our view be better preserved by restructuring.
We believe it would be possible to change the legislation to add a new limb to section 67 to give trustees more scope to restructure benefits when employer insolvency is very probable. We believe it would be helpful for a relaxation of s67 to be available where trustees decide, on the balance of probabilities, that employer insolvency is likely within 2 to 3 years. In our view having that as a barrier to relaxing s67 would be far more workable than trying to describe what a distressed scheme or distressed employer looks like.
We would then envisage the new limb of s67 having certain restrictions and requirements before the trustees could make changes. For example:
- it could only be used to restructure pension increases and revaluation unless tPR/PPF agreed otherwise (this would not just mean an RPI to CPI shift, there would need to be flexibility to reduce/remove any increase not required by statute)
- it would require the employer to provide such information as the trustees (and tPR and PPF) reasonably need to be able to evaluate the position of the employer
- it could require the trustees to secure mitigation from the employer (e.g. an equity holding in the employer) at a level the trustees (and tPR and PPF) are satisfied with. This would require a knock-on change in relation to section 40 of the Pensions Act 1995 to allow self-investment in the employer in these circumstances
- it could require the trustees to ensure that at the point of the restructuring, members’ headline benefits from the scheme would (overall) still be better than could be provided on a winding-up of the scheme immediately before the restructuring
- it could require the appointment of an independent professional trustee to the trustee board
- it could require overall tPR / PPF approval, but perhaps with a presumption that this approval would be given if e.g. certain regulatory guidelines had been met.
If the Halcrow restructuring model is seen to be useful (i.e. enabling a business to restructure pension liabilities, where the business is still viable with reduced pension liabilities, but insolvent if it cannot restructure) our view is that something like the above approach would be much clearer and more workable than the current process – and more likely to result in viable businesses being able to continue trading, with members receiving better outcomes than PPF compensation.
Measures of indexation/revaluation
In relation to the indexation of pensions in payment, the consultation asks whether the Government should consider a statutory over-ride to allow schemes to move to a different index, provided that protection against inflation is maintained. There has been a stream of High Court cases on this subject in recent years and we can see sense in such a measure, given the historic nature of pension scheme rules and the fact that recent changes to RPI and the Government’s view of it as a measure of inflation would not have been in the contemplation of the draftsman when such provisions were introduced in scheme rules. In our experience, trustees are increasingly being asked to change the index used for both indexation and the revaluation of deferred benefits. We therefore consider that there is a case for a statutory over-ride (or amendments to section 51 of the Pensions Act 1995) in relation to both indexation and revaluation, provided it is introduced alongside adequate safeguards.
The option of reducing indexation and revaluation on the future payment of accrued pension rights in order to improve the sustainability of the scheme is another option, and one which was under consideration in the consultation on options to help the British Steel Pension Scheme. Such an option has the potential to improve sustainability for any DB scheme. While it would not offer a guarantee as to a scheme’s longevity, we envisage there will be situations in which being able to reduce indexation and revaluation will result in better outcomes for members overall.
Do members need further protection, and should this be delivered by a stronger and more proactive Regulator, and/or trustees with enhanced powers?
Whether members need additional protection, is something that needs to be assessed on a case-by-case basis. In our view, tPR’s existing powers should be strong enough to ensure that scheme members and sponsors are supported.
However, there is a perception (well justified in many cases) that tPR’s powers are not fully utilised. By way of example, when the system of clearance was first introduced, and there was an expectation that tPR would take action in relation to certain transactions, the system worked well. Similarly, the failure by tPR to exercise its “tie-breaking” powers on valuations has meant that the perceived sanction for any failure to agree is very weak. A more pro-active approach from tPR, demonstrating the reach and consequences of its powers in practice, could therefore be beneficial. Stronger or more focused resourcing may help here.
One area where trustees can experience difficulties in practice is in ensuring they have sufficient information about the scheme sponsor(s) to be able to make a full assessment of the covenant. In this regard, the Scheme Administration regulations (SI 1996/1715) are not fit for purpose. Trustees could therefore benefit from stronger legislative requirements, to require employers to respond to appropriate requests for relevant information and encourage realistic and open valuation negotiations.
Changes to clearance etc.
The report of the Work and Pensions Committee on DB pensions (19 December 2016) noted that “there is a strong case for clearance to be mandatory in certain circumstances when there is the greatest risk of material detriment to pension schemes”. We also note its recommendation for the Government to “consult on proposals to empower tPR to impose punitive fines that could treble the amount payable”. While we support the review of the existing sanctions (including contribution notices and financial support directions), which have not in practice achieved their original aims. We believe that the focus should be on what can be done to ensure existing powers are more fully and appropriately utilised so as to act as an effective deterrent and as incentive to apply for clearance (as opposed to the introduction of yet more powers which tPR may in practice be disinclined or insufficiently resourced to use).
In our experience, tPR’s main focus is on trustees, and on encouraging trustees to reach agreement with their scheme’s sponsor. Given that scheme funding requires not just a dialogue, but for trustees and employers to work together, we consider that there should be a more balanced focus by tPR on both sides of the partnership.
TPR’s “section 89” reports raise awareness of its actions in relation to schemes. However, greater publicity, such as real time reporting by tPR of any action and follow-up, together with an active use of the notifiable events regime could help raise the profile of tPR’s powers. In our view, tPR should be encouraged to set more precedents for how it expects to engage with schemes when asked to use its powers. We believe this would help manage resources at tPR, and for employers / trustees, and give greater certainty for the industry.
As regards the question as to whether trustees should be consulted when the employer plans to pay dividends if the scheme is underfunded, it would be important to consider what the purpose of consulting the trustees would be, and why dividend payments are being singled out.
Would it be, for example, so that the trustees can try to negotiate some mitigation and/or get tPR involved? How this fits with the employers’ obligations under the notifiable events regime would also need to be factored in. Having advance information and an ability to make representations would be welcome for trustees but ultimately unless trustees are given stronger powers and/or more flexibilities/easements to restructure benefits, they will not necessarily have effective powers to take preventive or remedial action. To a large extent they would still be reliant on the employer to engage in good faith, or on tPR exercising its powers.
If there is going to be a consultation obligation, it will need to be meaningful (and coupled with a requirement for the employer to provide information), with sufficient timeframes built in to ensure that the trustees have an adequate opportunity to consider what is proposed and take action (if appropriate) before the company goes ahead.
While they do not result in an immediate loss of value, unlike dividend payments, other activities which may be of concern to trustees, particularly where employer insolvency is considered likely, include:
- Borrowing secured debt. Borrowing in itself would not necessarily be a concern if the monies borrowed are used within the business. However, if the debt is secured and the employer goes under, the lender of that debt will rank ahead of the trustees’ section 75 claim.
- Granting security over any assets to any creditors – for the same reasons as set out above regarding the lender – i.e. secured creditors’ claims will rank ahead of the trustees’ section 75 claim on insolvency.
- Potentially, the disposal of assets to other companies in the group where the consideration for that asset is left outstanding as an intercompany loan and/or the making of intercompany loans (by giving them cash) to other group companies. Whether that is a concern will depend on the creditworthiness of the other company and, therefore, the likelihood of the employer being repaid when it needs to be.
However, imposing any restrictions on such activity will not be popular with employers as it could impact the operation of their day-to-day business.
Should Government act to encourage, incentivise, or in some circumstances mandate the consolidation of smaller schemes into vehicles with greater scale and better governance in order to reduce the risk to members in future from the running down of closed, especially smaller, DB schemes?
We note that the PLSA has put forward for examination four possible models of consolidation, from simple consolidation of administration functions through to pooling of assets, combining governance and the pooling of liabilities with the removal of the employer. In our view, there is merit in considering the various different options, in addition to the full merger proposals put forward in the Green Paper.
In our view, key questions that will need to be considered from a policy perspective for consolidator schemes include determining what the appropriate regulatory regime will be, and what controls tPR and the PPF would expect to see on the way consolidator schemes invest.
The types of barrier that currently prevent schemes from consolidating, include differences in funding levels, benefit structures and employer covenant. The employer also wants to know how much a merger will cost and what the benefit is to them.
Some possible concerns
For employers, moving their scheme to a consolidator vehicle means giving up control – something which is unlikely to appeal where an employer is still in a position to fund their scheme.
For trustees, there may well be concerns about a lack of security – for example, what protections are members likely to have, over and above the existing protection of the PPF? Will the trustees get a full discharge on transfer and will the new scheme be eligible for the PPF? Also, if members’ benefits are harmonised on entry (and particularly if they are reduced and harmonised in a distressed scheme situation), trustees are likely to have concerns that members could receive lower PPF compensation (if ever needed) in future, if the PPF compensation structure impacts the re-shaped benefits in different ways to how it would have impacted the original benefit structure.
It is unclear from the Green Paper which DB schemes are being targeted here – whether just distressed schemes or schemes of a certain size. In any event, we do not consider there to be a case for mandatory consolidation. We can see however that it would potentially be possible to operate different consolidators for different “markets”.
For distressed schemes, we can also see practical issues with how employers would fund the “entry” fee to the consolidator. We also believe that if funds can be secured by an employer, some trustees may be more interested in using them to provide members with e.g. a PPF “plus” buy-out with an insurer than transferring to a consolidator, even if this provided potentially lower member benefits, as they may be attracted to what might be perceived greater security with an insurance company.
Costs and charges
The consultation asks whether costs and charges are too high in DB schemes. This can be difficult to assess, as there can be a lack of transparency in relation to certain, generally more complicated types of investments. However, it should be recognised that some schemes will be in a position to use investments with a greater risk / reward ratio, which are generally more expensive, depending on their risk profile. Schemes should remain able to access a wide range of investments which, it is acknowledged, will have a range of fee structures.