Options for Defined Benefit schemes: a call for evidence

Highlights from our response to the DWP’s call for evidence, September 2023

The current environment from a pension’s perspective

Until the UK can free up the assets that are tied up in residential property, the main avenue for most people to make long term savings will remain via their pension scheme investments.  There is nothing necessarily wrong with this although more direct saving would encourage engagement, commercial knowledge, and competition so ideally any changes would be alongside steps to encourage saving from a young age perhaps via some kind of young person investment scheme.

The challenge is then how to retain and encourage that long term investment outlook which has been eroded over time through a mixture of;

• Mark to market valuations which have resulted in a short term focus compounded by managers who are judged and incentivised based on their short term performance
• Shift to DC arrangements where crystallisation is brought forward to the retirement date despite a significant time horizon still remaining and potentially encourages a simplified investment approach
• Regulator and legislative environment focused on security above all things resulting in reckless prudence. 
• Inflation targeting regime that is too rigid and does not allow for global trends which has ended up producing entrenched low inflation which means everything is pulled back towards this low base line reducing incentives to take risks, make long term investments and reward success. 
• Forcing DB pension schemes to target funding positions that are too prudent thereby reducing their reliance on the employer (and therefore the interest of a long term stakeholder in the business which includes employees) and diverting assets into the pension scheme that might otherwise have been used for investment in the sponsor.  Once fully funded, no incentive to take risk.
• The Government have been too slow to step in and allow schemes to take practical approaches to drafting and other issues (such as GMP equalisation and the recent s37 court case) which has resulted in significant additional costs for the company with marginal gains for members.
• The number of guarantees that DB schemes are required to give has grown exponentially over the years.  In order for members to also be engaged with the investment strategy, one option might be to reduce some of the guarantees and instead let members participate in any investment out-performance.
• For mature schemes and insurance companies, mortality risk can become a significant issue that requires them to hold significant margins for prudence which are eventually released.  One option might be for the Government (perhaps via the PPF) to provide the option to secure annuities after, say, age 85 on competitive terms which can be based on best estimate life expectancies and a more aggressive investment strategy.  This should help free up the longer end of the market and provide more certainty.  It makes sense for these assets to be invested in building up the UK and its ability to pay pensions in the future.

Basically, we have reached a point where companies are totally fed up with DB schemes and the continuing hassle (witness latest s37 debacle) as well as the ever spiralling costs of running schemes.  They want to get rid of them and any liability off their balance sheet as soon as they can.  There is no potential benefit to them in running the DB scheme and it is not their business to be concerned about investment in start-ups. 

Tweaks to the existing system

This might include;

• Reduce/remove the tax penalty applied to surpluses and make it easier for them to be drawn by the employer subject to satisfying a sensible funding target which would require a significant change in regulatory approach.
• PPF/Government could act as “lender of last resort” to provide liquidity in the very mature (over 85) market where margins for prudence and are large and particularly inefficient. 
• Push forward with collective DC schemes to try and reduce the cliff edge that occurs when DC members reach retirement and many either take a lump sum or purchase an annuity.
• Remove the distractions of GMP equalisation and s37 issues, allow schemes to convert their benefits to a simpler equivalent benefit.  This might have lower guarantees but have the option for members to participate in any investment out-performance.

Look to encourage a more vibrant investment environment with incentives provided for setting up national and regional development funds that will look to support local business (including startups), invest in infrastructure, and invest in companies that are judged to be investing in the UK and have longer term objectives.  I believe that having a competitive environment with several different players and allowing schemes/members to invest as they wish in these funds will produce better results in having a small number of super funds where decisions are made purely by the investment managers.

Settlement options for fully funded schemes

For companies that are looking to remove the link to their pension scheme, the main (only) option is buy-out unless we can come up with an alternative.  Consolidators seem to just be pseudo insurance companies that have lower solvency requirements so why not just reduce insurance company solvency margins?    Obviously, this would be a no-go.  Are consolidators that different from sponsors and, in many respects, provide less protection as they have no risk diversification?  I suppose the main difference would be that they have more relaxed funding requirements so can take a longer term view.  So why not just relax the funding standards to schemes that cannot buy-out.  Use a best estimate –½% basis for funding.  Encourage contributions where required by offsets from the PPF levy where contributions are made and make it easier to return surpluses.  This implies a much lighter Regulator touch.

Perhaps returned surpluses should be made into a business development fund which pays a dividend and realised after 10 years (say) with normal corporation tax rather than being returned less tax at 35%

As small scheme specialists, we are finding that it is usually possible to find a buyout provider who will take the benefits but there will usually only be one option and therefore the scheme is given little choice in terms of the process they must follow, and the eventual price paid.  Those providers that are in the smaller scheme market are looking to put in place pathways that will make the process more straightforward.  However, this was before the significant increase in demand for buyouts and we are starting to witness some supply constraints in those providers who were previously happy to quote (although at this stage it is more the case of delays in the process rather than them refusing).

Consolidation – does it deliver benefits?

I do not believe that consolidation in the panacea that it is made out to be.  

• Reducing the number of participants in a market often reduces innovation, makes herding/group think more likely, can concentrate decision making in one place, can be too large to be able to impact markets in a positive way and generate returns (for instance, focus might only be on the larger asset holdings).  I believe it is better to have a vibrant ecosystem with many players with their own bespoke approach which is open to competition which drives performance, efficiency, and costs.
• Is there evidence that concentrated ownership, in and of itself, produces better outcomes particularly longer term.  I believe that many UK utility firms have overseas pension schemes as major shareholders and have suffered years of chronic underinvestment and a focus purely on delivering short term returns to the shareholders.  Even if these superfunds do have longer term objectives, the challenge will be for this to be pervasive in the actual culture so that the short term consequences are accepted even where they might be negative.
• Need to be take care that long term holdings do not end up being too passive and slow to react to changes in conditions.  Pension schemes with their specialist investment advisors should be the first to react not act as a stabiliser as more nimble investors cream off the out-performance.
• Many investment managers have developed significant ESG/governance platforms which already have a focus on longer term returns which could be used to promote engagement more generally.  These do tend to focus on larger companies but do appear to have some influence on overall behaviour.  One benefit of not consolidating this aspect is that these approaches then filter out across the market and become available outside of the pensions bubble.
• Impact on investment managers (and other advisors) of the changes being made. Consolidation may result in significant assets moving out of current arrangements making them unsustainable.
• Steps should be taken to make consolidators more accessible, but I do not believe it would be appropriate to provide additional incentives or disincentives to encourage take up, they should succeed based on what they are providing and that should be assessed in a sensible way against what is currently in place. Any streamlined approach should ensure that members are not losing out.  This should be alongside taking steps to encourage desired behaviour outside of the consolidated scheme environment which will help to find out what works and make it efficient.

Perhaps most importantly is the direct impact having a pension scheme has on the management which can encourage them to look longer term just by the nature of the liabilities and their potential participation.

An alternative vision: reintroducing DB schemes with lessons learnt.

Ultimately, the best platform to encourage long term investing, providing security to members and avoiding the need to derisk too early are open DB schemes.  I suspect that, as the shortcomings in DC arrangements become apparent, it is not impossible that DB arrangements may return in some form.  Therefore, I wonder whether some sort of DB arrangement which involves all the main stakeholders (employer/member/Government) taking some level of managed risk and partaking in any upside should be looked at again now.  This might involve substantially less guarantees than we see now which are underwritten by the government (perhaps via the PPF) to make them a stakeholder and so reduce the likelihood that guarantees are added in the future and employer but the members and the employer both partake in any upside.  I believe lessons have been learnt from the past and such an arrangement can be made to be workable from all sides.  Putting these schemes in now whilst the expertise is available and there are existing schemes which could be made more efficient by opening them up to new members is the best course of action.