Based on alarming headlines you could be forgiven for believing that defined benefit (DB) pension schemes are in crisis, that the system is unaffordable and that the only solution is to slash members’ pensions.
I don’t believe that narrative bears much scrutiny.
Whilst we expect deficits to have increased for most schemes this year, the majority of sponsoring employers can and will afford to meet their benefit promises. The risk of a system-wide failure remains remote. This means the regulatory framework is working largely as parliament intended.
There are several reasons for schemes being in deficit—anticipated investment returns have been lower for longer due to economic conditions, pensioners are living longer, and some investment decisions have not worked out as expected—but does it mean that the DB system is now unaffordable?
The short answer is no, but the reason for saying that is complicated.
All schemes are obliged to submit their valuations to us, the Pensions Regulator, every three years. Therefore, we have a full picture of the funding position of every DB scheme, although we are estimating this using data from schemes’ latest funding valuations.
Looking at the entire DB universe and taking into account investment strategies pursued, economic conditions and the deficit recovery contributions (DRCs) paid since each scheme’s last valuation, we estimate the current total DB deficit at around £350bn-£400bn.
Using different, publicly available data, we can also estimate the financial position of the sponsoring employer of most DB schemes. There are several ways of doing this, but when looking at the question of whether a company can afford to increase its DRCs, its profits before tax (PBT) and dividend payments can be a useful indicator.
For example, we know that in 2010, among the FTSE350 companies paying both DRCs and dividends, half of them paid six times more in dividends than they did in DRCs. We also know from the latest published information that this ratio now stands at 11.
Of course, the FTSE350 does not represent the full spectrum of schemes and we need to be mindful of the range of scheme and employer circumstance.
A minority of schemes and sponsors are finding it tough. They may represent around 10 per cent of the headline deficit figure—in other words around £35-40bn—and some may end up in the industry’s lifeboat scheme, the Pension Protection Fund (PPF).
We continue to explore with the DWP what changes could be made to the existing regime to help the most stressed schemes—and what the consequences of such changes might be.
The numbers I am using are a lot less than those that feature in the media headlines. I have seen some quote a figure of around £1-1.5trn—why are the numbers so different? The answer lies in the way deficits are calculated for different purposes. The numbers often quoted in the media are calculated on a “buy-out” basis, whilst the number I am using is the “scheme specific” basis.
The buy-out basis tells you how much a scheme would have to pay an insurance company to guarantee its full liabilities. Insurance companies price these guarantees based upon the anticipated income yield on government bonds and other similar assets. In addition, they are required to hold a capital buffer assessed on similar yields, and of course they include a profit margin. Because bond yields are exceptionally low currently, the price of a buy-out is very high.
By contrast a pension scheme does not have to invest only in bonds, but has great flexibility to diversify its investments across a wide variety of asset classes including equities, property, infrastructure and even derivatives.
As the returns on these assets are generally anticipated to be higher than the yields on bonds, the discount rate used to calculate the scheme specific deficit will be higher too, and the deficit correspondingly lower. Of course investing in higher returning assets brings with it higher levels of risk and we are keen that schemes have an integrated risk management plan to deal with them.
In other words, the scheme specific basis allows schemes to carry out their valuations in a way that reflects the anticipated returns on the investments they actually hold now and anticipate holding as their investment strategy matures. Therefore scheme specific funding is the more relevant measure.
Every spring we publish our annual guidance for scheme trustees on the funding of DB pension schemes. It sets out what we expect from them in areas such as funding, affordability and integrated risk management to make best use of the flexible funding regime that already exists.
There is a minority of employers whose businesses may fail in the future, and the schemes they sponsor may end up in the PPF—but that is why parliament set it up, and there is no evidence the PPF will be overwhelmed in the process.
So whilst things may not be ideal, most DB scheme members can expect to receive their expected pension. But that doesn’t make for such a good headline, does it?
