Making Sense of Pensions

Angela Burns

In our last update we provided a summary of the GMP equalisation ruling in the Lloyds Banking Group court case that has required all pension schemes to equalise guaranteed minimum pensions.

Our update was very much ‘wait and see’ as a number of points had still to be clarified. 

There are still a number of outstanding issues but there has also been positive movement in some areas.

The formation of the GMP Equalisation Working Group

The first guidance from the GMP Equalisation Working Group has been issued.

Contrary to previous updates, the working party guidance has more of a ‘get things moving’ feel to it.  The path for equalising GMP’s seems a bit clearer although there are still a number of outstanding issues to be clarified.

The guidance sets out a summary of the requirements of GMP equalisation and includes some helpful worked examples on each permissible method for equalising GMP’s.

There were some interesting comments in the guidance surrounding previously raised issues:

  • De minimis cases – the guidance states that it expects most Trustees would not apply a de minimis amount, as the work required to determine the amount is comparable to the work required to calculate and pay the uplift;
  • No further liability cases  – the guidance suggests Trustees should write to members to determine if contact can be made, prior to agreeing that no calculations should be carried out;
  • Lack of opportunity cases – where members have lost out on an opportunity as a result of having unequalised benefits (for example retiring early) it will not be possible to compensate for this.

The GMP Equalisation Working Group will produce further guidance on:

  • the availability of data to carry out the exercise;
    • impacted transactions;
    • tax issues (alongside HMRC guidance);
    • reconciliation and rectification of GMP’s.

Issues still to be clarified

The following issues have still to be clarified:

  • There will be a further instalment of the Lloyds court case to determine if transferred out benefits have to be considered in equalisation projects;
  • HMRC are producing guidance on how uplifts should be treated for tax purposes.

Actions for Trustees

The guidance expects that most schemes won’t implement a solution until the tax implications are fully understood.  However, Trustees should be speaking to their advisers about:

  • An appropriate methodology given their schemes circumstances;
  • Availability of data and GMP reconciliation (bearing in mind that further guidance will be released);
  • Understanding the Trust Deed and Rules and any forfeiture rules.
Brendan McLean

Recently, the government rejected the suggestion from the British Business Bank (a state-owned bank that helps finance new and growing businesses) to reform the current 0.75% cap on annual charges that defined contribution pension scheme members pay for the default investment strategy. Maintaining the current charge cap can reduce members’ ability to invest in more alternative (and also more expensive) asset classes such as venture capital (VC).

No entry to the dragon’s den

Venture capital involves investing into early stage companies, as in the premise of the BBC show Dragons’ Den. VC investments can grow from minor beginnings into hugely successful companies, e.g. Facebook and Uber. It offers investors the opportunity of significant returns. The government’s rejection denotes that members may find it difficult to get access to a potentially rewarding area of the market which would help diversify and increase their pension pots. However, it will save them from paying high management fees, and also from the risk of their capital being locked away for a long time due to the inherent illiquid nature of the asset class.

Allowing VC and other expensive and illiquid funds to be accessible to DC members would increase member potential returns, but also increase risk. Selecting any investment manager that outperforms net of fees is notoriously difficult and there is little evidence to suggest retail, or even institutional investors, can do this successfully over time. The performance of VC managers varies considerably and there is no way of knowing which would be successful – this would put members’ capital at risk.

What’s the alternative?

A key challenge to changing the charge cap is in answering the question ‘what do we change it to?’. VC fees can become complicated as they charge carried interest, similar to a performance fee. This could result in the member paying many multiples of 0.75%. Carried interest could encourage the VC manager to take excessive risks to get their very lucrative carried interest fee. Perhaps having a higher base fee could be a solution i.e. some funds have two share classes, one with a performance fee, the other with no performance fee but a higher standard fee.

An alternative to VC could be investing into small or micro-cap passive indices as these are more correlated to VC than traditional large cap indices. This may help members achieve higher growth but will increase the volatility of returns. As most members are likely to be invested for an extremely long time (e.g. 30-40 years), many listed and passive funds could provide a similar return to their illiquid active peers without the need to allocate to expensive and illiquid VC funds.

Brendan McLean

Unrated bonds

Rated bonds have been assessed for a fee by a credit rating agency (Fitch, S&P or Moody’s), and the agency issues a rating based on the likelihood of a bond’s default. Unrated bonds are simply bonds which have not been through this process and do not appear in benchmark indices.

Many companies, particularly large multinational firms, have both rated and unrated debt in issue; they may just choose not to pay a ratings agency to analyse a particular bond.

This can be for a number of reasons, including the size of the debt issuance, the cost of obtaining a rating, the need (or lack of) for visibility, and the level of complexity of the issue. Unrated bonds do not necessarily mean less liquid, for example, The Kingdom of Spain government bonds are highly liquid, but not rated. The sovereign (i.e. the country as a whole) is rated but not each bond.

Active bond managers are able to identify market inefficiencies between two similar bonds, one rated and the other unrated. The rated bond will often command a higher price, without necessarily offering better security or value, purely on account of being rated by one of the rating agencies (the enhancement of the rating).

By investing in unrated bonds, investment managers can increase the diversification of their portfolios, enabling them to better manage risks and enhance yield.

We prefer investment managers which can make full use of their credit research skills and investment universe by allocating to unrated bonds and build portfolios that are designed to achieve superior long-term returns.

David Davison

Employers in England, Wales and Northern Ireland LGPS will be bracing themselves for the results of the March 2019 actuarial valuations which should be landing in the inbox shortly (Scottish employers have another year to wait). So, what are they likely to see?

Asset returns have been positive over the period which will have a positive impact on the funding level, all other things being equal. Inflation is also broadly unchanged over the period. There was some optimism around mortality rates although an announcement of a fall in deaths in 2019 has potentially put something of a damper on that.

However, that’s likely to be all the good news. Gilt yields have continued to fall from just below 2.3% in 2016 to around 1.6% in 2019 placing a higher value on liabilities. Gilt yields have continued to fall subsequently with yields down around the 1.0% level now.

The big issues likely to make an impact are likely to be legislative ones. These valuations will see the incorporation of additional liabilities related to GMP equalisation. In July we also witnessed the Government being defeated in the McCloud case with speculation this could cost Funds billions of pounds. The case found that the Government had forced younger members of the Judges and Firefighters schemes to join less valuable schemes while older colleagues were protected by transitional arrangements providing them with valuable additional benefits. The Government was not granted leave to appeal so steps will now have to be taken to rectify the problem. The LGPS has similar transitional protections.

These issues will likely increase liabilities and therefore funding costs.

The uncertainty created is also likely to hit exiting employers and will result in uncertainty around the impact for employers providing out-sourced services who may be left ‘holding the baby’.

Many schemes had been going through a cost cap review which suggested they may have to increase the level of benefits being provided (as there was a cost surplus), however these deliberations were deferred awaiting the impact of these changes.

Employers may have to brace themselves for further cost increases with no real viable route to escape. Hopefully the LGPS England & Wales Consultation will look at offering some additional flexibilities and a more equitable exit basis. Fingers crossed.

Alan Collins

20 years in pensions

Last week, I passed through the ‘20 years in pensions’ landmark. Year 21 is as busy as ever, but I did find some time to pause for some reflection.

1999 was my first year in a ‘proper job’. It was the year when people waited to party like Prince predicted back in 1982. It was the year when businesses were fixated by the impending doom of the Millennium Bug, which after greater preparation, pretty much came to nothing (see GDPR). In 1999, Scotland had recently qualified for a major football tournament and suffered its first of many glorious failures in attempting to qualify for Euro 2000. Ah, the days of glorious failure instead of just plain old failure.

I started work in Towers Perrin’s North of England Office (St Albans!) and so my quest for the actuarial fellowship qualification commenced. In the financial world of 1999, the Bank of England base rate was 5.0% a year (no I haven’t missed the decimal point). Long-term interest rates were expected to average at 4.5% a year for the next 20 years.

So, if you were to borrow £1,000 for 20 years back in 1999, you would be expected to pay back £2,412 i.e. £1,412 of interest. Today, the amount to pay back would only be around £1,220 i.e. only £220 on interest of around 1% a year.

The late-90s pensions industry was adapting to the post-Maxwell world of the Pensions Act 1995 (PA95) and the soon to be forgotten Minimum Funding Requirement (MFR). Amongst a raft of legislation, PA95 introduced mandatory pension in payment increases and enshrined in law the protection of pension benefits built up in the past.

It was also a time-period when it was becoming clear that the actuarial profession had significantly underestimated life expectancy. This was (and still is) another significant factor in past pension promises costing more than had been expected.

My years in pensions have sped past, now finding my home at Spence for almost ten years now. Fellowship of the actuarial profession eventually came in 2006 and I have been proud to advise many pension scheme trustees as their Scheme Actuary since 2008. I have seen the sad, but inevitable, demise of final salary pension schemes for most members. As such, my job in the main involves helping trustees and sponsors deliver the past benefits that have been built up.

To end this reflection, I mused about the most significant turning points in the pensions industry over my time. Several came to mind, but I would plump for the introduction of full buyout solvency debts on sponsoring employers and the introduction of the Pension Protection Fund (PPF).

From what I recall, the introduction of full buyout debt sort of snuck up on sponsoring employers. Of course, the vast majority want to provide full pensions for all members. However, with the huge challenges and costs of pension schemes, how many would turn back the clock and wind-up schemes with lower obligations? Very many, I am sure.

The mere existence of the PPF is often cause for celebration and rightly so. In the fifteen years since it opened its doors, it has given shelter to around 250,000 members and undoubtedly provided them with a much better financial outcome than would otherwise have been the case. So, to the next 20 years.

What will happen? Don’t ask me, I’m an actuary!

Hugh Nolan


(Almost) every stakeholder in the pensions industry wants the same thing – better member outcomes. Sponsors. Trustees. Regulators. Government. And, of course, members.

Why the odd and perhaps grammatically shady parenthesis at the start of the sentence? Well, unfortunately, operating on the fringes, or even lurking in the shadows, are parties less interested in the member outcome and more interested in personal gain. Sponsors do occasionally misappropriate members’ pension funds. Not all financial advice is given exclusively in the interests of the member. Scammers will leave retirement plans in tatters and jet off to sunnier climes without a second thought.

Governance is used widely across the industry to reaffirm how seriously we take our duties in support of better member outcomes. Quite rightly, we need to be rigorous in how we govern schemes in relation to matters of investment, risk, administration and member communications.

However, when it comes to protecting members’ interests when they transfer out of schemes, the industry is sometimes caught between a rock and a hard place. The rock being the individual’s statutory right to take their pension in a different shape or form, through a more flexible arrangement; the hard place being the industry’s desire to protect the member from making decisions that could have a detrimental effect on their financial future.

Perfect storm

To paraphrase a well-worn cliché, every cloud has the potential for rain. The significant fall in gilt yields over the last year has proved good news for defined benefit transfers with the average amount having risen substantially. However, the allure of pension freedoms, coupled with increased transfer values, may have brought on something of a perfect storm.

Members need to be aware that the decision to sail away from the safe harbour of defined benefit to the unchartered waters of pension freedoms will not always lead to an island paradise. They will need to first avoid the pirates and sharks.

The FCA has previously stated that defined benefit transfers are not generally in the interests of individuals and that advisers must provide compelling factors that mitigate the transfer. Nevertheless, between April 2015 and September 2018, seven out of ten transfers from defined benefit schemes were apparently approved by independent financial advisers.

The government has ruled that every individual with a transfer value of more than £30,000 must take independent financial advice before transferring from a defined benefit scheme. Without sufficient education and support to make the right decision for their own specific circumstances, members may not make the most appropriate decision for their future. The Work and Pensions Committee has said that the rise in defined benefit transfers is a ‘major mis-selling scandal’ and sees contingent charging – where advisers only receive payment when transfers go ahead – as a ‘key driver’ of poor advice.

Industry collaboration

Step forward the Pensions Administration Standards Association (PASA). It has launched new transfer guidance to help support members of defined benefit schemes to make better choices. PASA’s transfer guidance aims to improve the administrative efficiency of transfers, assist the overall member experience (both in terms of speed, and crucially, safety) and provide better communications and transparency. PASA’s DB Transfer Guidance is intended to make it easier for providers, advisers and members to see all the information they need to make better informed choices.

While many within and without the industry firmly believe that members are likely to be better off staying in their defined benefit scheme, the appeal of pension freedoms will often be too strong to resist.

Those members that choose to transfer need all the support the industry can provide. This new guidance is a good example of the industry working collaboratively, along with government and The Pensions Regulator, to help provide more support to members and deliver the better outcome (most) stakeholders are looking for.

Alan Collins

The art of discretion

Discretion matters for pension schemes and their members. If you know your Shakespeare, discretion is ‘the better part of valor’ (Henry IV), meaning better to be cautious than make rash decisions. Also a consideration for pension schemes and members, but not the kind of discretion I want to discuss here.

When pension scheme trustees operate discretion over who receives pension benefits, the benefits will not be subject to inheritance tax (IHT). Discretionary benefits are usually lump sum payments on death in service (normally insured due to the amounts involved) and sometimes also death after retirement payments.

Members are given the opportunity to complete an expression of wish (or nomination) form where they can give the trustees a note of their preferred beneficiaries and the proportion of any benefits they would like paid to each. But these nominations are always (to the surprise of many) not actually binding on the trustees. The trustees have the freedom to choose to whom to pay the benefits – this decision is at their ‘discretion’. The nominations are for guidance only, otherwise the IHT benefit would be lost.

In most cases, trustees will ask for a copy of the deceased’s will and details of financial dependence so they can determine the circumstances of the case before making a decision.

Going against the grain

Sometimes the decision can be straightforward. In other cases, trustees can face a tricky task when there are multiple beneficiaries or the deceased does not nominate relatives. They may choose to follow the member’s expression of wishes. Or after considering all the circumstances available to them and exercising discretion with due care and attention, the trustees may make a decision that is not in line with the member’s nomination.

One area trustees may need watch out for is where direction is switched to discretion. The Supreme Court is ruling on a case (‘Staveley’) where HMRC successfully claimed that a transfer from a S32 policy (where benefits would be paid to the member’s estate) to a personal pension plan (where benefits are discretionary) was tax avoidance as the member was terminally ill. Occupational schemes could see similar cases.

Sometimes trustees may find that their decision is contested. This is becoming more and more common. In fact, death benefit decisions now account for 10% of the Pensions Ombudsman cases, a threefold rise since the advent of pension freedoms when compared to the same period prior to 2015.

Raising awareness

Perhaps this is simply a case that large sums of money make it more likely that there will be an aggrieved party who has not received what they thought they should.

Or maybe it’s a lack of understanding of the benefits of discretion over direction. Does the expression of wish form do enough to explain the need for discretion to ensure IHT benefits? Does it explain sufficiently the loss of control to the member over decision making? How many members read the caveat that the trustees will usually follow the member’s wishes but are not bound to and ignore the last part. The key element of the discretion.

It is important that scheme administrators take the opportunity of regular member communications, such as newsletters, benefit statements and summary funding statements to remind members to keep their expression of wish form up to date. A form can be enclosed with traditional print communications, members can be directed to a website to download a form or prompted to contact the administrator by telephone or email.

The more up to date the member’s expression of wish form, the less likely it is that the trustees’ decision will be challenged and the member’s wishes can be fulfilled.

David Davison

In my last Bulletin I provided some detail on why the current exit basis used by LGPS funds is based upon excessive prudence and is totally inequitable to exiting charities costing them £100’s of millions in excess exit payments, swelling Fund assets and reducing Council costs.

The approach is unfortunately also counter-productive as it locks charities in schemes by presenting them with unaffordable exit payments thereby increasing risk for other participants in the Scheme. Funds focus on the risk of default and don’t really assess the material risk of future accrual, particularly for organisations with a weak covenant. It could be argued that the greater risk lies with an employer continuing to accrue further liabilities, which they may be unable to afford, which places other employers at risk.

The cessation lottery

Below is a table showing gilt yields and inflation over the last 12 years.

It can be seen from this that yields were broadly above 4% until around 2011 when we began to witness a steady decline to current levels where they are at or below 2%. There has been some volatility in the inflation position though not to the same extent as with gilt yields. Lower gilt yields will be resulting in very materially higher cessation debts being required from exiting employers which often makes them unaffordable.

Cessation debts could have been 2 to 3 times the size depending upon when the cessation debt was calculated. As an example we recently witnessed a debt move by around 50% over a matter of months and because of where the assets were held the employer had no control over the figure during the period when they were awaiting cessation numbers from the Fund Actuary.

Taking cessation payments based on gilt yields may make some theoretical sense where liabilities in Funds are being secured by the purchase of broadly matching gilts. However, very few Funds do this and we would question if that is sensible and a good use of public monies given the longer term view that Funds can adopt, the relatively small proportion of overall liabilities these Funds are likely to represent as well as the potential returns which could be foregone. This would be particularly the case where small exiting employers had very young staff where a 100% gilts-based investment would be wholly inappropriate.

The vast majority of Funds take these cessation payments and continue to fully invest them in their standard growth portfolio meaning the Fund continues to take the investment risk, and indeed return, as demonstrated in my previous article.

Alternative solutions

A number of alternatives exist which could provide for a fairer distribution of risk on exit.

The PWC Report referred to in my previous article suggested the use of Liability Driven Investments which could increase the ‘secure’ discount rate which could be used, thereby reducing exit payments and making exit more affordable.

The cessation basis could also reflect the likely duration of the liabilities with a moving discount rate applied depending upon the likely term the assets will be held. This basis could also be adjusted depending upon the level of any security which could be provided.

We would urge the Ministry of Housing, Communities and Local Government and LGPS to consider these alternative solutions to look to achieve a more equitable distribution of risk and reward.

David Davison

I have long been of the view that the current basis of assessing payments for charities when they exit an LGPS is excessive and doesn’t provide a fair balance between the schemes and the charities. Indeed I’m not the only one to hold this view.

In 2015 the Scheme Advisory Board in England & Wales commissioned research from PWC on this specific issue which commented:-

“We recommend that Funds should not be permitted to use very onerous assumptions for exit bases. One way to achieve this would be to require that the discount rate applied should not be stronger than CPI plus 1.0% or plus 1.5%. This would be the maximum strength exit basis. The range suggested is consistent with cautious investment policies but not zero risk investment policies.”

Needless to say this view represented ‘an inconvenient truth’ for LGPS Funds so the recommendation was just completely ignored. Its likely that this approach may have needlessly cost the UK’s charity sector many £100’s of millions. So just how much have Funds, and indeed their sponsoring local authorities, benefitted from these payments?

If we use a simple example comparing returns and gilt yields to highlight the issue (i.e. at this stage we are assuming all other factors remain constant). We have cessation assets and liabilities of £1m at outset with estimated on-going liabilities of £670,000 based on a 67% cessation funding rate. Table 1 shows the potential return based upon a gilts-based discount rate of 1.7% and returns of 0.5%, 1.0% and 2.0% above gilt yield (the latter reflecting broadly the on-going funding assumption).

The table shows that a matching gilts-based liability would have increased to £1.4m after 20 years and £1.66m after 30 years. Over 20 years the equivalent asset value covering this at 0.5%, 1.0% and 2.0% above gilts would be £1.55m, £1.70m and £2.07m respectively. So effectively the Fund (i.e. other active employers – primarily the Council) would have benefitted from the cessation payment by anywhere between £150,000 (11%) to £670,000 (48%) over this period based on these assumptions.

The equivalent ‘on-going’ liability reflecting a 2% return above gilts would have been around £670,000 so the exiting employer would have been paying a cessation ‘premium’ of £330,000. Allowing for a discount rate of 1.0% and 0.5% above gilts this cessation payment would reduce by £180,000 and £90,000 respectively while still providing a reasonable security margin for the Fund.

However, the position is in reality much worse than the example as the actual returns achieved by the Funds over the last decade or so have been hugely in excess of those assumed. If we consider an employer exiting in 2008 using the actual average return disclosed in the LGPS SAB Annual Reports across all Funds (net of charges) and the actual prevailing gilt yields the picture is alarming.

Based upon the £1m starting point the actual return from April 2007 to March 2018 was 87.7% (average 7.97% p.a.) and the gilts return over the same period was 35.75% (average 3.25% p.a.). This means that the actual gilt value of the £1m liability would now be around £1.42m however the actual value of the assets would be nearly £2.3m. So the Fund will have made nearly £900,000 excess return over gilts on the £1m of assets over only 11 years and around £1.3m in total. Even with no cessation payment the assumed on-going asset value (£670,000) would by 2018 be in excess of £1.5m and therefore over the gilts-based value and well in excess of a likely ‘on-going’ value which would be around £1.2m.

Funds are therefore collecting huge and, in our view, unreasonable payments on exit well in excess of the amount of money actually needed to provide the benefits. We do not question the need for some form of prudence margin to be applicable for exiting employers but Funds are demonstrating excessive prudence and refusing to consider change because they have the power not to do so. It is not unreasonable to assume that Funds could easily have taken £100’s of millions in cessation debts from the charitable sector over the last decade or so and benefitted by additional multiples of that figure. Is it reasonable for public bodies to effectively ask our charitable organisations to cross subsidise their costs to that extent?

We are firmly of the view that the existing approach is flawed and in need of revision and we made some proposals how this could be addressed in our submission to the Consultation on LGPS in England & Wales though would be less than confident that the turkeys will vote for Christmas!

Brendan McLean

How low can rates go?

The recent decline in yields is a sign of how quickly market expectations can change.

While the UK base rate has remained at 0.75% since August 2018, longer dated rates have recently been falling fast. Between April 2019 and August 2019, the UK 10-year government bond rate has fallen from 1.27% to 0.52% and 20-year rates from 1.77% to 1.11%. This will have dramatically increased pension scheme liabilities unless they have been fully hedged.

Global decline

It is not just the UK where rates have seen dramatic declines – it is happening across the globe. The 10-year US Treasury yield fell from 3.24% in November 2018 to 1.69% in August 2019, with a 0.38% fall in the last few weeks alone. This huge decline can be explained by the US Federal Reserve reducing its benchmark rate by 0.25% on 31 July (the first reduction since 2008) and also deciding to end the process of shrinking its balance sheet, known as quantitative tightening, two months ahead of schedule.

PIMCO estimates that $14 trillion in government bonds, or 25% of the global government bond market, has negative yields. In early August 2019, German 10-year yields were -0.58%, and the Japanese 10-year yield was -0.22%. Large bond managers say it would not be impossible for the US Federal Reserve to reduce rates to 0%; they are currently 2% to 2.25%. It seems unlikely that UK rates will go as low as Germany or Japan, but it highlights that investors are willing to accept negative returns in government debt.

Monetary policy driver

The driver of the recent declines is changing central bank monetary policy. Global central banks have started to reduce interest rates due to slowing economic growth and investors are pricing in more rate cuts. Recently, India, New Zealand and Thailand surprised investors with larger than expected rate cuts. Investors are becoming more concerned about global growth, particularly in light of the US/China trade war which is showing no sign of ending and is beginning to develop into a currency war. Investors are worried, which is leading to declines in equities, more flows into safe-haven fixed income assets and depressing yields even more.

A popular recession indicator is the yield spread between US 10-year and 3-month Treasuries. It has turned negative before every recession since the Second World War and has been negative since May – so investors could have good reason to believe a recession is likely.

A key tool central banks use to encourage growth when there is a recession is to lower rates. But considering how low rates currently are for developed economies, they will not be able to pull this lever and will need to find alternative solutions to avoid a prolonged recession.

So – just how low can rates go?

No one knows. We are in a period of low but stable global economic growth (except for the UK) with high employment – central banks are beginning to reduce rates to prolong the business cycle. Therefore, when the next recession occurs, central banks will cut rates even more. We may not have seen the bottom yet.

The recent decline in yields poses a question for pension scheme trustees. Should they increase the level of interest rate hedging even though rates have fallen? This has been a key challenge for trustees over the last 10 years as rates have declined. While hedging won’t offer the same benefits as it did previously, because yields are lower, it should provide trustees with a more stable funding level.

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