Making Sense of Pensions

Angela Burns

You would have to have been living on the moon over the past few months not to have seen the huge amount of press about pension transfers. Reading it you would be lead to believe that all individuals are gullible idiots and that all financial advisers are scurrilous rogues. Whilst undoubtedly there may be some who fit in to these categories it is far from all. So what is actually driving individuals to consider transferring their defined benefit pot to something with a much less certain outcome?

There is no doubt from my experience that individuals have a more unhealthy pessimism about their life expectancy than statistics would justify and a greater sense of expectation about how they can manage money than experience would suggest.

A starting premise for financial advisers when providing transfer advice is to begin with the assumption that it is not in the individuals best interests to transfer out of a defined benefit arrangement. However with more than 100,000 people having transferred out of DB schemes over the last year (according to Royal London), £10.6bn transferred in the first quarter of 2018 and no sign of a slow down – why has transfer activity increased so significantly in recent years?

Pension Freedoms

Undoubtedly the pension freedoms and choice introduced in April 2015 are the single greatest reason for the increase in transfer activity.  On transferring liabilities to a defined contribution scheme, individuals can access a range of flexibilities including:

  • Purchasing an income (always available but no longer a requirement)
  • Taking their fund as cash subject to tax charges
  • Entering into a drawdown arrangement whereby an income can be taken each year and the fund remains invested

There are also changes to death benefits whereby residual funds pass to dependants tax free on death before age 75 (previously taxed at 55%).

With this in mind, many individuals have looked to access these flexibilities.  Individuals may also feel that they get better value from transferring if:

  • They are single and would not benefit from a spouse pension on death from a defined benefit arrangement. Transferring to a defined contribution scheme means they can access the full value of their accrued benefits with nothing lost on death;
  • They are in ill health and have a lower life expectancy where greater value can be derived over a shorter term.

If an individual already has sufficient pension savings elsewhere or their spouse has material savings, then transferring part of a defined benefit to a defined contribution arrangement could provide a fund that can be taken more flexibly facilitating early retirement, a new career or even a release of early value to children or grand children.

Releasing funds to deal with debt may be more attractive than securing long term income and for those in financial hardship and accessing pension savings via a defined contribution arrangement may be their only option.

Shape of benefits

The provision of a set income increasing by a fixed rate with a spouse benefit may not provide an individual with the shape of benefits they may need or want. The ability to take more income early to facilitate early retirement for example,  and lead a lifestyle in the earlier years of retirement may be a strong driver.

Value for money

With interest rates still at very low levels and inflation relatively high, transfer values are much higher than they might have been historically and as a result, are being seen as good value.  Multiples of 30-40 times the individual’s pension are not unheard of.

Discharging pension scheme liabilities via transfer values is a lower cost option for employers and as such incentivised employer sponsored transfer exercises are still prevalent in the industry.  Individuals may view a transfer value already set at an attractive level but with a further enhancement, as too attractive to turn down.

Overall the perception that transfer values are now providing good value for money is resulting in more individuals now considering this as an option.

Risk

Finally, individuals in a defined benefit scheme with a high risk sponsor may feel that remaining in the scheme presents a risk.

Some individuals may also feel that they can manage their money better and invest their defined contribution fund in such a way that they get more at retirement.

Ultimately the decision is a highly complex one hence the requirement for anyone with a transfer value about £30,000 to receive independent financial advice is a sensible one. There are a huge amount of issues that should be considered and individuals should do what is right for them based on their own circumstances. Without this expert guidance people may make decisions which are unsuitable based upon inappropriate, misleading or indeed no information which may ultimately lead to bad outcomes.

Brendan McLean

The UK property market is one of the most developed and stable in the world. For investors, that means greater potential for stable income and capital growth over the long-term. We believe this potential still exists despite market concerns over Brexit and high street store closures.

Since Brexit, UK property has performed well and has seen a surprise surge in transaction volumes, particularly from overseas investors; this can be partly attributed to sterling weakness. There is the possibility that some international companies may choose to locate themselves outside of London post-Brexit, which could negatively impact central London offices – however outside of the capital other segments should prove more resilient. A broad portfolio, well-diversified across sectors and locations, should help weather any headwinds.

The high street retail sector continues to underperform due to the shift towards online shopping; high profile casualties such as Toys R Us, Maplin, New Look and Carpetright have decreased high street rental demand.  However the shift to online shopping has benefited distribution warehouses that store online purchases, these will continue to grow for the next few years as more people shop online.

The property market is not without its challenges, both from Brexit and from consumers choosing to shop online rather than in-store. Nevertheless, there is still room for capital appreciation and secure income. We are confident that diverse UK property allocation continues to have a place in portfolios.

We particularly like property for its ability to produce a steady income stream that is potentially inflation linked.  This income stream can be used by pension schemes to meet their cashflow profile.  Investors are also being paid a premium to invest in an asset class which is illiquid in nature – more below.  An Investment in property should be a serious consideration for a pension scheme.

A downside to investing in property is the significant transaction costs to enter and leave this asset – sometimes you might not even be able to enter or leave!  However, for most pension schemes with a long term time horizon and other liquid assets this should not be too much of an issue.

Hugh Nolan

At the end of 2017, a survey by the Society of Pension Professionals (SPP) found that 79% of its members felt that the UK pensions system was unfair to young people. Frankly, I wonder what the 15% of SPP members who disagreed were thinking, especially the 3% who strongly disagreed with this fairly obvious statement of fact. Perhaps they just pressed the wrong voting button accidentally…

Let’s look at the State pension first. The Office of Budget Responsibility (OBR) has forecast an increase in the cost of the State pension from 5.0% of GDP to 7.1% of GDP over the next 45 years. This forecast assumes no change to current pension policy, so includes allowance for planned rises in State Pension Age (SPA). The extra cost of £700 each year for every household in the UK seems unlikely to be affordable so my guess is that further reductions will be necessary to balance the budget. The triple lock on pension increases alone is expected to add over 1% of GDP to the cost of the State pension within 50 years. I imagine the new voters hoping for Jeremy Corbyn to be Prime Minister may be voting for more generous pensions for the current generation of retirees than they can realistically expect to get themselves.

Moving on to private sector pensions, there were 3,500 Defined Benefit (DB) schemes open to new members in 2006 but only 700 left in 2016. Over the same period, the number of employees earning DB benefits fell from 3.6 million to 1.3 million. The Institute and Faculty of Actuaries (IFOA) says that a private sector worker born in the 1960s is almost four times as likely to have a DB pension as one born in the early 80s.

The typical rule of thumb used to be that a DB scheme might cost 15% of salary, with the employer bearing two-thirds of the cost. Recent analysis shows that the surviving DB schemes are costing 22.7% on average, with only a quarter of this cost met by employees. That means that employers with DB schemes are on average paying five times as much as those with Defined Contribution (DC) schemes, where the average employer contribution rate is only 3.2% (with employees paying an average 1.0% too).

In fairness, these DC contribution rates are distorted by new Auto-Enrolment (AE) schemes and the average DC contribution from employers in 2012 was 6.6%, still only just over a third of the corresponding rate for DB schemes. Employers in AE schemes are also going to be forced to make higher contributions, with the minimum rate having increased to 2% in April and due to rise again to 3% in 2019. Meanwhile, employees will have to pay 5% contributions, meaning that they are paying more than half the cost overall, while DB members still only pay a quarter of the cost of a much higher benefit.

The Government is perfectly aware of this issue (which is much wider than pensions) and has made some efforts to address it. The policy to increase SPA as people live longer is unpopular but has been defended to date, albeit slightly weakly, and Theresa May’s manifesto admission that the triple lock would go was a massive vote loser. Several kites have been flown about intergenerational taxes but none have met with anything other than resistance. The public aren’t thinking about affordability or fairness over the coming decades and a Parliament only lasts for five years, so can we really blame the politicians for letting the unfairness drift on?

David Davison

The more I read about defined benefit (DB) consolidation, the more it appears to have a key parallel to Brexit, namely: everyone seems to have a different expectation of the outcome.

The DWP’s White Paper “Protecting Defined Benefit Schemes” was published in March and followed up last year’s Green Paper with further proposals on the benefits of consolidation.

There are multiple consolidation options. Each will have a different impact and will be complicated to achieve.

The suggestion is that bigger is better. Having larger schemes reduces cost and improves governance. Interestingly, however, the 2017 Purple Book suggests that smaller schemes (i.e. those with less than 100 members) are on average better funded than those with more members.

So, in considering consolidation, what options are possible, what are their potential benefits and what might be the associated considerations?

Investment consolidation

The potential to consolidate investments seems relatively simple, can reduce costs and provide schemes with access to a greater level of investment choice.

Access to investment platforms can provide cost and administrative benefits even without wholesale changes to underlying governance or administration.

Governance consolidation

Consolidating governance, for example, in the form of sole ‘professional’ trusteeship also seems to present schemes with a straight-forward path to governance improvements and can be achieved without upheaval to the schemes’ delivery services.

Going beyond the above there is further potential, but the benefit improvements are much less certain based upon the specific circumstances of each scheme and employer.

Operational consolidation

There may be operational opportunities to merge key scheme services such as administration and actuarial.

It’s far from clear cut, however, that such a move will result in cost savings.

There is little evidence that the provision of services within a DB Master Trust are provided at a materially lower cost unless some form of benefit consolidation can be achieved.

In addition, the likely scheme time horizon will have a huge bearing on the cost effectiveness of any move given the inevitable set-up costs of a service change. If, for example, the time horizon to buyout is within 5-10 years then annual savings may not outweigh initial transition costs.

Any move to a DB Master Trust must be reviewed in terms of flexibility. Such a move will require a scheme to fit within the DB Master Trust model where any pricing improvements which can be achieved are done so via some form of standardisation.

The timing of valuations or the approach to administration may not be something that suits all schemes or employers.

What is the Master Trust approach to employer covenant, member communication and benefit options and is any approach outside the norm likely to incur additional costs which may negate any savings?

This will be an important initial consideration as in my experience these schemes are much easier to join than they are to exit.

Benefit consolidation

This is even more problematic.

Converting one scheme benefit basis to another has long been fraught with difficulty given that ultimately a guarantee will have to be provided that members will be no worse off.

This will undoubtedly result in up-front costs that again have to be considered against any savings which can be made in future.

There have been calls for Government to standardise benefits to make consolidation easier, but it remains to be seen how this can be achieved.

Ultimately a Scheme Actuary will have to sign-off any benefit conversion to confirm that the change does not detrimentally impact on members’ accrued benefits, which is far from an easy hurdle to get over.

It is also difficult to envisage how consolidation can happen for schemes with unequal funding levels, as trustees would surely seek a “levelling-up” of funding. This has been an issue which has undoubtedly slowed the pace of consolidation in Local Government Pension Schemes (LGPS).

There must also be a concern that close links to key personnel in a scheme sponsor who can provide valuable insight from an employer covenant and operational perspective could be lost through consolidation.

Are ‘Superfunds’ the answer?

There have been proposals that a middle way between own-scheme funding and buying-out with an insurer may be possible.

This would be via what have become known as ‘Superfunds’ which would consolidate scheme benefits from multiple schemes. The suggestion is that sponsors would benefit from lower costs than that required to fund a buyout.

Proponents have been quick to highlight that any transfer in to Superfunds would need to be fully assessed by Trustees as being in members’ interests and that any agreement is likely to result in accelerated employer contributions over those paid under a funding plan in order to gain access.

An initial entrant to the market has suggested that revised legislation is not required as their scheme is just the same as any other occupational pension scheme and could run under existing regulation.

This, however, differs from proposals put forward by the Pensions and Lifetime Savings Association (PLSA) where it was expected revisions to the regulatory framework would be required.

Clearly we are at a very early stage in terms of this potential solution and it is likely to evolve over the coming months. Undoubtedly questions remain over this approach, particularly around the break in the link to the sponsoring employer and therefore the strength of the employer debt security.

Industry unconvinced by consolidation

The Association of Consulting Actuaries’ Pensions Trends Survey 2017 suggested that only 16% of sponsors would consider consolidation and only 32% thought that potential cost savings were real.

That would seem to suggest there are real concerns about how successful any consolidation might be and a high level of scepticism that promised improvements can be achieved.

It is interesting that LGPS schemes where the benefit basis is the same have primarily gone for investment consolidation. This may well be a first step, but where funds have merged for delivery services the impact in the end-user experience has been patchy.

There are undoubtedly efficiencies and opportunities for improved investment and governance available through some form of consolidation, however, the extent will be very much based on individual circumstances and requirements.

Those in favour of much greater reform certainly have a lot of convincing to do.

This article originally appeared in CA Today on the ICAS website here – on the 19th May

Andrew Kerrin

The first quarter of 2018 has flown by and has proved to be an eventful three months. We have had no problem finding topics worthy of inclusion in this Quarterly Update – it’s been more of a problem deciding what NOT to include. We have been ruthless however and pulled together the topics that we believe you need to know about from January to March 2018. Enjoy!

The topics of note this quarter include:

  • GDPR Compliance
  • Government White Paper on DB Schemes
  • The Pensions Regulator and recent Corporate Failures
  • DC Consolidation
  • Reviewing your Currency Hedge
  • EIOPA Market Development Report
  • New CMI mortality improvements

To download this report click here or on the image above.

As always we love to get feedback from you. If you like what we do please tell us – it’s nice to get great feedback. If you would like things included, excluded or done differently please drop us a line too. The report is to help you, so help us tailor it to your needs.

And … if you find that you do have time to keep up with things, why not follow us on Twitter @SpencePartners and keep up to date as you go along.

Angela Burns

This guide is intended to be a useful reference for companies preparing their 31 March 2018 pensions accounting disclosures, whether under FRS 102 or IAS 19.

In this guide, we will review the changes in the investment markets over the last 12 months and consider the impact these will have had on a typical pension scheme. We will also review recent developments in the area of pensions accounting, highlighting issues that you should be aware of.

To discuss these topics further, please contact Spence through your usual contact or connect with our Corporate Advisory practice associate, Angela Burns, at angela_burns@spenceandpartners.co.uk or by telephone on 0141 331 9984.

Rachel Graham

The Pensions Regulator (TPR) has now issued their 2018 annual funding statement (“the Statement”) for defined benefit (“DB”) pension schemes undertaking valuations with effective dates in the period 22 September 2017 to 21 September 2018.

As per the 2017 Statement, TPR outline the ‘appropriate action’ they expect trustees to take with regards to funding. The recommended actions depend on the strength of the employer covenant and the funding characteristics of the scheme in question.  This can be a helpful tool for Trustees undertaking valuations, giving a list of issues to consider and potential action to take.

The Statement puts a particular focus on the need for Trustees to negotiate robustly with employers to ensure pension schemes are being treated fairly.  TPR are “concerned about the growing disparity between dividend growth and stable deficit reduction payments”.  TPR notes that Trustees should monitor ‘covenant leakage’ (i.e. value leaving the business) and decide if the overall covenant strength is affected.  If it is felt there is a change in the covenant, funding and investment decisions should be revisited to ensure an appropriate level of risk in the funding plan.

The Statement goes on to advise Trustees to monitor transfer activity and to consider the potential impact on scheme funding.  If Trustees decide to make an allowance for transfer activity in the funding plan then this should be based on evidence, monitored over time and a contingency plan put in place should experience not be as expected.

The Statement also touches on the uncertainty of Brexit and encourages a collaborative approach to be taken between trustees and employers in order to understand the potential impact of Brexit on the scheme and employer.

The Statement makes a number of references, explicitly and inexplicitly, to TPRs Integrated Risk Management guidance and stresses the importance of having sufficient contingency plans in place should things not turn out as expected. TPR are clear that they will taker a tougher approach to trustees who fail to act in the best interest of members, and as part of their risk assessment approach, TPR will question schemes’ funding and investment strategies if they do not believe they are appropriate.

In our view, it is becoming more and more important for Trustees to have access to information quickly and efficiently to ensure that monitoring can be carried out and contingency plans implemented where required.  TPR are also taking a tougher view on late valuations again supporting the need for efficient valuation processes.  We welcome this approach and hope that Trustees and employers are challenging advisors to meet these requirements.

http://www.thepensionsregulator.gov.uk/docs/db-afs-key-messages-2018.pdf

http://www.thepensionsregulator.gov.uk/docs/db-annual-funding-statement-2018.pdf

Alan Collins

It did not take Holmes-ian powers of deduction to pick up the influence of recent corporate failures in the Pensions Regulator’s annual funding statement that was issued on 5 April.

The annual “state of the nation” address on funding of Defined Benefit Pension Schemes made clear the disquiet from the Regulator that dividend payments were increasing but deficit contributions were not. The statement stresses the need for trustees to ensure “fairness” for their schemes relative to corporate shareholders/stakeholders. Where employers are strong, trustees should be “looking to fix the roof while the sun is shining” if you like. The Regulator has (pleasingly) avoided the temptation to try and fix parameters against which trustees should judge fairness. The current regime is founded on flexibility and I do hope this continues. Recent implications (in the Government’s White Paper) that greater direction/restriction is coming has me fearing a return to the days of a set Minimum Funding Requirement. The last attempt at MFR didn’t work and was quickly swept aside. I suspect that any attempt to turn back the clock on this would meet a similar fate.

There was also a reminder that dividends are not the only target, with the introduction of what might become a buzz-phrase – “covenant leakage”. This is really a catch-all phrase to describe any route by which the security of the scheme’s position is damaged by corporate activity. For me, this points strongly towards trustees drawing up and monitoring some key indicators to monitor company performance and company strength and take action to prevent deterioration or react swiftly if there is a change. And remember, it can be just as important for trustees to react when their sponsor’s position improves, allowing the scheme to share in this success and put their scheme on to a stronger footing.

The statement contained further “hints” that some trustee boards are not sufficiently well-equipped to tackle complex funding and investment issues. Trustees are expected to seek appropriate advice, especially where the board does not have the sufficient expertise or where potential conflicts exist.

Many other themes in the 2018 statement were follow-ons from 2017, such as the prominence given to the importance of contingency planning.
One part I struggle with is the continued highlighting of “Brexit uncertainty”. Yes, we know there is uncertainty. However, if the Government doesn’t know what is going to happen, the markets don’t know what is going to happen, advisors don’t know what is going to happen, then what chance do trustees have? I fear that trustee resources could be diverted in speculative discussions about future scenarios rather than focussing on more measurable, controllable risks.

David Davison

The Security Obsession

In an earlier bulletin entitled ‘The Cessation Plot thickens’ I highlighted something of an anomaly in LGPS practice around security which I’d like to explore a bit further.

Firstly, I will consider an example of an admitted body looking to close off to accrual to better manage risk. Prior to doing this let’s assume that the organisation has £1m of accrued liabilities and £800,000 of assets covering them so a deficit of £200,000. The organisation is building further liabilities of £50,000 a year. Contributions for these new liabilities are £20,000 a year so each year the net position is worsening by £30,000 (excluding any investment return).

As an active employer the Fund has not taken any security so the Fund and therefore other participating employers are exposed to additional risk as liabilities continue to build.

If the admitted body was permitted to close to future accrual of benefits the accrued benefits are no worse pre and post the change (they will likely be lower afterwards if the link to salary on past benefits is removed), so why should security be required when none was previously in place. In addition a proportion of the contributions which were being used to build additional benefits in the Fund could be used to pay down the existing benefits rather than build up new ones. Let’s assume some of the £20,000 is needed to buy replacement benefits in another scheme so only £15,000 is available as a contribution. This will therefore reduce the deficit over time thereby reducing the risk to the Fund. This can only be good for all concerned and further supportive of the view that no security is needed.

So, why is there an obsession for Funds to get access to security on scheme change? It’s probably because they’re using it as an excuse to do so! A bit of a reality check is needed.

It’s potentially reasonable for Funds to look for security if some additional flexibility is being offered, such as access to a higher risk investment fund where the deficit risk could increase but without this the default position should be that additional security should not be necessary.

So if you’re being pushed for security by a Fund you may need to ask a few more questions, especially as any arrangement of this type is likely to be time consuming and expensive to arrange.

In my view there should be clear and consistent guidelines which Funds employ in relation to the provision of security. Some Funds are adopting a more pragmatic and indeed enlightened approach to the issue of security and it can only be hoped that others will begin to follow suit, especially if admitted bodies ask the right questions.

Brendan McLean

The annual Pensions and Lifetime Savings Association (PLSA) conference in Edinburgh brought together leaders of the pension industry from trustees to investment managers, and addresses the biggest challenges faced by the industry with the aid of key guest speakers and expert knowledge.

This year’s focus was on cost transparency, regulation, and diversity, and below are some of my personal highlights.

Gaining the public’s trust again

The pension industry gaining more public trust was a key theme of the conference, with reference to a focus on cost transparency. Costs are an obviously important issue for investors; however I feel there should be concentration on the best value manager, not the cheapest.

Remembering the financial crisis

Nick Clegg, former Deputy Prime Minster in the years of the financial crisis, was one of the key speakers and discussed the notion that people are already starting to forget the way that imbalances, exposures, and liabilities can brew in a financial system, as during the 2007/8 financial crisis, if left unchecked. I believe he was making reference to senior members of systemically important firms (such as banks) having left their businesses or retired from work, leaving people who did not experience the crisis in their previous positions in charge.

The impact of advances in technology

Advances in technology were also alluded to – firms now have access to blockchain technology to help reduce costs trading (although this isn’t yet widely used), however there is concern with this in that firms will need to share information which will probably cause a greater delay than getting the technology.

Ethical investing

Ethical/impact investing was mentioned often. Ethical investments are not just about ethical investing, but also about reducing the risk in a portfolio – for example, challenges facing tobacco firms due to increased regulation will reduce sales and therefore share price. Ethical investing is more aligned with long-term investing, allocating to things such as renewable energy.

Asset bubble

A panel discussion was held on asset bubbles because of equity markets being at all time highs. It was debated that given the high valuations of equities it would not be unimaginable for the US equity markets to halve in value based on P/E ratios, and counter-argued that other valuation techniques don’t consider them to be overvalued at all. I struggle to see the where the growth in equites will come from given the rise of interest rates in the US.

If you would like to discuss any of the topics or issues raised above you can get in touch with me by phone on 020 3794 0193 or email I’d love to hear from you.