Nicola Parish at the Professional Pensions Scheme Funding Summit
Wednesday 30 November 2016
Many thanks for inviting me to speak today.
I’m going to spend the next 20 minutes or so to outline the challenges faced by defined benefit (DB) schemes, and highlighting some of the things that might help address these challenges. I’m also going to share just a few examples with you of some real schemes and the solutions they have found to their funding challenges.
Current DB situation
I’ll start off with the landscape. It’s clear that the 6,000 plus DB schemes that exist in the UK are operating in a particularly challenging environment. Low gilt yields and persistent low interest rates have obviously played their part. And we’ve had market volatility and uncertainty caused at least in part by Brexit and the US Presidential election result. And of course on the plus side, we are all living longer.
These factors have all contributed to growing scheme deficits, along with some fairly alarming headlines.
As many of you will know, there are many different ways in which scheme funding deficits can be calculated, and calculating them on a 'buy out' basis is a particularly expensive way to do it. If deficits were to be valued on a 'scheme specific' basis, which reflects the actual investments held by the scheme, and the returns they are expected to generate, then the total deficit figure that is most often quoted in the press would be much lower, something in the region of between £350 to £400 billion.
We have also seen some high-profile cases, which have brought intense scrutiny of pensions, and particularly of defined benefit pensions.
So it’s understandable that there is a growing debate around the affordability and the sustainability of defined benefit schemes; the willingness of employers to stand behind their schemes and the robustness of the pensions regulatory framework.
But it’s important to remember that headlines about large deficits do not necessarily mean the system is not working. Pensions are long term vehicles and most schemes will be paying out for another 50 years or so.
All of our research continues to show that the vast majority of employers with defined benefit pension schemes should be able to repair their deficits and meet their long-term financial obligations to their schemes’ members.
Our 2016 Annual Funding Statement shows that generally, there has been an increase in employer’s profits since their last valuation dates. More than half of FTSE 350 companies with DB schemes paid out 10 times or more to shareholders than to their schemes. As for recovery periods, roughly half of the recovery plans of schemes carrying out valuations in 2016 have five years or less to run, with the average being about eight years.
So, in our view, the flexibilities available to defined benefit pension schemes and their sponsoring employer means that over the longer term most employers will be able to pay their members their promised benefits.
This flexibility within the system is key – and I will talk in more detail shortly about how, in practice, for those schemes who may be struggling – or, to borrow a phrase from Theresa May – for those schemes who are 'just about managing', these flexibilities can help.
There is of course a minority of employers whose businesses may fail in the future, and as a result the schemes they sponsor may end up falling into the Pension Protection Fund – but that is why Parliament set up the PPF, and there is no evidence to show that the PPF is going to be overwhelmed in the process.
So we are not witnessing a failure of the DB system as a whole.
However it’s right that the system is reviewed from time to time to take into account changing circumstances. And as many of you will know, it’s under review now.
The Pensions Minister, Richard Harrington, has said that the Department for Work and Pensions (DWP) will shortly be launching a comprehensive Green Paper on DB pensions. It’s not for me to pre-empt what might be in the paper, but the Minister has suggested that it could cover consolidation of schemes, scheme valuations, the regulator’s powers, and investment.
And you may be aware that the Work and Pensions Select Committee has been conducting its enquiry into the regulatory framework and the affordability of DB schemes. TPR has been actively participating in that enquiry and we have suggested a number of specific areas where we think the system could be improved.
We are continuing to discuss these areas with government; in particular, in the areas of information gathering, clearance and anti-avoidance, scheme funding and valuations, and scheme governance.
But we’re careful about requesting new powers or suggesting changes to the system, that could have knock on effects elsewhere. In the case of what we call ‘mandatory clearance’ for example, we wouldn’t want to make it mandatory for every company to come to us for clearance for every transaction. But we can see that in certain circumstances, for example where a scheme has a serious level of underfunding, or where an employer covenant would be materially weakened by a transaction – then there is a case for mandatory clearance. If this is progressed, then there will be consultation.
So generally then, we think there is not a systemic affordability problem. However, we recognise that some schemes are operating under strain. And we appreciate that low interest rates and increasing longevity have increased scheme liabilities by more than the growth in asset values in many schemes.
One possible solution to the deficit problem that’s been suggested is to reduce the rate of indexation, specifically by changing the index used from RPI (retail price index) to CPI (consumer price index).
It was the Pensions Act 1995 that made indexation mandatory and the minimum increase required – for non GMP benefits – was based on RPI. Its purpose clearly was to protect members from inflation.
In 2011 the government switched its official measure of inflation from RPI to CPI. However, it did not, at that time, take forward a statutory override to allow all schemes to move to CPI.
So I guess there are two main arguments for switching the index to CPI now. Firstly that the CPI is now the generally accepted inflation measure. And secondly that CPI is generally lower than RPI.
So some argue that switching to CPI would give sponsoring employers some breathing space and potentially make the scheme more affordable and sustainable.
At TPR we don’t think that rushing to reduce member benefits is necessarily the right way to go. We don’t believe there is an affordability problem across all schemes, so a blanket change to indexation is not justified on the basis of affordability. It is also not clear that reducing member benefits for highly stressed schemes would make a material difference to the chance of the scheme and the employer surviving.
There are various options on indexation - other than the statutory override that I’ve just talked about that may be worth exploring. For example other countries have interpreted it differently such as conditional indexation, but again each option needs to be weighed up against its pros and cons.
Ultimately though, any changes to the system, such as indexation will of course be for Parliament to decide. There may be a case for introducing one of these options to give breathing space for some stressed employers.
Flexibilities within the regulatory system
I spoke earlier about the flexibilities which are built into the regulatory system. Before I talk more about that, it’s probably worth reminding everybody of what we often refer to as ‘fixing the roof while the sun shines’. By which I mean that when an employer can afford to put more cash into its scheme without impacting on its sustainable growth then that’s what we’d like the employer to do.
However, I want to emphasise that where schemes are struggling, we are open to innovative ideas; we recognise the challenges some schemes are facing and we encourage schemes – through their trustees and employers to make use of the flexibilities. Employers and trustees don’t always make as much use of the flexibilities as they might.
And of course we have a statutory objective to minimise the impact on the sustainable growth of the employer. This means we have to give due regard to the sustainable growth of the employer, as we do for the pensions scheme it sponsors.
So I’d like to give you three real examples of where these flexibilities have been used by struggling employers to ultimately strengthen their position and scheme.
Two of my examples are from our proactive case work – which is where we engage with trustees and employers ahead of the submission of their valuation. These two examples are anonymous. The third example is published on our website, so I will use the scheme name.
1. The first example is one where flexibilities were used to enable support for the turnaround of the employer whilst also improving the security of the scheme.
The scheme’s employer was weak following a period of decline. In order to deal with the situation, the employer developed a 'turnaround plan' for the business. However, this required capital investment and so the scheme was asked to accept lower deficit repair contributions than had previously been agreed.
The scheme had a significant deficit, and ordinarily you’d expect trustees to be thinking about at least maintaining if not increasing their contributions. However this employer was struggling.
The trustees of the scheme obtained advice in relation to that turnaround plan so that they properly understood its prospects and properly understood the impact on the scheme. TPR provided input to the trustees to help focus the advice on the key elements of the employer’s position.
It was also noted during the course of this, that certain of the employer’s assets were unencumbered. TPR suggested that the trustees’ seek security over those assets in return for accepting lower contributions to help finance the 'turnaround plan'.
Security of over £100 million was subsequently granted in favour of the scheme. This enabled the trustees to be more comfortable in accepting reduced contributions. And it enabled the employer to proceed with its 'turnaround plan' which, if successful, would improve the covenant available to the scheme.
It’s too early yet, to tell whether the employer’s turnaround plan will be successful. However, the trustees have facilitated the employer having the best possible chance of achieving the turnaround, whilst ensuring that they will have a more secure position if it fails. At the next valuation, we would expect to see the scheme benefiting from the improved covenant through additional deficit repair contributions if the employer covenant has improved.
2. This second example I’m going to talk to you about is a sponsoring employer, which was struggling and wanted breathing space from paying its deficit repair contributions in order to invest in research and development.
The sponsoring employer was supporting two pension schemes with assets in the billions. It also had substantial deficits.
The sponsor was operating in a sector of the market that was generally finding trading difficult in the economic environment prevailing at the time, and this employer was experiencing particular trading difficulties. But it had a coherent plan to turn things around, which included substantial investment in R and D.
Early on, the employer shared its plans with the trustees, explaining why they needed a break in the deficit repair contributions; how they planned to invest, what the potential up and down sides were and the timescales for delivery.
In this particular case, there were no unencumbered assets available for the scheme to take security over and no prospect of support from the wider group. It was imperative that the trustees fully understood the prospects of success of the employer’s plan, and the potential impacts on the scheme in the event of the success and failure of the employer’s plans. The trustees were fully engaged in the process and were well advised. And in the end, the trustees and sponsor agreed a three-year deficit repair contribution holiday. TPR discussed the proposals with the employer and trustees. We decided to select the scheme for our proactive case work.
We took the view that the employer was under stress and it was reasonable for investment in the business to be the priority. It was in the scheme’s long-term interests for the business to survive and grow.
In this case we were comfortable with the sponsoring employer taking a 3-year contribution holiday during the downturn in order to invest in research and development, placing the business on a stronger footing for the long term. Of course, we recognised the risk in the investment and the contribution holiday. However, we also believed that the employer had a cogent and credible plan to rescue the business. We were greatly reassured because the trustees were fully engaged in the process with the employer and were well advised.
So far, a happy result.
The scheme now benefits from a much stronger covenant as a result of investment in the future of the business. Deficit repair contributions (DRCs) of tens of millions of pounds each year re-commenced in 2013. The scheme has now agreed a new recovery plan in its recent valuation, with which we are comfortable.
This case demonstrates that we are prepared to allow sponsors some breathing space where necessary and where it is in the long-term interests of the scheme.
It demonstrates that we do balance the interests of members, PPF and employers. And after all, the best protection for a scheme is a strong supporting employer.
3. Halcrow Pension Scheme. This third case I’m going to talk to you about shows that if an employer is genuinely struggling to survive, then it is possible to sever the employer’s obligation to a pension scheme to enable the employer to continue to trade. We’ve published a Section 89 report on our website which describes this case in detail. So I’ll just give you a high level overview.
Halcrow is a consulting engineering business and is the sponsoring employer of the scheme. Halcrow was making a loss when it was bought by an American firm called CH2M. CH2M had no legal obligation to support the Halcrow pension scheme. However, after the purchase, CH2M provided significant help to Halcrow to turn its fortunes around, but nonetheless, the amount Halcrow could afford to pay in DRCs was well below the amount needed to fund the scheme appropriately.
The parent continued to support the scheme to enable the trustees and Halcrow to find a solution, because they had been unable to agree a valuation. An independent trustee was also appointed to try to help matters. The solution put forward by the trustees and Halcrow proposed a Regulated Apportionment Arrangement, known as an RAA.
Legislation has provided a mechanism, which can be used in a very rare set of circumstances. RAAs must be approved by the regulator, and the Pension Protection Fund must not object to the scenario.
Under the Halcrow RAA, members could choose whether to enter the PPF or join a new scheme which had reduced benefits. The scheme received £80 million in cash, which is more than would have been available had Halcrow gone insolvent. And the scheme and the PPF took a share in the equity of Halcrow going forward.
So Halcrow continues to support a new pension scheme, which is in a much stronger position and which the employer can now afford.
So in conclusion then, yes we appreciate at TPR that these are challenging times for schemes and trustees. But the evidence shows that there is no general affordability problem across the entire DB landscape, and I hope my case examples have demonstrated how the flexibilities can help struggling schemes and employers. I want to stress that we are open to innovative ideas and we are prepared to listen.