The future of pensions regulation

Speech: Michael O’Higgins
NAPF Conference 2011 - Manchester, 21 October

Introduction

Coming towards the end of my first year as Chair of The Pensions Regulator, this is a perfect time for me to take a look back over what has been a busy period, but also to look ahead to further shifts in the pension landscape.

In just a few years, we have seen major changes to the environment in which we all work. The number of open defined benefit schemes has continued to decline – a trend which has pushed defined contribution pensions up the agenda.

And with just one year until the first employers reach their automatic enrolment staging date in October 2012, we are now facing one of the most significant changes in the pensions landscape in decades – one which will challenge not just how we work as individual organisations and interest groups, but how we work together as an industry.

A quick update on DC and automatic enrolment

The introduction of the new employer duties will signal a change in the way that employers interact with pensions; and in many cases the way that employers interact with their pension scheme trustees. It will also greatly increase our interaction with employers.

Over 1.3 million employers will be subject to the new duties in the next 6 years. We will need to ensure that every one of those employers is enabled to comply, and that if they don’t comply, the necessary action is taken to help them to do so.

We will communicate directly with every employer as well as carry out more wide scale communication campaigns. Our direct communication starts off on a relatively small scale, focusing on the largest employers – those who are often already familiar with pension provision.

The volume of employers however increases dramatically as small and micro employers reach their staging dates from 2014 onwards.

By October 2014, upwards of 50,000 employers each month will reach their staging date.

And by October 2015, almost 200,000 small and micro employers each month will reach their staging date.

But it is not only the scale of this new audience which is new, but also the variety in knowledge and engagement with the issues. The information and support needs of small and micro employers, who may have little or no existing pensions knowledge, are clearly very different to the needs of those large employers who have pensions experts on hand and are more often than not already engaged with pension provision.

With this in mind we have committed to making available a wide range of tools and information that suit the needs of employers of all levels of pensions knowledge. A range of tools are already available on our website.

We know that most employers will choose a DC scheme to fulfil their new duties. And this, for many, has made the risks borne by members saving into a DC scheme, and the different challenges facing trustees of DC schemes, a practical consideration for the first time.

The segmentation we have carried out of the DC landscape forms a central part of our analysis. This highlighted a range of practice within different segments; some that work well for members, but others that may place members at higher risk.

Our priority is to ensure that all products used for automatic enrolment are fit for purpose and that they enable all members to achieve a good outcome from their savings.

Following our discussion paper earlier this year we are now taking the first definitive steps towards this goal.

An overwhelming majority of respondents to our discussion identified scheme governance as key to good DC provision. So earlier this month we published a statement which reinforces how being a DC trustee poses different challenges to being a DB trustee. We will also shortly publish a statement for trustees that will make clear some of the main issues associated with the governance and administration of hybrid schemes, for example, where the DB and DC assets are mixed together and not separately identifiable.

In the coming months we will also publish the principles that we believe underpin good DC provision – both contract and trust-based - to encourage providers to design products that contain the features most likely to enable a member to achieve a good outcome.

This document will be a central part of our longer term strategy for regulating DC.

Based on the needs of the different segments, our strategy considers some central questions such as:

1. How do we devise an approach that protects those members who are unwilling or unable to make informed decisions about their pension; but that also allows those members who want to take control of their pension savings and personal finances to properly manage those decisions?
2. How do we ensure that the providers and suppliers who bring new products to market are fit and proper to do so, and do not exploit the lack of pensions knowledge of many employers and members? and
3. How we can learn from other countries who have already addressed some of the issues that we raised in our discussion paper?

The challenges facing DB schemes

Current economic outlook

Although DC and automatic enrolment have both moved up the pensions agenda in the past few months, DB still represents around 8 million members and over £900 billion of assets, and it is a top priority for the regulator that wherever possible pension promises are kept.

We appreciate that DB schemes have been under pressure in recent times, not least as a result of the impact of rising longevity on long-term liabilities. Despite the trend towards DB scheme closure, in 2010 18 per cent of DB and hybrid schemes were still open to new members and new accrual.

We also appreciate that the current economic situation presents a continuing challenge to pension scheme trustees: with pressure on the profitability of sponsoring employers; greater uncertainty on investment returns; and the continuation of low interest rates with implications for the calculation of liabilities. And, as NAPF has emphasised, Quantitative Easing has contributed to the latter - as well as, we all hope, helping to stimulate growth in the economy more generally.

When the UK last faced a severe economic shock we produced a number of statements to help guide trustees. The material in this guidance still stands.

In our February 2009 statement, we particularly emphasised the flexibility that there is within the scheme funding framework, and that we will look to apply this pragmatically - recognising that the best support for a scheme comes from a healthy, going-concern employer.

Where there are short-term concerns over affordability, the trustees and sponsor may agree to reschedule a deficit recovery plan to make higher contributions later on – this is known as ‘back-end loading’. Should a valuation show a larger deficit, a longer recovery plan may be appropriate. We have also emphasised the importance of monitoring the strength of the employer covenant – the employer’s ability to meet its obligations to the scheme. In cash-constrained situations, we have emphasised that trustees may wish to strengthen the support available for the scheme through legally enforceable contingent assets, group guarantees or other security.

A segmented approach to the landscape

In light of our regulatory experiences over the last six years, and the range of challenges within different parts of the DB landscape, we are currently reviewing our strategic approach to regulating DB schemes.

Segmentation of the DB market proves a useful way to identify areas where we are more comfortable with how things are going - as well as areas in greater need of our attention in order to address risks to members, and PPF levy payers.

What has become clear from the data we have collected is that different schemes are on different paths – and leading to potentially different destinations.

There are a number of very general categories that schemes fall into.

En route to self-sufficiency

Some schemes are already in a strong position. They have a strong sponsoring employer and can make robust long-term plans. These schemes can realistically plan for reaching self-sufficiency and being in a position to pay member benefits in full.

Governance will be a major consideration for these schemes. As schemes close to new members and the population ages there are fewer members with a direct relationship to the employer. Schemes will naturally become distanced from their sponsor and will operate much more like independent financial institutions.

For many, the long-term solution that will bring certainty about costs will be to secure benefits through a full buy-out with an insurance company. For others, the trustee structure will remain in place and security will be maintained through strong governance arrangements and careful management of assets and investments.

Importance of the employer covenant

For many schemes self-sufficiency will not be a realistic proposition for a number of years and they will continue to rely upon the support of their sponsoring employer.

The strength of the employer’s ability to support the scheme – the employer covenant – will continue to be vital in these situations.

The funding regime has proved flexible enough to support schemes through the trough of the economic downturn, allowing schemes flexibility in terms of the structure and duration of recovery plans.

We believe that, even when cash-flow is limited, trustees and employers should be able to work together to agree reasonable and realisable plans to support the scheme.

For trustees the key will be to manage risks to the scheme in a sensible way, taking action to limit losses during the lean times and to lock in any gains made by the scheme as economic conditions improve.

Trustees can look to strengthen the support in place for members through mechanisms such as legally enforceable agreements on contingent assets, group guarantees or other forms of security.

Schemes with a fragile employer covenant and growing deficit

There are a small number of schemes where the sponsoring employer will never be able to meet the scheme’s liabilities. The funding gap between assets and liabilities continues to grow, despite the best efforts of the trustees and sponsoring employer to put together a plan to make up the shortfall.

With little support available from the employer, the only way to bridge the funding gap is by taking excessive investment risk – risk that cannot be underwritten by the strength of the employer covenant.

If this strategy back-fires, the scheme can be placed in a worse position, posing a significant risk to members and PPF levy payers.

The Ilford judgement makes it very clear that trustees cannot rely upon the existence of the PPF safety net as part of their strategy for improving the scheme’s funding.

As we said last year, for such schemes we believe that the starting point should be to prevent the deficit from increasing. Schemes should look seriously at whether future accrual should continue and investment risk should only be taken to the extent that it can be underwritten by the sponsoring employer.

We will increasingly be working proactively with trustees to help them resolve these sorts of challenging situations. We encourage trustees to approach us to discuss the issues they face in order to reach the best possible solution for all members and PPF levy payers.

The recent Uniq case is a good example of how, where there is no viable recovery plan available, positive engagement between the scheme trustees, sponsoring employer, and regulator can help to bring about a positive outcome in very difficult circumstances.

Avoidance

As is already the case, we will not hesitate to use our powers in situations where a weak covenant has been ‘manufactured’ in a bid to offload the scheme.

We are concerned that pre-pack insolvencies may be used to offload the pension liabilities quickly and cheaply. Whilst we are all glad to see businesses and jobs rescued in the current climate, any employer insolvency crystallises members' benefits and if schemes are underfunded members will receive a lesser pension payout than promised. It is also a blow to other PPF levy payers - who pick up the bill via increases in the levy. We will look into such situations to assess whether they have been deliberately manufactured with the aim of avoiding the pension scheme debt.

To-date in a small number of situations we have seen a potential investor take control of a struggling company by purchasing the senior debt from the lender. This position is then used to trigger a pre-pack insolvency with the investor in the best position to buy the resulting business with the pension liabilities removed.

We have already opened investigations into a number of such situations to ascertain if it is appropriate to take further action in support of the pension schemes.

These investigations are at an early stage, seeking information from a variety of parties. We cannot pre-judge what, if any, action we will be able to take.

Communicating our approach to regulation

When I joined the regulator I undertook to increase transparency about our regulatory activity in order to help the industry to better understand when and how we investigate employer or scheme activity.

Over the past year I believe we have made some positive steps in that direction. We have made use of our ability to publish s89 notices on a number of occasions and you can expect more such reports of our case considerations in future.

I hope that the industry will find these reports useful.

It remains important to emphasise that we see a significant variety of circumstances and that every case must be judged on the specifics of that situation and by weighing up the particular benefits and risks to members. Nonetheless, after 6 years experience I think we should look to see whether we can set out more general principles that have emerged from our deliberations during that period - to give you all more clarity about the “rules of the game”.

The shifting landscape – UK and Europe

No discussion of the future of pensions regulation in the UK would be complete without also reflecting on the current review of the IORP Directive - the EU directive for pension funds - by the European Commission.

In March of this year, the Commission asked the EU's 27 national pension regulators who make up EIOPA - the European Insurance and Occupational Pensions Authority - to provide what is known as "technical advice" on a range of questions about the EU's regulatory regime for DB and DC pensions. In particular, they asked for a view on the degree to which rules set down for insurance companies in the Solvency 2 Directive could be applied to pensions.

These questions focused on the scope of the IORP Directive, governance standards, funding rules, investment practices and information disclosure.

The Pensions Regulator took part in these discussions, highlighting the intricacies of the UK approach, especially the important role played by the employer covenant and how, in marked contrast to the Solvency 2 approach, full credit should be given to sponsor support when calculating assets and liabilities. We also underlined the role and value of the Pension Protection Fund.

I know that many of you in this room will agree with me that it is essential that any future EU proposals must take account of these two key elements of the UK regime - the employer covenant and the PPF.

The next step in the review of the EU pension regime comes when EIOPA will undertake a public consultation on its draft response to the Commission. This document, as you will shortly see, contains many different options and is quite lengthy. We urge UK stakeholders to send responses to EIOPA and we shall be holding a special briefing for all pension stakeholders in November to help you navigate your way through the document.

EIOPA will then consider stakeholder responses before submitting its final response to the European Commission around the end of this year.

Final decisions on any new EU law will be taken at a political level - by national Ministers meeting in Council and by MEPs in the European Parliament - but our input at a technical level will at least ensure that the key elements of the UK approach will be fully considered at the point when the European Commission makes its proposals. I should add, perhaps, that we estimate that any new rules resulting from the review are unlikely to come into effect before 2016 at the earliest - and it is quite possible that any major changes would probably be only adopted after additional transitional arrangements lasting several years.

Conclusion

We have an important opportunity now to make a real difference to the standard of life that millions of people in the UK enjoy in their retirement.

The Government's reform of the state pension and the introduction of automatic enrolment, will improve incentives to save and in the long term have the ability to make pensioner poverty a thing of the past.

The work we are doing to maximise compliance with automatic enrolment and to improve outcomes from DC schemes are key to getting our hands on this valuable prize.

We must all work together to ensure that every person who is automatically enrolled into a pension scheme is enabled to get a good outcome from their savings and to receive worthwhile benefits from saving.

This is an invaluable prize for our industry and the next 12 months and beyond will be a critical time in laying the foundations.

I look forward to working with many of you as we move ahead and I welcome any and all suggestions, feedback or thoughts about how we can work together to reach the outcomes we all desire.

Thank you.