Solutions for rising DB deficits are being sought from a wide range of bodies, including the Work and Pensions Committee. James Phillips explores some of the suggestions
The defined benefit (DB) industry is arguably in crisis. Falling discount rates and gilt yields are sending schemes spiralling deeper into deficits, with more and more moving into the Pension Protection Fund (PPF).
But the industry thinks there is a way to salvage the benefits in order to protect members' retirement incomes.
The views are expressed in response to the Work and Pensions Committee's (WPC) inquiry into DB regulation, which seeks the best way to alter the pensions landscape to make sure members are not left overly disappointed.
The inquiry received around 75 submissions from across the industry, and will be exploring them in more detail in evidence sessions in October.
Here's what some of the contributors hope the WPC considers.
Some respondents voice concerns the regulatory regime is too rigid to allow schemes to take proactive action by temporarily reducing members' benefits. Schemes are unable to take temporary measures to protect members' benefits prior to declaring insolvency and moving the fund into the PPF.
In its response, Aon Hewitt argued when a scheme is underfunded, the trustees and sponsoring employer should be able to agree to reduce benefits. This would avoid the scheme moving into the PPF and cutting benefits even further, while costing employers' jobs.
It called for a greater use of conditional indexation, assuming schemes satisfy the regulator that it would be in members' best interests.
Cardano also pointed to this conclusion in its response and stated if a major financial crisis, or recession, hits, a large number of schemes could move into the PPF, straining its resources and resulting in higher levies for surviving companies.
As a result, these surviving companies would face higher pension administration costs, reducing their ability to invest in their business, and therefore increasing the likelihood of their own scheme going into the PPF.
Aon Hewitt suggested introducing more flexible, intermediate solutions that aim to dodge the PPF bullet, as long as there are safeguards to ensure sponsoring employers do not force schemes into difficult funding positions to ensure lower benefits are paid.
Such possible solutions would include allowing indexation to be converted from the retail price index to the consumer price index, reducing benefits, swapping a variable employer obligation for a fixed obligation, or swapping guaranteed increases for conditional indexation.
Aon Hewitt principal consultant Lynda Whitney says allowing schemes to use conditional indexation would protect member benefits above the PPF level, while allowing increases where there is enough money to do so.
"At the moment, the situation is very black and white. Either the company is viable and is expected to pay everything it promised, or the company is not viable, and the scheme is going to the PPF with reduced benefits for members.
"The middle ground, for example, is conditional indexation where there are no guaranteed increases. There would be an investment aim to provide increases; you can guarantee to pay no increases, but aim to pay more. Members will still end up getting something better than they would in the PPF.
"Our recommendation is where it is in the best interests of members, there should be the ability to have a solution that sits between the 'everything is guaranteed' and 'you're in the PPF' from the members' perspective.
"From the corporate perspective, it should be between 'you have to pay everything' and 'you're out of the game'."
Such safeguards would mean access to these intermediate solutions would only be possible with the mutual agreement of the trustees and the Pensions Regulator (TPR) that it would be in members' best interests.
Redington head of DB Dan Mikulskis agrees the select committee should recognise employers need flexibility.
"Regulation is trying to mitigate the covenant risk that exists in a lot of underfunded schemes, where they are dependent on the employer to continue to exist, as well as mitigate the risk to the PPF. There is a key balance to be acknowledged.
"You don't want to be so draconian with regulation in the pursuit of security that you end up forcing businesses out of business that, if given a little bit of flexibility, would be able to ride out a temporary bad patch.
"Flexibility is key and what that means in practice is flexibility over the term of the recovery period and possibility on the actual valuation basis of the recovery plan."
All agree that although members could lose out on full benefits, providing flexibility would improve the chances of members receiving benefits above PPF levels.
Aon Hewitt said: "For many current members of DB schemes, an intermediate solution would mean changing to a reasonable chance of success (of receiving their current pension promises) rather than a guaranteed certainty of failure."
Schemes may also be too focused on the present value of their assets and liabilities, rather than whether they will be able to pay their obligations when required.
In its response, Cardano argued the technical provision basis helps schemes deceive themselves about the true value of their liabilities. It said schemes should instead move to a risk-free economic basis for valuations.
Head of innovation Stefan Lundbergh says: "We should abandon the technical provisions when actuaries make assumptions on how much assets will grow, which deflate the size of a deficit. It allows schemes to use the swap curve or gilts for the valuation and then they tend to use the one that makes liabilities look smallest.
"If schemes do this, it's like if you're feeling a bit sick and a thermometer tells you your temperature is 39 degrees, so you say 'maybe I should regrade my thermometer and declare myself healthy'. Or, instead, you say 'I'm sick, let's do something about it'.
"We need to change the regulation about how we steer and evaluate pension funds. You need to value the liabilities one way or another, so why not use an economic valuation instead of technical provisions?"
The firm believes such an economic basis would help DB schemes get to grips with deficits much more effectively, reducing the risk of the schemes going into the PPF.
But Whitney disagrees, arguing that the technical provisions basis should not be dropped and that each valuation measurement provides use to different parties.
"The solvency basis is giving trustees information about what the funding position could be if the worst happened, which they can take into account," she says.
"That's not a bad measure. When you're looking at the accounting method, it's trying to compare one company with another company in a fair way.
"It is a more proscribed approach, whereas scheme funding is all about being scheme specific and taking into account integrated covenant investment funding. It's the right measure for asking how much cash trustees need to ask for the company for.
"It sometimes makes it difficult for people to understand pension funds, but there is a logical rationale behind the different measures."
Nevertheless, some schemes are not in difficult situations, and have mitigated the effect of a stagnating economic environment. For example, the Co-operative group recently reported its pension surplus had increased by 78% over a year. RRedington's Mikulskis worries schemes are ignoring examples of best practice when there are lessons to be learned, which could help other schemes in dire funding situations.
He says: "There are a lot of challenges for DB schemes. Clearly, when one looks at various barometers of the overall financial health of the system, things don't look great, but there are some success stories.
"There are some schemes that have been able to navigate from positions of poor financial health to much stronger positions, contrary to what's happened to other ones. A thorough analysis of what's created the conditions for these success stories is quite important, and that's definitely worth focusing on."
Aon Hewitt agreed, but argued for a more global outlook to consider how schemes across the world are managing both DB and defined contribution (DC) schemes. Whitney says: "We need to look globally at what is happening with schemes.
"In the Netherlands, you can see how they've moved from a lot of schemes to a much smaller number, reducing the costs and improving the efficiency.
"In Australia, in the DC environment, they have to justify how they are giving value to members - part of that is considering whether it would be better off as part of a bigger scheme.
"There is something to think about in terms of the structure we have in the UK and if it can be improved upon for efficiency."
These are just a few of the arguments that the WPC is likely to hear in its evidence sessions, and it is uncertain as to what the conclusion of its inquiry is likely to be.
But, of the submissions seen so far, it is unanimous some change is needed on DB regulation.
The industry will simply have to wait until the New Year to find out what is recommended, and then watch out for the government's response.
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