Consolidating DB schemes could prove a solution for small schemes with significant deficits, but how can the UK move ahead? James Phillips reports
Defined benefit (DB) consolidation has been put forward as one of the solutions to climbing scheme deficits, especially for smaller schemes.
The idea is smaller schemes cannot grow their assets as quickly as larger schemes, while liabilities mount, because they do not have the same investment opportunities available to them.
Meanwhile, a lack of funds can have an impact on governance standards and create inefficiencies.
There are nearly 6,000 DB schemes in the country, but many industry professionals believe this is too many, and small schemes should be merged together, and with a larger scheme, to leave the system with fewer, but larger schemes.
Two types of consolidation model are commonly spoken about. The first would see small schemes merged into one large scheme, but with individual segments to compartmentalise assets and liabilities. This would ensure the other schemes do not bear the risk of having to pay for incoming schemes' deficits.
On the other hand, all schemes could be merged into a unified scheme, where assets and liabilities are shared. However, this could raise problems with section 75 debt regulations, as seen in the Plumbers' Pension Scheme, where solvent employers have to pick up the tab for companies that go bust.
The Pensions and Lifetime Savings Association (PLSA) last year launched a report on the state of DB, concluding the system was too fragmented, risked members' benefits and needed greater consolidation.
Yet its interim paper did not advocate a particular model. The association's DB taskforce chairman Ashok Gupta says it does not yet have the evidence it needs to back a particular model.
"We're looking at what type of consolidation model is most likely to work, and what are the benefits of various models," he says. "Doing nothing is creating the worst problem, because you leave sponsors with a never-reducing bill for legacy benefits.
"Something needs to happen, but we've not yet bottomed the benefits of the various models."
Perhaps the industry can provide a steer. JLT Employee Benefits director Charles Cowling and Pensions Institute director Professor David Blake both believe the segmented model is the way forward.
Cowling says this is because the total aggregation option has proven to be the least desirable.
"Where liabilities and assets are segregated, you don't have the risk of an employer picking up the tab for somebody else's deficit," he argues.
"A lot of the old multi-employer schemes that were set up were not segregated because they were well before section 75 debt issues were of any relevance. They tend to have everything pooled, which causes problems, because one group of employers ends up subsidising others."
Blake says: "The benefits come from having better governance, the assets have a scale, you have a common investment strategy, but the liabilities sit with the original scheme.
"If you're going for proper merger, you'll end up with a last-man standing model. Then you've got all the problems as we've seen in the Plumbers' Pension Scheme. No-one is going to vote for that."
Small schemes certainly have the most to benefit from scheme consolidation, but it should in no way be limited to just small schemes.
"The starting point is there is definitely a problem with small schemes," Gupta states. "You can create efficiencies through consolidation. Do you then say to larger schemes you are going to prevent them from accessing these efficiencies?
"The large schemes could be the schemes doing the consolidation. We tend to look at it and say 'can you create consolidation to deliver benefits?'"
However, there is an argument that an upper limit exists on scheme size. The larger the scheme is, the more its investments are likely to affect the market, potentially affecting its actual ability to invest.
Cowling does not believe this would ever be a problem, but does caution against the potential effect on market competition.
"Size gives you massive buying power at the investment end. I've seen that not just in the UK but globally," he states. "Some of the massive pension schemes in North America have got very significant buying power.
"Inevitably, there will be a size beyond which it is too big, and there's also an issue of creating competition. If you are going to aggregate, you don't want to entirely take competition out of the system because that creates inefficiencies.
"There will be a limit but it's so far away that it's not something we need to worry about."
This is a point Gupta does recognise, however, although he agrees with Cowling, stating schemes would need to be "in excess of £100bn" before facing problems with investment.
Blake believes it is not the size of the schemes that matter, but the companies and industries involved.
"You've got to look at where the synergies can be best explored," he argues. "Companies in the same industry have more natural synergies because they know each other. You can't have strangers on the train.
"There's got to be some basis for trust, understanding the industry's problems, and taking this forward."
Yet, he does recognise a counterargument that combining schemes within the same industry does not diversify risk. If the industry suffers a downturn, all of the schemes are likely to be hit.
For small schemes, there are immediate advantages to funds coming together, in that it creates economies of scale, where investment opportunities are greater and more varied.
It can also mean funds can pool together for greater investment and other expertise, and reduce some administrative costs that come with running a scheme.
JLT Employee Benefits reported schemes could save as much as £500m every year if there was greater consolidation of DB funds.
On top of this, schemes could benefit by being able to write new rules. Upon agreement from members and winding up, trustees could agree new terms of managing the fund, providing greater opportunities to rid themselves of out-dated or badly-written rules.
For example, the move could provide the chance for schemes to move from the Retail Prices Index (RPI) to the Consumer Prices Index (CPI) where they had previously been unable to do so because RPI was hardcoded.
Cowling says: "There are two ways you could consolidate," he says. "You could consolidate with your existing scheme rules or with new rules.
"With existing rules you lose some of the benefits of consolidation. It seems to make more sense to consolidate into a standard set of rules but, if you're going to do that, you've got to make sure you're not going to prejudice members.
"This might be a creative way if you've got very badly worded rules. You could get permission to merge into rules that are much better worded."
Yet Blake argues the UK has already missed out on an opportunity to receive the full benefits of consolidation, arguing we should have made the move decades ago like the Dutch.
"With the demise of DB, this really is a case of bolted horses. It ought to have been done when the Dutch did it," he states. "We might have saved the DB model, or modified it along the defined contribution model. We might have preserved a better model than we're moving towards."
Nevertheless, the UK could still salvage some of the remaining DB schemes through consolidation. In fact, technically there is little stopping schemes doing anything right now, but there has been little uptake. What is stopping them?
Gupta states it's a combination of factors: "The benefits structures are complex, the system wasn't built to facilitate consolidation, and there is myriad issues which get in the way, such as regulation, administration, and culture.
"You need to create the right incentives, and you need to have the right sticks as well."
Cowling says providing incentives or promoting benefits is the best approach, as the government is unlikely to mandate any action.
"Theoretically, DB consolidation is possible already but there's a fair bit of inertia," he says. "It's turkeys voting for Christmas; people don't want to propose solutions that write themselves out of a job.
"Those things you can get around by more direction, although the government is probably going to be loath to. It goes against a principle of free trade to force the schemes to do something."
What we do know is the government will include something on DB consolidation in its upcoming green paper on regulation of the sector. However, how far it is willing to go to push DB schemes in this direction is yet to be seen.
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