In his second article on DB issues Con Keating asks what the purpose is of a pension fund?
In the course of preparing the earlier article on the valuation of corporate defined benefit (DB) pension liabilities, discussions with pension professionals indicated that they hold a surprisingly wide range of views on this subject.
Many questions appear to have passed unasked or at least not to have been considered widely or deeply. Why do companies opt for the institutional forms we observe; why do trustees accept the arrangements established? What are the costs and benefits of these and other possible arrangements; what motivates the choices made?
By way of starting point, it should be recognised that a sponsor might well retain contributions internally while making a DB pension promise. No fund is in fact necessary. Pensions are paid when due by the sponsor employer. The pension is offered by the sponsor employer as part of an employment contract, and this form of organisation would have the attraction of being simple and reflecting that basic commercial reality. There appear to be no tax or National Insurance obstacles.
Some ‘unfunded' schemes do exist in the UK, but they are almost invariably supplements to other arrangements which themselves assure adequate or even good retirement incomes; for the beneficiary, these are cream for the cake they already have.
In this arrangement the retained contributions constitute part of the capital base of the employer and are shown in company accounts as a book liability. They might serve to reduce a company's indebtedness to banks or dependence on capital markets. The scale could be significant - for a mature scheme, with terms similar to those commonly observed in the DB world, these might amount to book liabilities of between four and six times the annual wage bill. This would be long-term finance, which may otherwise be either unavailable to or unaffordable by the company.
Of course, for a mature scheme with a stable workforce, the payment of pensions to retired workers would place cash flow demands upon the company, and under plausible assumptions, these cash flow calls may lie in the range between 30% and 60% of the annual wage bill. By virtue of its high predictability, this is surely manageable.
The objection that the liabilities reported in accounts would be highly volatile and could overstate the true cost of this pension capital to the company under current accounting standards may be true; and this could constitute an obstacle to their introduction now. However, that objection does not explain why they did not exist in the past.
Most of the objections to the book-reserve arrangement centred on the failure of the sponsor, the likelihood of employer insolvency, and many stated that this was why pension funds existed. Almost none had any informed idea of the prevalence of insolvency among companies in the economy as a whole, or of the Pension Protection Fund's (PPF) experience. The few that did offer an opinion seemed to think that it was extremely high and a number cited the alarmist study from the Pensions Institute which forecast 1,000 insolvencies in the coming decade.
If the current, low rate of insolvency (0.4% p.a. by number), which is reflected in the experience of the PPF, continues, this number is likely to be 250 insolvencies; a return to normal rates would see 350 occur, and it would take a rate of 1.8% for the projected 1,000 to occur.
Such an insolvency rate is without sustained precedent in the post-war history of UK corporate finances. Those with experience of covenant review for their schemes expressed these judgements qualitatively rather quantitatively, using expressions such as good, poor, high or low.
Notwithstanding these observations, all were fully aware of the highly publicised difficulties of a few schemes. Given the catastrophic nature of sponsor insolvency, it is perhaps not surprising that perceptions might exceed and overemphasise the reality.
While the prospect of insolvency should be and is a valid concern, this does not, in and of itself, warrant the creation and maintenance of a fund; other arrangements, such as pension indemnity assurance, may prove superior in any of a number of ways.
This form of book-reserve arrangement is common in Germany where there are some 93,000 insured schemes and in Sweden, where the mutual PRI-Pensionsgaranti provides this insurance to the 1400 book-reserve schemes of some 700 corporate sponsors. Indeed, there are examples of precisely this type of arrangement occurring in the UK during the 1930s.
The cost of this insurance has historically been far lower than the costs of maintaining and administering a funded scheme; 0.3% of liabilities versus 2% of assets. These indemnity insurance arrangements pay the full benefits of scheme members, while funded schemes need to be funded to higher levels than full-funding of the best estimate of liabilities if they are to successfully run-off liabilities fully or execute a bulk annuitisation, post sponsor insolvency.
With these costs of run-off or annuitisation in the range between 120% and 140% of the best estimate of liabilities, this represents an additional annual cost of the order of a further 35 to 70 basis points annually. In reality, few schemes will be so well funded at the point of sponsor insolvency and in most cases members will suffer a reduction in pensions to the levels set by the PPF. Put another way, funding a DB pension scheme is at best an expensive way to mitigate the risk of sponsor insolvency and at worst incomplete.
Companies should, quite rightly, resist the efforts of trustees to fund to these higher levels and incur these extra costs, as should other stakeholders. It is only by consideration of the further effects of the presence of a funded scheme in the balance sheet and income statements that the management of a company may justify funding to such levels, and in general other stakeholders should continue to resist this.
It is notable that the majority of these further effects stem from the use of market-consistent discounted present value liability accounting rather than a true and fair view of the company position.
While many other aspects of pension funds have been discussed in the academic and practitioner literature, these are incidental consequences of the existence of funds rather than motivations for their creation.
Take the case of market liquidity: it is undoubtedly true that the presence of pension funds in traded securities markets enhances the liquidity of those markets for all. However, this particular benefit does not come without cost to the fund; by investing in liquid securities it is both paying the cost of liquidity and accepting the unique, high risks of the most actively traded securities in a market.
With this large a cost disparity between buying insurance cover and operating a pension fund, some additional motivation is needed to justify the wide-spread use of pension funds.
Put simply, if the concern was merely with insolvency and its consequences, the scheme would simply buy pension indemnity and have this issue resolved cost-effectively and fully.
Indeed, it seems likely, if these were the sole concerns and motivations, that we would by now have seen regulation of the credit standing and sustainability of companies permitted to offer authorised DB arrangements, as well as limitations on the generosity of benefits awarded by a company, notably with respect to the accrual rate embedded in awards. Indeed, if this were the complete motivation, the PPF would be expected to offer full, rather than reduced benefits to the members of schemes whose sponsor had failed.
"... when you have eliminated the impossible, whatever remains, however improbable, must be the truth" This, then brings us to the sponsor employer. In the earlier companion to this article, Pension Liability Valuation, the two elements of the cost of DB provision were distinguished: contribution and accrual rate cost.
In contrast to the apparently popular and prevalent view that the pension fund exists to provide security to scheme members and to pay their pensions on time and in full, it appears that the pension fund primarily exists to offset or defease the accrual cost of occupational DB provision the production cost of the sponsor employer, and only incidentally to offer a degree of security to members.
With this motivation for the existence of a fund, the responsibility and management of the fund rightly rests with its prime beneficiary, the corporate sponsor, and only secondarily with the trustees as the agents and representatives of scheme members.
Moreover, this viewpoint goes far in explaining how the well-intentioned but fund- and security-centric regulation could have so disastrously backfired and led to scheme closure and widespread cessation of provision of DB pensions.
Finally, it would also explain many of the perversities of investment and scheme management that have developed in the past decade. It is notable that schemes outside of these regulations and reporting standards have not embraced these techniques to anything like the same degree.
With this worldview, the objective function for investment management is simplicity itself; it is to achieve sustainably the accrual rate or better, a well-defined target. Realisation of this accrual target objective, in turn, makes pensions secure for members, and facilitates the continuing provision of occupational DB pensions.
Con Keating is head of research at Brighton Rock Group
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