By Ilonka Oudenampsen
Low gilt yields could lead to big increases in the levies schemes pay to the Pension Protection Fund (PPF) in 2013/14, Towers Watson has warned.
The PPF calculate levies by putting several pieces of data into a prescribed formula, but the funding data used is highly sensitive to gilt yields, which have recently been at record lows. As each day’s market conditions feed into levy calculations, the longer gilt yields stay this low, the more impact it will have on next year’s levy.
The development of market conditions between now and 31 March 2013 and each scheme’s circumstances will affect how much levies will go up next year. However, Towers Watson estimates it would not be uncommon for levies to increase by 25 per cent, based on current market conditions and if the current levy formula remains in place. The consultancy said that, even if gilt yields were to rise strongly and assets perform well over the next nine months, large increases for many schemes would still be likely.
Towers Watson senior consultant Joanne Shepard said: “The PPF’s five-year smoothing formula means that, for 2013/14 levies, data for the year to March 2008 will drop out of the equation and be replaced by data for the year to March 2013. Gilt yields are much lower now than they were five years ago, so average underfunding levels are going to look worse and that will make levies bigger. Ironically, smoothing is leading to some very bumpy outcomes. The increases that are on the cards can be serious money for the sponsors of large schemes whose levy bills are already hundreds of thousands, and in some cases millions, of pounds each year.”
Some employers might offset some of the impact by new security pledged to the pension plan, by improvements in the D&B score, which determines the assumed risk of the employer becoming insolvent, or by changes to the investment model.
Shepard added: “Employers should think about this sooner rather than later. For example, the PPF now looks at D&B scores at the end of each month in order to assess an employer’s strength over the year, so the sooner action is taken the more impact it could have. However, as there are now only 10 bands of insolvency risk rather than 100, employers need to consider whether they can improve their score enough to move up a whole band. Changes which would previously have had a small impact will now either make a big difference or no difference at all.”
However, legislation prevents the PPF from increasing its total expected revenue from levies by more than 25 per cent in any one year.
“Some employers can certainly expect very significant increases. The question is whether the overall impact will be big enough to make the PPF go back to the drawing board and change some of the numbers in the levy equation,” Shepard commented. “This could happen either if the 25 per cent threshold would otherwise be breached or if policymakers thought higher costs for employers would make it harder for the economy to turn the corner. Although bigger deficits do pose more risk to the PPF, it always expected that levies of £550 million a year would more than cover new claims and enable it to build up a war chest for the future.”
Aon Hewitt principal consultant Milan Makhecha added: “UK companies should not let their financial fate rest in the hands of the PPF. If they proactively manage the credit ratings used to establish PPF levies – D&B failure scores – they can achieve a significant reduction to their eventual PPF levy. For example, in our experience it is not uncommon for small increases in D&B scores to lead to reductions of around 50-60 per cent in PPF levies.
"It's clear that the PPF faces a difficult dilemma – whether to bank the levy windfall from low UK gilt yields, or tinker with the fixed formula they set last year. The problem for companies is that they may not know what the PPF decides to do until September. This may be too late for some, given the PPF takes a 12-month average of D&B failure scores for the levy calculation, but many UK companies still have time – if they act fast – to understand their credit rating and act to improve it."