New DB life expectancy improvement funding approach could boost investment

A revised regulatory approach to how defined benefit (DB) pension schemes fund for life expectancy improvements could potentially allow for “significant investment” to boost the economy after the pandemic, according to analysis by PwC.

The firm’s analysis found that more than £130bn is tied up in UK DB pension schemes due to previously projected life expectancy improvements, which have not yet materialised.

Furthermore, it stated that the redirection of just one third of these reserves could support the creation for around 150,000 new jobs for the next decade, in turn boosting the broader economy post-Covid-19.

In particular, the firm has recommended a revised regulatory approach which reduces the cash required from viable companies in the short term, even if prudent assumptions are made for the long term.

The analysis explained that pension funds, on average, are assuming life expectancy continues to improve by 1.5 per cent per year, stressing that this can build up to substantial reductions in death rates after being applied every year for several decades.

Considering this, it emphasised that, although pension schemes must be run prudently, DB funding is a “one-way valve” with sponsoring companies facing difficulties when looking to retrieve surplus assets.

It also noted that whilst the current regime includes a similar feature for asset performance, where prudent allowance is made for future investment returns but the shortfall is not plugged with additional funding, no such facility exists for life expectancy assumptions.

PwC global head of pensions, Raj Mody, added that whilst it's natural for pension schemes to make conservative assumptions, long-term life expectancy is “notoriously difficult to predict”.

He stated: “The challenge for pension scheme funding is that if the assumptions overshoot reality, then money will be tied up in the pension scheme and difficult to get back any time soon.

“There is a complex trade-off for companies and trustees to consider - put the money into the pension scheme now if you think the company won’t be able to support the fund in the future, or reinvest now to create new jobs and strengthen the business for the future.

“It’s a tricky dilemma - for trustees, sponsors and regulators - to balance the issues of prudent management of pension funds versus how to deploy limited resources. It would be easier if the regulatory framework allowed more flexibility.

“Even if prudent assumptions are used to calculate the target deficit, what if a much longer period of time was allowed to fund the difference, or contingent arrangements were put in place?”

Indeed, the analysis found that the average deficit recovery period was around seven years, with a gradual trend for that period to be shortening over time.

However, PwC noted that an alternative for many viable companies could be a more gradual approach to funding prudent longevity forecasts, such as doubling the recovery period for this component to an average of 15 years, for instance, which would allow gradual corrective action over time as future projections firm up.

The firm also illustrated the effect of different forecasts by considering the example of a female member aged 45, with standard assumptions already allowing for that member to live to 86, assuming no extra long-term improvements.

It stated that using an additional 1 per cent per year long-term improvement, she would be expected to live to age 88, whilst improvements of 1.5 per cent per year would expect her to live to 89.

The firm clarified however, that if these improvements were to happen, those extra years of payments wouldn’t be needed until after 2060.

PwC pensions actuary, Emma Morton, added: “We might hope for substantial improvements in longevity, but that doesn’t necessarily mean that viable businesses should pre-fund their pension schemes today for that future scenario.

“While new medical technologies may improve life expectancy, there is the question of how accessible and affordable those treatments would be, for the specific population and age profile of defined benefit pension scheme members.

“There is the question of how soon any new innovations would be widely available."

She continued: “Current practice means that trustees are asking sponsors to fund for these long-term improvements over a relatively short period.

“But most trustees and sponsors have time to see whether or not these improvements are likely to happen.

“They carry out formal funding checks at least every three years, with informal reviews in between, so the matter can be kept under consideration.

“Another solution could be to fund for the potential impact in separate arrangements, so-called Reservoir Trusts, which support the pension scheme but are also easier to refund back to the sponsor if the funds are ultimately not needed.”

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