Reducing DB schemes stress

Hi, and welcome to our Pensions Age video interview. I’m Laura Blows, editor of Pensions Age, and joining me today is Tim Middleton, technical consultant at the PMI, to discuss DB scheme funding.

So Tim, this has been an issue that has been in the press a lot lately, both in the trade media and the national press. What have been the issues with this? Why has it become so prominent?

Well it is unusual for something so technical involving pensions to achieve a national profile in the press the way that this has. But there have been two very high profile cases. Firstly we saw the case with British Steel, which was looking to restructure its UK business and couldn’t really do any kind of restructuring deal due to the deficit in the pension scheme. So this created a major problem in south Wales.

Then we’ve also seen the very high profile case with BHS, whereby Sir Philip Green offloaded this scheme to Dominic Chappell and the scheme was quite seriously underfunded and there was the issue of how this deficit was going to be made good.

Over a year ago we had David Blake at The Pensions Institute put out a paper called The greatest good for the greatest number, which argues that there were in fact a number of so-called stressed schemes – seriously underfunded schemes – which were never going to achieve full funding and so it would be pragmatic to consider alternatives to just having these schemes drop into the PPF.

All of this culminated in a Green Paper the government put out earlier this year, which explored a number of options for DB pension schemes that have some kind of underfunding problems.

The main areas that it focused on, which caused the most controversy and discussion with the industry, are the subjects of whether we should allow schemes to scale down benefits that have been accrued, reduce accrued rights or alternatively, to consider the suspension of indexation of benefits in payment. And the other thing it looked at was could we improve funding for schemes if we were to consider consolidation of stressed DB schemes.

So there is quite a lot coming into discussion here and it had provoked some very interesting debates within the industry.

So a couple of solutions you mentioned were the reduction in accrued rights for DB scheme members, and also suspending indexation.  What would you say are the pros and cons of these suggestions?

The most obvious pro at the moment is that we have a simple binary choice for an underfunded scheme. One, it’s required by law to achieve full funding within a set period of time – its recovery plan. If that doesn’t happen, if the scheme sponsor does go under and the scheme is seriously underfunded, then the scheme will drop into the Pensions Protection Fund (PPF) and that will provide guaranteed benefits. Things have been working very well for the PPF at the moment, but of course for many people they will see a reduction of benefits [being in the PPF] compared to what they would have had, had the scheme been fully funded.

Now the argument here is that it is a real pro for some people, in negotiating reduced pension benefits, because although they might not get what their full entitlement might be under the scheme rules, they would at least get a better benefit than what would be provided under the PPF.

So, on the principle that half a loaf is better than no bread, it would be beneficial, from a purely pragmatic perspective, to allow people to have reduced benefits that are still better than what the PPF would provide.

Now the big con with this is that once you allow the benefits to be reduced in some way, it does open a can of worms. You have to decide the circumstances under which you allow this to happen.

Once you set a precedent of allowing a scheme sponsor to walk away from its existing responsibilities, then you have the problem that you can have the unscrupulous employer trying to create or manufacture a situation whereby it walks away from its responsibilities where otherwise it may have been in a position where it could have achieved full funding.

So the problem is how do you determine the circumstances where you would allow a scheme to pay out reduced benefits. Under what circumstances would you allow that? It’s very difficult to have absolutely precisely defined terms under which it would be allowable for a scheme to proceed under that basis. It is a very difficult thing to do. On the one hand, it would be nice to think a scheme could pay out better benefits than simply the default option at the moment, which is the PPF. But on the other hand, it’s working out exactly what the circumstances are that would allow that to happen.

So it can be difficult to weigh up the pros and cons. I believe the PMI actually surveyed its members, asking their views on a reduction in pension rights. What were their responses to weighing up these issues?

We did quite an extensive survey and this formed the basis of our response to the Green Paper. We asked that particular question. It was probably the single biggest question in the whole of the green paper – do you agree that people’s accrued rights should be allowed to be reduced. The majority of our members – 70 per cent – said you should not allow this under any circumstances. So we had a 70/30 split amongst our members.

I have also seen this debated elsewhere and that 70/30 split is consistent with what I have seen where it has been formally debated in other places as well.

So that response seems quite clear, with 70 percent against reducing benefits.

Yes, but we did ask a further question saying that if you did allow it, under what circumstances would you allow it to happen.  Overwhelmingly, the only circumstance in which people thought it might be acceptable would be if it was to keep a scheme out of the PPF. So there is an idea that people recognise, from a purely pragmatic level, that if it means giving people better benefits than what would be paid by the PPF, than it would be an acceptable idea. But I think we have to emphasise the point that 70 per cent versus 30 per cent is a fairly clear majority who wouldn’t want the current rules changed at all.

Another suggestion you mentioned earlier to try to tackle the issue of DB scheme funding was arguably an even more extreme solution, which is that of DB scheme consolidation.

It is an interesting idea certainly, and if you could make it work, you could make a lot of smaller schemes merge into one larger scheme. But there’s a real problem there. It’s about creating some kind of Frankenstein’s monster out of various bits and trying to weld them all together. There are some really significant technical difficulties that would make this a very difficult thing to do. You have got to consider the differences in scheme covenant between one employer and another. It is particularly important in the context of stressed schemes. There are also the differences in funding levels and differences in scheme maturity. Corporate culture is another factor that has to be considered. So whilst on paper it looks like a nice idea, in reality trying to merge very different schemes together, which have got very different histories, would be a logistical nightmare. It would be a very difficult thing to try to achieve. So I would be interested to see if anybody can come up with some practical ideas for how this could be made to work.

It seems these are going to be the discussions the industry and beyond will be having for quite a while.

It is one that, as Private Eye would say, will run and run.

The modern age
Deputy editor Natalie Tuck chats to the ABI’s Yvonne Braun about her work at the ABI and her thoughts on key pension topics

Stepping into the spotlight
Laura Blows speaks to Laird R. Landmann, group managing director and co-director of fixed income at US-based TCW, about the opportunities TCW can provide for UK pension funds