We Know Zero

The Pensions Regulator has a consultation on the go. In fact they have two: regulating defined benefit pension schemes and regulating public service pension schemes. Both started in December and are due to wind up in February. The defined benefit pension schemes one alone runs to over 160 pages across the four documents published. All at the busiest time of the year for most pensions actuaries, caught between the 31 December 2013 accounting disclosures and the looming deadlines for submitting the 31 December 2012 scheme funding assessments. Could it be that they are rather hoping to limit the feedback they get?

Because the changes that are being proposed to the funding regime known as scheme specific funding which has run for 8 years are dramatic. Under the pretext of only making changes to allow the introduction of the Regulator’s new objective to “minimise any adverse impact on the sustainable growth of an employer” (see my previous post on this), they have effectively announced the death of scheme specific funding and proposed a system which looks very much like the Minimum Funding Requirement (or MFR – the previous discredited funding regulations) mark two to me, although the Regulator insists that it will be completely different this time.

The main problem with the MFR was that it was a one-size-fits-all approach (although it did vary in strength depending on how far on average members had to go until benefits were paid – known as the duration of the scheme), which encouraged an inappropriate level of contributions for many schemes (the minimum funding requirement effectively became a maximum funding requirement in many cases).

Fast forward to now, and the new proposed funding approach based around something called the Balanced Funding Outcome (BFO). This calculates a required level of assets for each scheme on an “objective liability measure, independent of the scheme’s funding assumptions”. The actual assets will be compared with the required amount and a recommended level of contributions to get up to the required level will then be calculated by the Regulator. The contributions the scheme trustees have agreed with the scheme’s employer will then be assessed to see if they measure up. Where MFR varied by duration, BFO will vary by duration and covenant (how likely the employer is to stick around to pay the last pensioner). So, as you can see, completely different!

At the end of Appendix G of the 50 page draft funding policy, we finally find the problem that I think the Pensions Regulator really wants to solve:

Look at all those dots. They’re all over the place. There is currently absolutely no correlation between the deficit reduction contributions (DRCs) employers are paying and the funding level in their schemes. The Regulator is determined to change that, by giving trustees and employers sight of their preferred contribution number during their negotiations. The contribution number won’t be compulsory of course, but if you use it then the Regulator will leave you alone. It is almost as if they have never heard of Daniel Kahneman or behavioural economics.

What will happen? Well who knows but here’s a guess. Schemes to the bottom left of the chart above (ie low assets and contributions) are already being subjected to extra scrutiny and generally have employers in such a poor financial state that there is very little they can do about it. But those in the top right will effectively have been given permission to swoop down to the blue line with a whoop of “Pensions Regulator’s new objective”. It will be like the 90s all over again when pension schemes took contribution holidays because they were measuring their funding in an unrealistic way. It will be seen as financially stupid to be in the top right of the Regulator’s graph. Group think will be in charge once more. But, to use another quote from Yogi Berra, the baseball icon, “If you don’t know where you are going, you might wind up someplace else”.

If we agree to this we will be making the pensions system more fragile. The model used by the Regulator will not anticipate the next defaulting economy or other Black Swan that throws currency and financial markets into meltdown (no one was suggesting Argentina would default a month ago) and reduces everyone’s level of funding, so when that happens everyone will be in trouble rather than just the proportion of schemes in difficulties we have now. The overall funding risk of defined benefit pension schemes will be inflated so much that the system may not easily recover.

It gets worse. There is a lot in this consultation about governance, and also references to asset liability modelling, due diligence, reverse stress testing, scenario testing and covenant advice. These are all things which are likely to be a problem for small schemes, which I pointed out previously when they were proposed by EIOPA (because, let’s be clear, it is compliance with prospective EU legislation which has driven many of these proposals). But guess which group are going to see an almost total reduction in the scrutiny they get from the Regulator under the new regime? That’s right: small schemes.

There is still time to register your opposition to reliving the last 15 years of defined benefit pensions all over again: the consultation runs until 7 February.

For those people who are not pensions geeks, let me start by explaining what the Pension Protection Fund (PPF) is. Brought in by the Pensions Act 2004 in response to several examples of people getting to retirement and finding little or no funds left in their defined benefit (DB) pension schemes to pay them benefits, it is a quasi autonomous non-governmental (allegedly) organisation (QUANGO) charged with accepting pension schemes who have lost their sponsors and don’t have enough money to buy at least PPF level benefits from an insurance company. It is, as the PPF themselves appear to have acknowledged with several references to the schemes not yet in their clutches as the “insured” in a talk I attended last week, a statutory insurance scheme for defined benefit occupational pension schemes, paid for by statutory levies on those insured. As a scheme actuary I have always been very glad that it exists.

The number of insured schemes has dwindled since it was named the 7800 index in 2007 (with not quite 7,800 members at the time) to the 6,300 left standing today. As you can imagine, the ever smaller number of schemes whose levies are keeping the PPF ship afloat are very nervous about how that cost is going to vary in the future. They have seen how volatile the funding of their own schemes is, and seemingly always in the worst case direction, and worry that, when their numbers get small enough, funding the variations in PPF deficits could become overwhelming. Particularly as the current Government says whenever it is asked (although no one completely believes it) they will never ever bail out the PPF.

So there has been keen interest in the PPF explanations of how those levies are going to change next year.

PPF levies are in two parts. The scheme-based levy, which is a flat rate levy based on the liability of a scheme, and the normally-much-bigger-as-it-has-to-raise-around-90%-of-the-total-and-some-schemes-don’t-pay-it-if-they-are-well-funded-enough risk-based levy. The risk-based levy depends on how well funded you are, how risky your investment strategy is and the risk your sponsor will become insolvent over the next 12 months.

It is this last one, the insolvency risk, which is about to change. Dun and Bradstreet have lost the contract to work out these insolvency probabilities after eight years in favour of Experian. However, unfortunately and for reasons not divulged, the PPF has struggled to finalise exactly what they want Experian to do.

The choices are fairly fundamental:

• The model used. This will either be something called commercial Delphi (similar to the approach D&B currently use) or a more PPF-specific version which takes account of how different companies which run DB schemes are from companies which don’t. The PPF-specific version looks like it was originally the front runner but has taken longer to develop than expected.

• The number of risk levels. Currently there are 10, ie there are 10 different probabilities of insolvency you can have based on the average risk of the bucket you have landed in. One possibility still being considered at this late stage is not grouping schemes at all and basing the probability on what falls out of the as yet to be announced risk model directly. This could result in considerable uncertainty about the eventual levy. Even currently, being in bucket 10 means a levy 22 times bigger than being in bucket 1.

So reason for nervousness amongst the 6,300 perhaps? The delay will mean that it won’t be known by 1 April (an appropriate date perhaps) when data starts to be collected for the first levies under the new system next year. Insolvency risk is supposed to be based on the average insolvency probability over the 12 months to the following March, but the PPF will either have to average over a smaller number of months now or go back and adjust the “failure scores” (as the scale numbers which allocate you to a bucket are endearingly called) to the new system at a later date. Again, the decision has yet to be made.

All of this suggests an organisation where making models is much easier than making decisions. And that is in no one’s interest.

Perhaps surprisingly in the audience I was in, the greatest concern expressed was about the fact that the model the PPF uses to assess the overall risk to their future funding (and therefore used to set the total levy they are trying to collect each year) was different from either the current D&B approach, or either of the two possible future approaches, to setting failure scores, ie the levies they pay are not really based on the risk they pose to the PPF at all.

There are obviously reasons why this should be the case. Many of the risk factors to the PPF’s funding as a whole would be hard to attribute, and therefore charge, to individual sponsors. For instance the PPF’s Long-Term Risk Model runs 1,000 different economic scenarios (leading to 500,000 different scenarios in total) to assess the amount of levy required to ensure at least an 80% chance of the PPF meeting its funding objective of no longer needing levies by 2030. Plus it plays to sponsors’ basic sense of fairness that things like their credit history and items in their accounts (although perhaps not including, as now, the number of directors) should affect where they stand on the insolvency scale, rather than things that would impact more on PPF funding, like the robustness of their scheme deficit recovery plans for instance.

It is rather like the no claims discount system for car insurance. This has been shown to be an inefficient method for reallocating premiums to where the risk lies in the car driving population, and this fact has been a standard exam question staple for actuarial students for many years. However it is widely seen as fair by that car driving population and would therefore be commercial madness for any insurer to abandon.

So there we have it. The new PPF levy system. Late. Not allocating levies in accordance with risk. And coming to a pension scheme near you soon.