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OPDU
Report 26 October 2009
Advisory Service Forum
Reducing corporate
DB pension costs
Con Keating
For as long as most of us can remember the cost of provision of
pensions has risen inexorably. Many, arguably most, of these
increases are rooted in the cost of compliance with increased
regulation rather than increased benefits payable to scheme members.
This article explains how and why pension indemnity assurance can lower pension costs
without harm to member benefits or security. To put this into
context, to offer this indemnity assurance to the entire UK
corporate pensions market would require the assurers to possess
total equity capital of £7 - £10 billion and would save sponsoring
employers’ pension expenses of the order of £100-£150 billion.
DB Pension Risks
In the UK a defined benefit (DB) arrangement specifies a real
income in retirement for life. The promise made to scheme members
removes from them entirely both biometric and inflationary risks;
these risks are borne by the sponsor employer. In this regard it is
far superior to defined contribution arrangements for all but a few
exceptional people. The assumption of these risks extends also to
that part of pensions financed by member contributions.
The pension contract is somewhat unusual as a form of contract in
that the sponsor employer’s liability is not limited to the
estimated value at the time when granted. That is, payment of the
expected value of the liability at a point in time into a separately
established pension scheme does not discharge the liability with
finality. From year to year, the reported sufficiency of scheme
funding to meet liabilities can vary markedly. However, the source
of this variation is worth a little attention.
True increases in benefits payable arise only from increases in
longevity and inflation and perhaps further awards – and only those
increases which are unexpected constitute risk. Most of the
variation we observe arises from the pension accounting convention,
which compares the discounted present values of liabilities with
fund assets that are marked to market, rather than actual changes in
the benefits ultimately payable. Most of the much-promoted hedging
and liability-driven investment ‘solutions’ address this accounting
convention rather than any true risk.
Sponsor Failure
The real problem with a DB pension scheme arises when the sponsor
fails. In this circumstance, the scheme is faced with a situation
where it needs additional funding in excess of the best estimate of
liabilities. This is to cope with the risks of potential
adverse development in the value of liabilities or assets over the
remaining life of the scheme. The level of bulk annuity buy-out
pricing provides an indication of the amount of this additional
funding – currently some 30-50% of liabilities. It makes no sense at
all for any company to fund this conditional liability for the
pension scheme; such action would be entirely counter-productive,
increasing the likelihood of failure of that sponsor employer.
Pension Indemnity Assurance
Pension indemnity assurance can be used to resolve these
difficulties, and in the process lower the expense of pension
provision. A mutual guarantee fund, such as the Pension Protection
Fund (PPF), cannot deliver these advantages. A pension
indemnity assurance policy requires that in the event of sponsor
insolvency, the assurer to steps in and assumes liability for the
full entitlements of all members, for whom it will issue or procure
individual annuities. Unlike the PPF’s current compensation, members
would not receive reduced benefits.
Pension Scheme Costs
It is important to understand that there are two sources of cost
for a pension scheme – the costs of scheme administration and the
costs of scheme funding.
Figures published by the UK National Statistics Office indicate
the costs of scheme administration have doubled over the past twenty
years, under the weight of new regulation. These expenses are
irretrievable sunk costs and include such things as superfluous
valuations and PPF levy contributions. However, the premiums paid
under a pension indemnity assurance policy are not lost, sunk costs.
The policy is an asset of the scheme from the inception of cover and
the policy wording may even be constructed so that the policy
minimum value is the sum of all premiums previously paid.
Scheme funding is the second, but more important area in which
pension indemnity assurance can lower costs. The most fundamental attribute of any company or government
agency is its covenant. The Pensions Regulator takes a very narrow
and incomplete view of this topic, viz a covenant is little more
than a credit rating. An enterprise’s covenant is the set of
promises which enable it to capitalise itself and fund its economic
activities. Funding for a scheme is just a simple device to lower
the dependence upon the sponsor covenant and by doing so enhance
member security. Note that active scheme members may have an
unusually large exposure to the employer as they may have employment
and specialised human capital at risk in addition to their
accumulated pension benefits.
Member Security
It is worth repeating that funding a scheme is simply a device to
enhance member security and lower dependence upon the sponsor
covenant. With that in mind, we can consider the position of the
civil service pension fund, which, of course, is unfunded. The
government could choose to borrow to fund this scheme using, as its
covenant for debt service, its ability to levy taxes and raise other
revenues and use the proceeds to fund the scheme. The scheme, once
funded, has to select assets to hold and of course it cannot do
better in terms of member security than those government securities
which were issued to fund it. The circularity and pointlessness of
this should be obvious to all.
In fact scheme funding rules which advocate 100% funding are
attempts to eliminate all dependence upon the sponsor covenant. This
arrangement is inefficient; the sponsor employer is at risk for
funding variation but only other companies benefit from the capital
investment of the fund. The cost of this inefficiency is enormous;
over the time horizon of pension liabilities, this can treble a
scheme’s funding costs.
Conclusion
Pension indemnity assurance guarantees the security of scheme
members, and it also allows the sponsor company to capitalise its
covenant, lowering its funding costs markedly. The presence of
pension indemnity assurance will not introduce any indirect costs by
constraining asset allocations or benefit structures – in particular
‘de-risking’ is unnecessary. The box opposite contains an
illustrative case study. In the situation where the sponsor employer
elects to pay the policy premium, it will raise a liability for
future premiums in its accounts. This is an unfunded liability to
the pension indemnity assurer. Premiums paid will pass through the
cash-flow accounts as expenses in the usual way.
An Illustrative Case Study
The policy is an asset of the scheme, valued as the higher of the
present value of the expected pay-offs of the policy or the totality
of premiums already paid. This value at policy inception will be
strictly greater than the liability raised in sponsor accounts –
this arises because of the effects of risk-sharing and recovery in
premium setting. The sponsor employer’s funding liability is reduced
by the full amount of the value of the policy as a scheme asset.
The policy also has some very interesting risk management
properties. For example, if the sponsor’s credit standing declines,
the value of the policy as an asset of the scheme increases. Or if
scheme funding deteriorates as a result of market gyrations, the
value of the policy as an asset increases.
The extent of these contra-cyclical properties is determined by
the precise terms of the policy together with fund and sponsor
status, and could be engineered to be perfect hedges. If perfectly
engineered, these would remove entirely the additional costs arising
from the full funding regulations.
DB pension provision does not have to be outrageously expensive,
as is currently the case. An alarming part of that expense arises
not from the economics of pension provision, nor from corporate
finance, but from inefficient, misguided regulation. Pension
indemnity assurance resolves the problems for which inappropriate
regulation was devised and hastily legislated; it correctly aligns
the interests of members and sponsoring employers.
Con Keating
Head of Research
BrightonRock Group
con.keating@brightonrockgroup.co.uk
www.brightonrockgroup.co.uk
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