- Amber Rudd is right to warn employers to take pension funding seriously.
- As most schemes are closed, employers have little business interest in the open-ended legacy liabilities – so important for trustees to increase funding sooner rather than later.
- DWP and Regulator should also encourage trustees to consider corporate finance advice to scrutinise employer business.
- Trustees, not employers, run investments and control balance of risks.
Amber Rudd has today put employers on notice that they must take their pension liabilities seriously. If they fail to do so, they risk severe fines and even imprisonment.
Government right to be concerned as these liabilities have people’s lives attached: Government and Regulators must be vigilant to ensure employers cannot just ignore their pension liabilities. The pension scheme ranks as an unsecured creditor, alongside all other unsecured creditors and recent insolvencies have suggested investors or shareholders can be prioritised over workers’ pensions. Company directors need to recognise that their pension scheme is not just like any other unsecured creditor, these liabilities have people’s lives attached.
The cost of providing these pension promises has soared and most of these schemes are now closed. 88% are no longer open to new members and 41% are closed to all workers.
Amber Rudd wants to help protect pension promises: These final salary-type (Defined Benefit) schemes are the traditional, ‘gold standard’ company pensions. These schemes promise each member a specified amount of pension in retirement, with the employer shouldering the risks and costs. They were most prevalent in post-war Britain, with millions of workers relying on receiving these promised pensions in retirement as an important part of pensioners’ income.
Costs of these employer-‘guaranteed’ pension promises much higher than expected: The costs of those pension promises soared, due to increasing life expectancy, lower than-expected investment returns, abolition of some tax breaks and interest rates depressed by Bank of England policy. Forecast contribution requirements were far too low and many schemes ended up with huge deficits. Employers must make up the shortfalls.
If the scheme fails, workers’ pensions are reduced in the PPF: There have been several high profile cases in employers have become insolvent, with inadequate resources to make up their scheme deficits. Before 2005, workers could lose their entire promised pension, but I am proud to have been able to help establish the Pension Protection Fund (PPF) which offers protection for members now. This replaces most of the promised pension, but by no means all and the PPF results in workers losing some of their promised pension.
PPF is funded by other employer pension schemes who pay a collective insurance levy: The costs of PPF compensation are not paid by the Government, but by other pension schemes, who pay an annual risk-related levy to cover the risk of failure. When schemes fail, the PPF takes in the assets and, together with the money received from annual levies, it also makes investment returns on its assets. Companies who fail to fund their schemes adequately will increase the burden on other schemes, because more scheme failures increase the potential cost of the PPF levy. All employers with DB pension schemes have an interest in ensuring unscrupulous or careless employers do not offload their pensions into the PPF.
Number of schemes fallen by 30% and PPF levy has doubled: Over the past few years, the number of pension schemes paying into the PPF has fallen sharply. The PPF Purple Book statistics show there were 5450 schemes in 2018, which is 30% lower than in 2006. Many schemes have failed, others have wound up and bought annuities for all members. In that same time period, the PPF levy has doubled from £271million to £541million, while the amount of compensation paid has increased from just £1million in 2006, to £725million in 2018. Clearly, the more schemes fail, the greater the burden on other employers still responsible for their DB schemes.
7 out of 8 schemes are now closed: The number of DB pension schemes open to new workers has plummeted. Only 12% are offered to new members (1.3million workers) and over 40% are closed altogether, with existing workers being forced into new arrangements. The 2018 figures show 10million members in these schemes, with 41% of members already retired and 46% being former workers who have left, but not yet at pension age (deferred members). Most employers and workers are now in modern ‘Defined Contribution (DC)’ schemes, in which the investment risks and costs are borne more by the workers themselves.
As we approach the end-game for these pension schemes, employers may be tempted to find ways to avoid paying for past workers: As more schemes close, companies increasingly own legacy liabilities with no existing workers paying into the scheme. Yet they are on the hook to pay promised pensions for decades into the future. They have little or no business interest in carrying this ongoing liability, so they may naturally be tempted to find ways to offload the scheme.
Companies can only get rid of the scheme by buying expensive annuities – unless facing insolvency – so important to get contributions in soon as possible: Legally, companies can only walk away from their pension liabilities if they pay a huge sum to secure annuities for all members. This is often an unsupportable cost. If, however, the employer can prove it is about to fail, then there are mechanisms to negotiate with the Pensions Regulator and PPF to pay a lower amount and continue trading. Or, if the company actually enters insolvency, the PPF must pick up the cost of paying its reduced level of benefits to all members. By the time a company is facing bankruptcy, it is normally too late to require bigger pension contributions to offset a scheme deficit. Therefore, the Government’s announcement that it will expect employers to fund their schemes more carefully is most welcome.
Trustees, not employers are responsible for investment risks: Today’s announcement suggests employers would be punished for their scheme taking unwarranted investment risks. However, it is the trustees of the schemes who decide on the asset allocation and, therefore, they are the ones who are accountable for managing both the risks and returns in an appropriate manner. I believe it is important for trustees to manage scheme assets appropriately and they do, of course, need to bear in mind the strength of their employer when making investment decisions. There is an important trade-off between achieving better returns, which can help reduce a deficit, and taking too much risk that could increase the shortfall. In recent years, there has been a sharp move away from equities, which have higher expected returns and into bonds, which do not properly match pension liabilities but are considered lower risk. If bond yields rise, the capital losses on these investments may result in larger deficits, and a weak employer may be unable to cope with higher contributions.
Trustees should try to get higher contributions in as soon as possible: Indeed, trustees are also responsible for negotiating the ongoing contributions that employers need to make, in order to properly fund their scheme. Therefore, it is important that trustees increase their scrutiny and understanding of the outlook for their employer business and try to negotiate as strongly as they can to get more money in at an early stage. Employers will often push back and claim they cannot afford to pay more, however in recent cases, the company has prioritised other creditors, and even paid its Directors significant extra sums, which could perhaps have been put into the pension scheme.
Trustee burdens increasing and they may need independent advice to scrutinise employers’ corporate finances: The burdens on trustees are increasing, but as time goes on and more schemes become an unwelcome liability on the company balance sheet, with no ongoing relationship with the business, it may be important for trustees to take their own corporate finance advice and scrutinise the financial position of the scheme employers more closely than in the past. They will need to be vigilant against attempts to underfund the scheme, or restructure the company, to try to reduce pension payments.