Transfer tightrope

We may be entering the endgame for defined benefit pensions says Stewart Ritchie, director of pensions development, Aegon Scottish Equitable

In recent months, we have seen headlines suggesting that many defined benefit pensions schemes are back “in surplus” on accounting standards FRS17 or IAS19. But is it a bit premature to be hanging out the flags?

First, let’s start with the good news. Significantly more money is going in to private sector defined benefit pensions because of the recovery plans which accompany the new scheme-specific valuation regime. The other piece of good news is, as the NAPF highlights, a minority of defined benefit employers are keeping their schemes open to new members and encouraging new employees to join. These employers are the unsung heroes of UK pension provision.

But there is bad news as well. On 18 December, the Pensions Regulator published The Purple Book 2007, which it describes as “the most up-to-date picture of the DB pension universe”. It offers the buy-out funding position, namely the ability of schemes to secure their liabilities on the open market if the employer went bust. On this basis the weighted average funding level was 64 per cent, and the simple average funding level 56 per cent. It is difficult to avoid the conclusion that the true ability of schemes to meet their accrued liabilities is heavily dependent on the employer covenant – hardly what funded pensions are supposed to be about. Over 60 per cent of the assets are in equity-type investments. This means a big mis-match between assets and buy-out liabilities, which makes the solvency level volatile.

A couple of years ago many commentators might have argued that buy-out rates presented a false picture because there were only two insurers in the market. Today there are at least 15 – including my own company – and some might say this is leading to unsustainably cheap buy-out rates!

On a positive note, all this competition is leading to market innovation. Partial buy-outs can be quoted for, say, today’s pensioners or deferreds. Imaginative packages are being put together by investment banks and life offices so that trustees and employers can confidently plot a path towards an endgame of buy-out solvency.

So what does all this mean for members of defined benefit schemes? Even if they distrust the employer covenant, they still have the safety net of the Pension Protection Fund (PPF). However it is important to note that the PPF benefits on average fall well short of the scheme’s own benefits, and that even these lesser benefits are not guaranteed. Consider, for example, what might happen in an economic recession if a lot of employers went bust. The PPF cannot refuse to take their pension schemes, but what happens if the resulting increase in levies becomes intolerable for solvent defined benefit employers?

What if the employer comes along with an incentive package to encourage deferred members to transfer out? This could entail a higher transfer value or a cash-in-hand incentive, but either way there is likely to be a time limit for acceptance. The Pensions Regulator published guidance on this on 24 January 2007, and around the same time HMRC worsened the tax treatment of cash-in-hand incentives. If anything, this seems to have boosted the incentive transfer market, as employers and advisers saw these changes as the establishment accepting and legitimising the concept. In my view the key objective should be that people make full and informed decisions. The acid test of this will be when transferors retire. If they are then worse off than if they had not transferred, will there be grounds for a compensation industry to emerge?

A big development in 2007 was the concept of “abandonment”, where the employer offloads the pension scheme, without winding it up and buying it out with a life office. Shareholders sell the company to a third party and buy back the business of the company, leaving the third party as the principal employer of the pension scheme. Some people regard this as regulatory arbitrage, because reserving for life offices is much tougher than reserving for ongoing pension schemes. The Pensions Regulator is watching closely, to make sure the security of the members’ benefits are not adversely affected by the abandonment.

Finally, if most private sector defined benefit provision is tailing off, where does that leave public sector pensions? In recent years the pension element of public sector remuneration packages has grown hugely in perceived value at the same time as, on average, it has fallen in the private sector. That is an unstable situation, and politicians are starting to understand that. I have a hunch that pensions will be a major battleground of the next general election.