Written evidence from Hymans Robertson LLP DBP0045
Executive summary
A UK defined benefit (DB) renaissance is possible and the societal benefits could be enormous. But rekindling UK DB will require large-scale policy incentives, to counterweight the inherent risks.
The policy initiatives most likely to tap into the UK’s £1.4 trillion of DB assets are:
1 Resetting legislative and regulatory objectives to balance past and future DB provision, as a minimum by carving-out open schemes from the proposed new DB funding regulations.
2 Enabling sponsors to use DB surpluses to fund benefits for current workers (ideally via DB, but potentially via Defined Contribution (DC) or Collective Defined Contribution (CDC)).
3 Encouraging trustees to allow early sponsor access to DB surpluses and removing penal taxes on refunds; and potentially offering tax incentives for refunds deployed into UK productive finance and/or climate initiatives.
Stronger tax incentives for saving via DB (compared to DC or CDC) could help to restore DB accrual as a mainstream benefit in the UK private sector.
The reasons why 90% of DB schemes closed to new entrants are manifold. Legislative reactions to high-profile corporate failures have led to prioritising more secure accrued benefits. Parliament’s greatest challenge may be garnering business confidence that DB legislation won’t become hostile in future, long after commitments are made based on a short-term policy incentive.
The professionalisation of DB trusteeship is bringing the strengths and weaknesses one might expect: increased knowledge and reduced member participation (in the case of sole trustees, circumventing the Pensions Act 1995 requirement for member nominated trustees altogether). This professionalisation amplifies whatever the DB legislative intent is. Absent substantial policy stimulus to the contrary, professional trustees will increasingly focus on securing past DB benefits.
As you will read in our responses, we do not anticipate limitations in insurer buy-out capacity. Nor do we see a role for mandating DB consolidation. That said, removing governance easements for sub-scale DB schemes would stimulate consolidation. This would lessen instances of unsatisfactory trustee governance amongst smaller DB schemes and help overcome insurer operational bandwidth limits that deter smaller buy-out deals.
We are greatly heartened that the Committee is asking these questions now, before the new DB funding regulations are finalised. The current draft regulations will exacerbate DB’s focus on insurance and run-off.
We sincerely hope that calls for a UK DB renaissance aren’t left to resurface in future, because the current generation of workers can’t afford to retire as a result of having inadequate DC savings.
Hymans Robertson LLP is one of the UK’s leading independent pensions and financial services consultancies. We work alongside employers, trustees, local authorities and financial services institutions; offering independent pensions, investments, benefits and risk consulting services and technology solutions.
Responses to the Committee’s questions
Question 1: Is the right regulatory framework in place to enable open DB schemes to thrive?
The current regulatory framework is not designed to help open DB schemes to thrive. The Pensions Regulator’s (TPR’s) five objectives focus on securing the past, rather than on intergenerational fairness or a better and more secure future for all in retirement. To thrive, open DB schemes would benefit from a regulatory framework or carve-out that reflects their goals of balancing security with pension sustainability for future generations.
TPR has limited resources, and so focuses on the needs of the 90% of DB schemes that are no longer open to new members. Most of these schemes aim to wind up and secure members’ pensions with an insurer over the next decade, and seek to reduce the risk of missing that target. Regulations therefore focus on de-commissioning the industry—and so securing the past.
However, 485 DB schemes in the private sector are open to new members. These are typically found where there is a unionised workforce, extraordinary paternalism or a connection to government (for example, non-departmental public bodies or outsourcers for public-sector work). These schemes seek to balance securing benefits accrued with sustainability for future generations. The regulatory framework strongly favours one side—security of pensions earned to date—at the expense of future benefits.
Some open schemes can thrive, but must take an appropriate approach. An open scheme needs to regard regulation as a ‘guard rail’ rather than a driver of strategy: develop an appropriate financial strategy first, and then ensure that it meets regulatory requirements. A sound strategy that balances success and risk across the decades should be compliant.
But an appropriate strategy is hard to implement. Doing something different from most is uncomfortable for trustees and for sponsors. In an industry that yearns for clear rules, an approach led from first principles requires effort and a great deal of experience, especially when only a minority of schemes are taking that approach. Independent thought, long-term thinking and stakeholder alignment are required to realise opportunities such as providing pensions for future generations.
The costs of DB pensions increased over the two decades to 2020, driven largely by falling long-term interest rates. In the past year, lower gilt prices and higher yields led to the cost of new DB pensions falling by around 50% . But falling costs are unlikely to stimulate the creation of new schemes—successive governments have made statutory and regulatory changes to pensions that have impaired the confidence of the private sector to make such long-term commitments.
A meaningful revival of DB schemes would require some form of tax incentive to make them more attractive than the DC alternative. This incentive might be preferential National Insurance rates for employers in respect of participating employees, or more flexibility in accessing scheme surpluses. In time, the market for new DB schemes could gain its own momentum as it becomes part of the employee value proposition. An open DB scheme could be a competitive advantage for an employer looking to attract and retain talent.
We would be delighted to share case studies of open DB schemes that we advise, which have thrived in the past two decades even in this regulatory environment.
Question 2: Is there sufficient capacity in the buy-out market to meet demand from DB schemes? If not, what are the alternatives?
Buy-out and buy-in deals in 2022 amounted to around £27.7bn. We expect the market to grow in the coming years, and foresee 80% of future bulk annuities to be whole-scheme buy-ins or buy-outs, in contrast with the past 16 years, when pensioner-only buy-ins predominated. Projections show that half of all private-sector DB pension scheme liabilities will have been insured by 2030, covering 5m members’ benefits and close to £1trn of liabilities.
We expect sufficient insurer appetite, capital and suitable investments will generally be available for insurers to meet this demand for DB bulk annuities. However, insurer-side resource, for both giving quotations and post-transaction work, will constrain volumes. Insurers will therefore continue to be selective about the schemes for which they quote.
Schemes may need to wait longer than currently to receive a quotation, and will need to prepare thoroughly before approaching the market, to show insurers that theirs will be an efficient and successful transaction. Resource pinch points could lead to schemes taking longer to get to buy-out than they were hoping.
Insurers will continue to recruit, and to encourage or drive standardisation and efficiency. Innovation in the market may help to reduce some strain on insurer resource, increasing the number of transactions that insurers can manage at once. More insurers are likely to enter the market.
Approaches for smaller schemes may become more streamlined. Consolidation could play a role here, by bringing efficiencies of scale, for example through master trusts.
If schemes face delays in getting quotes and transacting, they would need to manage risks in the meantime and prepare for an efficient transaction. For example, a scheme could manage its investment strategy well and bring forward work that might otherwise have been completed after the buy-in, such as GMP equalisation.
Investment developments may help schemes move towards assets that they can transfer more easily to an insurer when it is possible to transact. For example, insurers may in future have more flexibility on the assets they can take on and hold.
The alternatives to buy-out are limited. The main alternatives are superfunds, run-off and scheme rescues.
The superfund market is still developing and yet to complete a transaction. Furthermore, the only superfund provider that has completed TPR’s assessment itself ultimately insures schemes rather than running them off.
Schemes can run off with their existing trust structure and sponsor. In practice not many schemes are likely to choose run-off, particularly as accessing surplus remains challenging for employers (see question 7). We expect most schemes will chose to insure under the current regulatory regime, once they become well funded enough.
A scheme with a very weak covenant may be subject to a scheme rescue. For example, the sponsor could be replaced with a capital buffer, or scheme benefits are compromised in some way. A scheme rescue could be a way out for the sponsoring employer, although the scheme is still likely to end up buying out with an insurer.
Question 3: What should the Pensions Regulator (TPR) do to improve the quality of trustee boards?
TPR could focus more on the cultural and dynamic aspects of board effectiveness. It could more strongly encourage an annual board effectiveness review that appraises the governance arrangements and decision-making of the previous 12 months. TPR encourages board effectiveness evaluation, but this is not an explicit formal requirement—although the requirement for an effective system of governance might be seen to imply it.
Evaluation is not discussed enough in the General Code of Practice, which focuses on documentation rather than the dynamics and culture of an effective board. General business guidance, such as the FRC’s Guidance on Board Effectiveness, stresses the importance of diversity as ‘an important driver of a board’s effectiveness’. TPR’s recent guidance on equality, diversity and inclusion also encourages board diversity.
TPR could also focus more on the importance of high-quality governance support from the trustee executive and scheme secretary. These functions are vital for good governance from the trustees, whose role is oversight and strategy. To ensure good governance, the executive function would ideally be separate from the oversight that the trustee board provides.
The professionalisation of trusteeship has strengths and weaknesses. We see many instances where professional trustees and sole professional trustees work well and deliver excellent results. But it would be beneficial to compare these models to the FRC’s Combined Code for corporate governance as a matter of best practice. For example, the extent to which the provider of trustee services may appoint itself to provide ancillary services and/or requirements to review and appoint advisors (perhaps with parallels to the requirements regarding appointments of fiduciary asset managers).
The DWP and TPR may wish to revisit sole trusteeship arrangements in light of the enhanced focus on diversity in decision-making. The current arrangements were probably not anticipated when member-nominated trustee legislation was framed, but have developed from it: the requirement to have at least 1/3rd of trustees nominated from a scheme’s membership (brought in by the Pensions Act 1995) is circumvented when a sole independent trustee is appointed. Such appointments are usually under the control of a scheme’s sponsor.
Sole trustee arrangements may be useful in particular situations (for example, smaller schemes close to endgame), but may not be optimal in other circumstances. A scheme’s size and how near it is to implementing its endgame strategy are important factors in choosing an effective governance structure, and regulators should take these factors into account when setting guidance and regulations around trustee board structure.
Question 4: What, if any, further steps should be taken to encourage DB scheme consolidation?
DB schemes can consolidate either via a master trust that retains the sponsor link and seeks to achieve better governance and lower running costs, or via commercial superfunds that seek to replace the sponsor with an appropriate capital buffer. Both structures use master trusts.
The most common barrier to consolidation is a regulatory regime which is permissive of lower standards for small schemes on the premise of proportionate costs. Reducing or removing these easements would either raise standards of trusteeship amongst smaller schemes or render them uneconomical, thereby stimulating the commercial case to consolidate.
A DB master trust can offer cost savings for comparable quality governance for a smaller scheme. For example, for a scheme smaller than £150m, the Citrus master trust (which we advise and administer) has quoted a reduction of up to 30% in ongoing costs compared with the average TPR quote. Another advantage comes from bundling small sections or schemes into a single transaction for the buy-out market. In one case, Citrus quoted wind-up costs reducing by up to £200,000 as a result. Furthermore, some insurers do not quote for very small schemes, so bundling schemes in a master trust could attract more quotes.
To date only one superfund provider has completed TPR’s assessments, and it has not completed any transactions. The lack of progress is probably due to the challenges of transferring to a superfund at this time rather than an absence of demand. Superfunds have the potential to play an important role in the industry, and could be an attractive alternative to insurance for schemes with weaker covenants, particularly if the insurance market becomes resource-constrained.
We welcome TPR’s superfund guidance review and the anticipated superfund legislation. Explicit statutory recognition of the superfund option in the preservation legislation when the authorisation and supervision regime is established may also help consolidation. These developments will provide the clarity that trustees, providers and potential new entrants seek. In the long term such clarity will be crucial for the development of a healthy superfund market.
One legislative block to the growth of the superfund market is that schemes with an insolvent sponsor can’t secure less than 100% of benefits with a superfund, but they can do so with an insurer. Removing this block could enable superfunds to provide more benefits to members with insolvent employers than they can now. Currently, superfunds can only compete in this area in the niche circumstance where a scheme can’t secure 100% of benefits with an insurer, but can do so with a superfund.
Removing or reducing governance easements for small schemes would ensure that members are subject to the same level of governance regardless of scheme size. This move may encourage more DB consolidation if it would otherwise be uneconomical for small schemes to keep their current arrangement.
Another step to encourage consolidation would be education about the benefits that consolidators can bring in areas such as governance. DB master trusts and superfunds aim to offer improved governance, but effectiveness might not be sufficiently measured (see question 3).
Question 5: Are there any circumstances in which consolidation should be mandatory?
We do not see a widespread role for compulsory consolidation for DB pension schemes.
If consolidation were to be the most beneficial option for a scheme, we expect that trustees (or sponsors, where relevant) would naturally consider it. For example, in the event of a sponsor insolvency, trustees would be expected to explore a superfund if the alternative is insuring a lower level of member benefits than promised—with the caveat of the legislative block explained in question 4.
If regulation were to move towards compulsory consolidation for some schemes (such as those with members or assets below a minimum threshold), regulation of the consolidating vehicles such as DB master trusts would be appropriate.
Our response to Q4 regarding the stimulation of consolidation by removing governance easements for small schemes is pertinent. Setting minimum governance requirements could be a way to achieve this.
Question 6: Do the recent improvements in funding levels change the future role of DB schemes in UK pension provision?
Most private-sector DB schemes are already in run-off, so it would require a very significant stimulus to reverse their long-term decline. Funding level improvements are more likely to speed up schemes’ journey to buy-out, and we expect more schemes to approach the buy-out market as improvements continue.
Changes to the economy and labour market, financial conditions, increasing longevity, and tightening regulation have made DB pensions less attractive, less affordable and more risky to employers. Most private-sector DB schemes are closed to new members or to accrual, and active DB scheme membership stands below 1m. Only 10% of private-sector DB schemes were open to new members and future accrual in 2022, compared with 43% in 2006.
Falling DB pensions costs could keep these schemes open, but few employers are likely to be tempted to introduce a DB scheme, because the risks are too great and rewards too small. Substantial incentives would be needed to shift this perception.
However, the defined contribution pensions that most private-sector employees have are delivering inadequate retirements. We need a better version of DC, and employers need better return on investment on their DC spend.
Collective DC is a possible solution, but it will realistically only appeal to a few employers. It doesn’t offer the attraction of a DB scheme: the security of a guaranteed income for life, regardless of what happens to capital markets.
Hybrid solutions could better share the risk between employers and employees. For example, arrangements that offer a minimum DB pension with a DC top-up could share risk more equally. Cash balance schemes combine advantages of DB and DC pension provision by accumulating contributions at a specified rate.
A revival of DB schemes in the private sector is unlikely, but recent funding level improvements and lower DB costs could help to restart a purposeful conversation about the challenges of DB and DC pensions and ‘blended’ alternatives.
In a DB scheme, risk-sharing is asymmetric: members typically contribute to the scheme, but contribution risk lies with the employer. The regulatory framework has made benefits more secure for members, and more expensive and risky for employers.
Once a scheme is winding up and all the promised benefits have been fully secured with an insurer, it seems reasonable that at least part of any surplus can flow back to the employer rather than improving already good member benefits. However, scheme rules vary: in some schemes, surplus can be refunded to employers, but in others it can’t be refunded, or it must be used to augment benefits first. Any surplus ultimately refunded to the employer is taxed at 35%.
A recent exchange between the Work and Pensions Committee and Bristol Water suggests that a return of surplus to the employer on wind-up might need more justification than sharing it with members, even when the scheme rules allow it. It seems perverse to require an employer to contribute to a surplus that is not refundable, or refundable only after a penal tax charge. If the Committee’s intention in this call for evidence is to stimulate DB saving in the workplace then clear-minded and consistent thinking is needed about to whom surpluses belong.
We would like regulation that enables responsible employers to benefit from prudent funding while protecting the security of member benefits. Once a scheme is sufficiently funded, more flexibility in surplus management is reasonable. Employers should be able to get a surplus refund if they can prove the security of the benefits and employer support.
Policy actions that enable earlier or less-onerous access to surplus would help to stimulate DB schemes and more adventurous investment of DB assets. We see the taxation of DB surplus refunds as a key policy tool to incentivise the behaviours that Parliament wishes to see. It could, for example, remove the penal tax charge on refunds of surplus to stimulate investment in economic growth, or tax incentives in productive finance or climate initiatives.
In an open scheme, surplus could be used to help fund pensions for current workers. In a closed scheme, a surplus could be shared with members through benefit uplifts that would help a generation with already good pension benefits. A route to using surplus to fund current workers’ pensions could help ‘level up’ benefits and improve fairness between generations.
For example, it should be easier for an employer to use a surplus to improve workers’ DC savings. As most DB schemes have closed to new members and most DC provision is via insured contracts and master trusts, current workers’ DC pensions and previous generations’ DB pensions are in silos, and surplus assets can’t be shared between the two, tax-effectively.
Allowing transfer of surpluses in DB trusts to DC master trusts could increase current workers’ DC savings and help employers manage pension costs for current workers. As an incentive, an employer could access a surplus at a lower funding threshold if it uses that surplus for current workers’ pensions.
Although PPF levies are less of a burden for schemes than they used to be, improved funding levels mean that they could be reduced further.
The PPF has a surplus of around £12bn, and this is projected to grow. The PPF should think about how to use this surplus. It could consider using it to meet regulatory costs and take those costs away from schemes. For an increasing number of schemes, the TPR operating levy is larger than the PPF levy. The cost of running TPR is around £100m a year, while the PPF collects £200m a year in levies.
As more schemes are wound up and funding improves, the number that could claim on the PPF is dwindling. As the PPF’s surplus is unlikely to decrease, it is in danger of becoming irrecoverable. The PPF might be in a position to refund levies to employers, although current regulation may not allow it to do so, and it is unclear who would benefit.
The PPF built up its surplus in an environment of ultra-low gilt yields exacerbated by quantitative easing following the global financial crisis. The period of low yields appears to have ended, but this is unlikely to reverse scheme closures, showing the drawback of a short-term focus on prioritising the security of accrued benefits.
As a result of legal clarifications, compensation under the PPF has increased and is now generous for most scheme members. The FAS is already a legacy issue. We therefore think no further changes are needed to the PPF or the FAS to improve member outcomes.
The compensation these schemes provide is lower than the compensation for DB bulk annuity polices under the Financial Services Compensation Scheme (FSCS). This scheme has never been tested. If a claim were to emerge, it could affect all insurers, and would need government and ultimately taxpayer support.
April 2023