Written evidence from Pension Insurance Corporation (BPW0015)

Pension Insurance Corporation plc (“PIC”) does not regard any of the information in this document as confidential.

About PIC

1. PIC is a specialist insurance company that consolidates UK defined benefit assets and liabilities, operating within the Solvency II framework. At year-end 2017, PIC had consolidated the assets and liabilities of over 150 separate DB pension schemes, covering 151,600 pension scheme members and had £25.7 billion in financial investments. PIC consolidates pension scheme assets and liabilities through the provision of bulk annuities - pension insurance buyouts and buy-ins.

2. Pension schemes which have passed responsibility for managing the assets and liabilities of their pension obligations to PIC include, the Pensions and Lifetime Savings Association (“PLSA”), London Stock Exchange, Philips, Alliance Boots, Total, EMI, Cadbury, Honda and the Institute & Faculty of Actuaries, as well as the public sector, including DEFRA. PIC is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and Prudential Regulation Authority (FRN 454345).

3. We believe that our extensive experience of consolidating pension obligations, using economies of scale to bring efficiencies for investment and administration, under a regulatory regime which completely aligns the interests of the investors in, and Directors of, our company with those of our policyholders, is directly relevant to the issues under examination. The Committee is seeking to address some of the fundamental problems faced by defined benefit pension schemes and their sponsors and we hope that our views are helpful in this regard.

Summary

4. The crux of the debate over consolidation is whether new proposals increase the chances of defined benefit pension scheme members receiving their full benefits. We believe that this crucial question is being forgotten amidst the focus on the needs of sponsoring companies and, as proposals emerge, those of potential investors in non-insurance-based consolidation vehicles.

5. It is our view that the security of member benefits will be put at risk by employers and their shareholders seizing the opportunity to offload their pension obligations into non-insurance-based consolidation vehicles ahead of a clear regulatory framework that takes into account the inherent conflicts between the investors, their trustees and the members. We have seen some proposals in which schemes would transfer to the new vehicle, rather than the old employer ceasing to participate, and thus The Pensions Regulator (“TPR”) would not be involved. This does not seem sensible. Giving TPR powers to approve any such transfer would ensure members have appropriate protection and allow TPR to require additional funding should it be necessary.

6. Currently, TPR can issue Contribution Notices and Financial Support Directions to those associated with pension schemes. It seems likely that the new vehicles, which are being driven primarily for profit, will be structured such that there are only men of straw available beyond their initial commitment - so whilst they bear the reward, they will not bear the risk, as current sponsors and their Groups do. If non-insurance-based consolidation vehicles are to be regulated by TPR we recommend that necessary changes are also made to TPR’s powers to issue Contribution Notices and Financial Support Directions. As the White Paper notes: “The level of protection afforded to members [today] is high, regardless of the level of underfunding in the scheme.”[1] This protection needs to be maintained, taking into account the new proposals essentially turning the running of a pension scheme into a business and the inherent conflicts this presents.

7. A further protection would be to allow TPR to authorise a superfund; that would allow them to be satisfied with the proposed structure and governance as well as funding.

8. In reviewing the aims of the current drive for new non-insurance-based pension consolidation vehicles in detail, it is clear that their superficial attraction (economies of scale), is quickly outweighed by their more profound drawbacks for security of member benefits, which will serve to weaken this high level of protection:
1. The UK already has dozens of very large DB pension funds which have economies of scale, many of which have significant deficits and which perform no better than smaller DB pension funds
2. The current superfund plans suggest that the primary beneficiaries will be those sponsoring companies able to offload pension liabilities quickly, easily and cheaply
3. The high short-term returns available to superfund investors are in no way aligned to the long-term interests of pension scheme members
4. The lack of specific legislation and regulatory framework leaves the members at risk of being the victims of BHS and Carillion type scandals
5. Superfunds have inherent conflicts of interest that incentivise decisions that are not necessarily in the best interests of members
6. Any failure by non-insurance-based consolidation vehicles would have a significant reputational impact on pensions / long-term savings in general

9. It is our view that consolidation should not be thought of exclusively in the narrow sense suggested by the PLSA. Even in advance of the emergence of an adequate regulatory framework for non-insurance-based consolidation vehicles, there are a number of consolidation options already available to DB pension funds which do not weaken the security of member benefits. These include:
1. Pooled funds
2. Pooled administration
3. Multi-employer funds
4. Master Trusts
5. Bulk annuities

10. Our recommendations therefore, are:
1. Public Sector Pension Consolidation: Focus on achieving further consolidation savings in public sector pension funds, which are more directly comparable in nature to the successful, large Canadian and Dutch pension funds
2. Private Sector DB Pensions:
1. Investigate why multi-employer funds haven’t worked and encourage more attractive vehicles along these lines to be established
2. Explore why more pension funds haven’t taken advantage of cost savings available via pooled investment funds, which are currently, and widely, available
3. Require trustees to accurately document all fees and expenses incurred for professional services, including actuaries, lawyers and investment consultants, and publish this to members in an annual report. We note the FCA work on investment management fees may be helpful in this
4. Require trustees to calculate and disclose a quantitative measure of the risk to which they are exposed. This can be constructed as the increase in the scheme’s deficit following a 1 in [25/50/100] year event, using risk calibration methodologies that are already used by the insurance industry, and publish this to members in an annual report. This will also help TPR focus its resources on those schemes genuinely at long-term risk
5. Require sponsors to be more transparent with their shareholders about the level of exposure they have to DB liabilities in their Report & Accounts, in particular, there should be a requirement to publish their Section 75 deficit on an annual basis
3. A clear regulatory framework to oversee these vehicles:
1. The power to approve the investors in, and the structure of, non-insurance-based consolidation vehicles, for example via a Change in Control process
2. An approach to risk management that takes into account the severing of the corporate covenant and which is therefore appropriate to the nature and degree of risk in the vehicle (is it appropriate that they hold resources to have a 1 in 10 risk of failure, as proposed, meaning pensioners would on average have a benefit cut every 10 years?)
3. Governance and control processes in place that mirror those applied to banks and insurers and an approved persons regime
4. The power to order financial penalties, suspensions and restrictions
5. Detailed rules around who provides the capital/surplus resources, and how, when and to whom these are released when no longer required
6. Clear powers for TPR to approve transfers into non-insurance-based consolidation vehicles, require additional funding and take action against investors if necessary
7. Pricing set by a competitive market process, but only in conjunction with risk-based capital requirements (calibrated to deliver a minimum acceptable level of failure both in terms of maintaining a specific level of solvency and being able to deliver the promised benefits) and a robust regulatory regime, under the Prudential Regulation Authority (“PRA”)

To what extent is improving TPR's effectiveness a matter of greater powers, better use of resources or cultural change in the organisation?

11. Without a clear regulatory framework, and some power to authorise, we believe it is unfair to expect TPR to be able to fully regulate each and every one of these complex, potentially systemically significant non-insurance-based consolidation vehicles on an individual basis. We also have questions about the resources and cost that would need to be invested to allow TPR to adequately perform the task required, when the PRA already has a well-resourced, well-established supervisory framework for pension consolidators in place, within the Solvency II framework.

12. Any significantly increased burden on TPR without this framework may well divert manpower and resources away from the early identification and necessary interventions to prevent any future BHS-type scandals. Even worse, new structures are likely to be designed to put investors and funds beyond the reach of TPR’s powers. One of the lessons learned from the financial crisis means that regulation has moved away from allowing systemically important financial institutions to exist without detailed risk and governance frameworks. Non-insurance-based consolidation vehicles would have all the risks that were present in pre-crisis financial institutions without these mitigating structures.

13. One way to help TPR to better focus its resources is to require trustees to include in their valuation measures an explicit and quantitative measure of the risk exposure of the pension scheme. It is our view that pension schemes should be required to incorporate into their funding targets an explicit calculation of their risk exposure.

14. The discussion on funding between the sponsor and the trustee would then be focused on the extent to which the risk exposure needs to be funded explicitly by contributions into the scheme (and over what period), or whether it is appropriate for the trustees to rely on the sponsor to be able to afford the additional contributions needed after the risk events modelled have occurred. This is shown in the following diagram of how a pension funds balance sheet could be calculated and disclosed:

15. The full risk exposure of the pension fund calculated on this basis will be a very useful tool for TPR to use in focusing its resources, as this will help not only to identify those schemes that have a large deficit today, but those schemes that are at risk of having a large (and unaffordable) deficit in the future. This will help facilitate earlier intervention in distressed cases.

16. The discipline of calculating explicitly the pension scheme’s risk exposure, and incorporating this calculation into the funding requirements, will more directly avoid the practice of seeking to solve a deficit issue by simply taking more investment risk without allowance for whether taking that risk is affordable given the resources available to the scheme. We expand on this idea in the section “what should “prudent” and “appropriate” look like”, below.

What can be done to strengthen the regime for clearing corporate transactions (like dividend payouts, selloffs, takeovers)  that might weaken a pension scheme?

17. We agree with the Government’s proposal to strengthen the clearance regime so that sponsors give sufficient regard to their pension scheme during corporate transactions.

18. As part of this, we recommend that more transparency is brought to the pension scheme funding reporting process, not least because this would allow management teams to be empowered to tackle pension risk in a realistic way. This might include an explicit ultimate goal for the pension scheme, e.g. on-going reliance on the corporate covenant, self-sufficiency, or buyout.

19. More specifically, whilst sponsors have to make disclosures in line with financial reporting standards, the deficit figures that are published can often bear little resemblance to the contribution commitments of the employer or the exposure to a Section 75 deficit. 

20. Sponsors of these schemes should therefore be more transparent with their shareholders about the level of exposure they have to DB liabilities in their Report & Accounts. In particular, there should be a requirement to publish their Section 75 deficit on an annual basis. Sponsors should be required to demonstrate in their Report & Accounts how the interests of shareholders and the interests of pension scheme members have been balanced if there is a deficit.

Will a criminal offence provide a meaningful deterrent?

21. Directors who fail in their duties can already face criminal sanctions. It is in our view more appropriate to focus on protecting members; it will be cold comfort to them if a Director is in prison if they have lost their hard-earned pension. TPR’s powers to issue Contribution Notices and Financial Support Directions should be amended to ensure they apply to investors in non-insurance-based consolidation vehicles and in particular, partnership-type structures. TPR should also have the power to approve transfers into non-insurance-based consolidation vehicles, and their structure.

22. We believe that allowing superfunds to emerge ahead of any clear regulatory framework may well incentivise sponsors to offload pension liabilities whilst they can, with less of a view on the security of member benefits and more of a view on avoiding personal liability.

What should "prudent" and "appropriate" scheme funding mean?

23. The key area that is missing from the current valuation measures is an explicit and quantitative measure of the risk exposure of pension schemes. It is our view that pension schemes should be required to incorporate into their funding targets an explicit calculation of their risk exposure.

24. Techniques for quantifying risk are well developed in the insurance and banking sectors, and are used as a primary tool by insurance regulation to ensure that insurance companies are well capitalised and secure. It is something of an anomaly that pension funds as financial institutions are not required to calculate, fund to, and report their risk exposure on a quantitative and consistent basis. The techniques used are, however, applied by many pension funds on a voluntary basis and are often incorporated into the investment advice that is received.

25. Most scheme actuaries should have no problem calculating a risk metric as part of the valuation process.  This could be done utilising value at risk methodologies that are widely understood and applied.

26. The requirement to include an explicit risk measure in the funding objective, calculated in line with a consistent and well-defined set of principles, could replace the current practice of incorporating “prudent margins”, which are somewhat opaque. We believe that this change could be incorporated without any change to legislation, and the regulator would simply incorporate into its guidance that it expects pension schemes to use this approach to determine the appropriate level of prudent margins.

27. The value at risk would look at the increase in the scheme’s deficit following a series of risk events, for example:
1. A [1.0%] fall in long term interest rates
2. A [1.0] rise in long term inflation
3. A [2.0%] increase in credit spreads on corporate bonds
4. A [25%] fall in equity markets, or equity like investments
5. A [2] year increase in life expectancy
6. Other stresses relating to expenses, operational risks etc

How can consolidation of the fragmented DB landscape be best achieved?

28. The large Dutch and Canadian plans are often cited as examples of what consolidation can achieve. It should be remembered that these plans are generally either public sector plans with a commonality of employer/sponsor (taxpayer), or multi-employer plans resulting from compulsory collective labour agreements applying across industrial sectors (such labour agreements are not a feature of the UK labour market). The large Dutch and Canadian plans are therefore more of a template for UK public sector funds.

29. Looking at the private sector, the UK currently has dozens of what might be classified defined benefit superfunds, such as USS (396,000 members, liabilities of £73 billion and assets of £60 billion), BT Pension Scheme (300,000 members, liabilities of £61 billion and assets of £49 billion), and the Barclays Bank Pension Scheme (280,000 members, liabilities of £43 billion and assets of £34.6 billion), which provide pensions for millions of people. The Committee should note that size alone is no panacea, with many of these super-large pension schemes, a good number of which have professional in-house investment teams, running considerable deficits.

30. It is therefore pertinent to ask who benefits from the proposals for non-insurance-based consolidation vehicles that are currently being examined by this Committee. The PLSA’s rationale for consolidation of DB schemes is that, “…sharing certain functions to benefit from economies of scale and strong governance would have enormous benefits in reducing risk to scheme members, and also for sponsors and the wider economy.”[2]

31. Having carefully considered these proposals, and such plans as exist, it is our opinion that the primary beneficiaries will be the sponsoring companies, who can cheaply and easily sever the link to volatile and expensive pension schemes, “…the superfund would provide employers sponsoring these plans who wanted to offload their liabilities with a cheaper alternative to paying an insurer to take over the payment of pension commitments.”[3]

32. Other beneficiaries would be the investors in, and directors of, the superfunds, who will take a significant performance fee from managing the assets they consolidate. The suggestion is that the returns would be in the region of 28% NET IRRs per year[4], in effect offering investors their money back after just three years. This very short-term gain is in no way aligned with the long-term nature of the underlying pension benefits and serves to highlight the level of risk that will be run within the portfolio to generate this level of profit.

33. It is clearly the intention of superfunds to seek investment outperformance – and therefore profit for its investors – through engaging in regulatory arbitrage, rather than realising profit as an outcome of what should be their purpose: securing and paying their members’ pensions. Superfunds will not give members the benefit of insurance because they are not insurance. They will, however, give sponsors the benefit of being able to offload pension liabilities on the cheap, which means that the members are being asked to subsidise their employers’ costs by sacrificing the safety of their hard-earned pensions. We believe this regulatory arbitrage will only increase the likelihood of super-sized BHS and Carillion scandals, helping to undermine confidence in pensions and long-term savings more generally.

34. In our view, pension superfunds will be able to put pension benefits at risk precisely because there are no unambiguous legal and regulatory frameworks protecting those benefits. For example, in 2008, prior to its collapse, Lehman Brothers was attempting to offer a similar consolidation model: “Lehman Brothers is active in helping clients look at different ways of managing their pensions risks - including removing these from the balance sheet entirely if appropriate…According to market sources, the U.S. investment bank was one of the bidders for the pension scheme of U.K. engineered materials manufacturer Delta, a deal that was last month clinched by Pension Insurance Corporation.”[5] If Lehman Brothers had been successful, the 10,000 pensioners of the Delta Pension Scheme would have been caught up in the bankruptcy, perhaps not receiving any money for years. As it was, their benefits were 100% secured within the insurance regulatory framework, with total transparency and alignment of interests with the Directors of the insurer.

35. Despite appearances, superfunds are entirely different from both DB schemes and life insurance companies in design, incentive structures and investment outlook. Our main concerns about these non-insurance-based consolidation vehicles centre on two areas, deriving from the fact that the trust based pensions regime was never designed to protect members from those seeking to make commercial gain from pension obligations:

• Conflicts of interests
• Systemic risk

Conflicts of interest

36. There are several areas in which the superfund stakeholders are subject to conflicts of interest. It is our view that these funds should not be allowed to launch before legislation can remove, or significantly ameliorate, these conflicts of interest.

37. The first conflict of interest is the degree of separation in practice between superfund investors / management and the trustee board. A similar situation was created when Master Trusts were established. As Daniel Shaw and Alison Guy of CMS Cameron McKenna observe: “Originally, providers often set up master trusts on a bundled basis, usually appointing the trustee and providing various administrative or advisory services. The Pensions Regulator and the Department for Work and Pensions agreed that the lack of trustee independence from the provider could lead to poor member outcomes.”[6] What guarantees are there that this issue will not simply be replicated in these superfunds? The trust based pensions regime relies on the freedom of action of trustees. This would be in direct conflict with the commercial interests of those seeking to make a profit from pension obligations within a superfund.

38. A second conflict of interest arises when the needs of shareholders in sponsor companies are prioritised over the security of members’ benefits. Offloading burdensome DB liabilities more cheaply and easily through superfunds must be tempting for some management teams. This is moral hazard, letting those responsible for the pension promise off the hook, with the member left to bear the risk.

39. As is the case with the clear regulatory rules preventing the sponsoring company from abandoning a pension scheme (at least as the system has worked for the past 15 years), we recommend clear regulations to prevent superfund investors simply pulling the plug and walking away if the Trustees’ investment decisions lead to a large deficit. Likewise, we recommend clear regulation preventing investors taking advantage of a “PPF put”, whereby they can increase risk knowing that in the event of failure the PPF would be there to pick up the pieces. Equally, we recommend explicit protections for member benefits where ownership of the superfund top company changes (a good example of this is the PRA’s Change In Control process, which makes it a criminal offence to acquire or increase control in a regulated company without notifying them and receiving approval first).

40. One way to prevent any abuse is to make the directors of the superfunds personally liable, as the White Paper proposes the directors of sponsoring companies become personally liable. Personal liability, as it exists within the insurance regulatory framework, would help resolve one of the key questions around alignment of interests of investors, management and pensioners. Currently, the short-term interests of superfund investors and directors seem to have a higher premium than those of the members in the long-term. This misalignment of interests is particularly raw in the wake of the BHS and Carillion scandals.

41. It is our understanding that superfunds would attempt to tackle these inherent conflicts of interest through a multi-layered and extremely complicated web of governance arrangements, contracts and agreements. This complexity is first of all an admission of the unnecessary tensions inherent to this business model, and then an attempt to avoid further regulatory scrutiny. We believe this complexity will lead to confusion for scheme members, a lack of clarity about responsibilities and ultimately could increase operational and financial risk.

Systemic risk

42. In time, the sheer size of superfunds means they may become be too big to fail, representing a systemic risk. As has been noted, these superfunds are looking at consolidating very significant amounts of liabilities, “UK’s first pension consolidation fund targets £500bn in assets”[7].

43. There is not currently an adequate regulatory framework based on high levels of safety and security for member benefits. For example, the present regime appears to let superfunds determine for themselves appropriate capital levels. This is in sharp contrast to other parts of the financial system in which concentrated levels of risk are located – such as banking and insurance - where there are strictly mandated, supervised and stress-tested capital requirements.

44. Without a clear regulatory framework, we believe it is unfair to expect TPR to be able to fully regulate each and every one of these complex, potentially systemically significant entities on an individual basis, when the PRA has a well-resourced supervisory framework for pension consolidators already in place within the Solvency II framework. Any significantly increased burden on TPR without this framework may well divert manpower and resources away from the early identification and necessary interventions to prevent any future BHS-type situations. One of the lessons learned from the financial crisis means that regulation has moved away from allowing systemically important financial institutions to exist without detailed risk and governance frameworks. Superfunds would have the risks that were present in pre-crisis financial institutions without these mitigating structures. 

45. As the White Paper notes, careful consideration needs to be given to the fate of the members in the case of a superfund failure. The White Paper asserts, following suggestion from the PLSA, that consolidators should only be funded to “…80-85% of the cost of full buyout”. This 15%-20% gap in funding level represents the amount of capital required to cover today an insurance company’s pension liabilities in the case of failure (although there has never been a case in the UK of a guaranteed annuity not being paid). 

46. As superfunds, as proposed, will not have adequate capital levels to back all pension payments, and the link to the sponsor will have been severed as part of the transfer, there are genuine questions to be answered in the case of failure, in particular whether members simply have their benefits cut so assets match pension liabilities. If the proposal is that the members fall into the PPF, would the PPF be able to cope with a superfund collapse, perhaps encompassing hundreds of thousands of pensioners, or would the taxpayer ultimately have to provide for the lost pensions? It is hard not to conclude that the government of the day would come under immense pressure to act, as we saw with the near-collapse of the large (but not super) British Steel Pension Scheme.

47. We believe that it is therefore of critical importance that HM Treasury and the PRA consider and analyse the systemic risk implications of superfunds and ensure that there is both an appropriate capital regime and adequate supervision of these vehicles. 

Given the difficulties facing DB schemes, is a faster legislative timetable warranted?

48. We do not believe that a faster legislative timetable is warranted. However, we believe that allowing superfunds to emerge piecemeal before a clearly defined regulatory framework is in place to protect the benefits of scheme members is an error, will encourage regulatory arbitrage on the part of investors, moral hazard on the part of sponsoring companies, and put the security of members’ benefits at risk.

May 2018