PensionsMar 29 2017

The DB green paper under the microscope

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The DB green paper under the microscope

The long-awaited green paper issued by the Department for Work and Pensions (DWP) was a challenging read and covered a substantial amount. It followed an informal consultation in 2016, which was undertaken with a range of stakeholders, but no consensus was reached on whether or how to adjust the current balance between protecting members and supporting employers.

In the paper, the DWP sets out the available evidence concerning the key challenges facing defined benefit (DB) pension schemes, and highlights several options that have been suggested to improve confidence in the system. 

It focuses on four key areas: funding and investment, employer contributions and affordability, member protection and consolidation of schemes, giving proposed changes in each. The key section I am focusing on is the consolidation of schemes. 

 

The issue

The DB market is not only vast in size, but also diverse in nature, which makes trying to be cost efficient and cost effective very difficult.

According to the green paper there are more than 6,000 DB schemes in existence with more than 11 million members. However, 10 per cent of members account for 81 per cent of the schemes and 2,000 schemes have fewer than 100 members. This causes further challenges for sponsors and trustees because of the higher proportionate cost of running a smaller scheme. Schemes of this size are unable to benefit from the economies of scale enjoyed by larger schemes. Consolidation seems an obvious solution. 

The regulator would also find consolidation a good option: regulating such a landscape of small to large schemes with different characteristics is difficult. The regulator only has finite resources, which are focused on those schemes that present the largest risk to the most members. 

Consolidation would bring with it reduced risks because of reduced costs, improved governance standards, and would reduce the administration burden if it can be done well. This would not only benefit the regulator, but also the scheme sponsor, members, and possibly the Pension Protection Fund (PPF). 

 

The challenges

This may all sound great, with every side winning, but there are significant challenges to consolidation that in some cases cannot be overcome. 

Consolidation would clearly have an upfront cost, as anyone who has ever tried to merge two sets of data will know. There would need to be extensive work done on most schemes’ records to ensure they are as accurate as possible and able to be merged with another set of data that will have possibly been derived in a different way. 

Merging schemes under one employer would in theory be relatively easy, but the likelihood that the benefits would be the same is slim – else they would have been in the same scheme already. Consolidating schemes of differing employers throws up all sorts of additional issues. 

Businesses will want to keep some data confidential. This might be about the scheme members, retirement dates and the age of the workforce or it might be more commercially sensitive with regards to its strength, funding ability and commercial strategy, all of which could have an impact on the scheme. This could mean full consolidation with schemes that seem compatible might not be feasible. 

It is unlikely that many schemes, if any, have identical characteristics. The age of members, retirement dates, maturity of membership and, not least, the structure of the benefits might all differ. This in turn would likely mean different investment and funding strategies. 

 

Consolidation models

The various models for consolidation are suggested and considered in the green paper. Some seem more likely to work than others, but they all have one aim in common. That is to reduce costs and increase the likelihood of schemes surviving for long term without impacting on the sponsor’s ability to continue to exist. 

The first model and the simplest is the ring-fenced model, which would deal with some of the issues mentioned above, but would not necessarily solve all of them. It works on the basis that some services are consolidated. Which services and how much would depend on the schemes themselves.

The main area of consolidation would be back-office functions such as administration, legal and actuarial work as well as investment and covenant assessment functions, but the schemes would continue to maintain separate assets and liabilities. It could also cover trustee services, such as having a single trustee board that acts for the whole consolidated scheme. Investments could be pooled, increasing the buying power of the scheme, although the actual investment strategy could differ. 

This option is similar to the DB master trusts that offer one actuary, one set of trustees, a single pool of investments and a single back-office system.

These schemes have not yet proved popular, which implies they are not a suitable solution for many, but this could just be because they need some tweaks to provide an incentive to encourage consolidation in this way. That said, this is not  consolidation of schemes, but more like a selection of shared services that will, in theory, save money. But this cannot be guaranteed because of the diversity of the schemes that may have to be dealt with.

Dealing with this diversity at outset might be a solution, but given the uncertainty of the future when it comes to pensions and pensioners, it is difficult to accurately convert to universal benefits that guarantee no one will lose out. 

Full consolidation is another option, but it involves all of the above as well as the consolidation of liabilities, which brings with it even more issues. The main issue would likely be the cross-subsidy between schemes, especially where they differ from one other at the outset. Although this option would probably save the most money and be the most efficient in the long run, it is unlikely to be popular because of the initial complexity when establishing the scheme.

It has been suggested that the government could design consolidation vehicles and operate them on an arm’s length basis, or provide the framework for this type of ‘super fund’. It was even suggested by the work and pensions select committee that such a scheme could be operated by the PPF. 

It seems unlikely the government would want to interfere to this extent in the market or take on the risk from the scheme when it does not have to, so creating the opportunity for others to do this would seem the best option. 

The super fund approach may help those looking to exit who cannot afford a buy out and are not in such a situation that would put them into the PPF, so would surely be a good thing to protect members and sponsors alike. In addition, it would be particularly useful for those schemes or sponsors who are deemed stressed, because the cost savings could be enough to protect the sponsor and scheme for the long term, avoiding the need to go to the PPF. 

One of the biggest barriers to consolidation is the regulation surrounding it, and the green paper goes on to look at options for removing some of these barriers without putting members at risk.

This could encourage greater consolidation, but some think there is still a need to bring in criteria that would require schemes to consolidate. These criteria would be difficult to set and manage with schemes in detail, and high-level criteria may not tell the whole story of a scheme and its liabilities. 

 

Conclusions

The green paper is only the first official stage in this debate. It is so detailed, and considers so many areas, that concrete action is unlikely soon. DB schemes still generally provide the best benefits in the pension landscape and should be protected as much as possible.

If this means consolidating schemes to save costs and the burden on employers then surely this is a good thing. There are many issues to overcome for employers, trustees and even members before any type of scheme consolidation can commence, so it is not a quick fix, but it could save some schemes that would otherwise have ended up in the PPF. 

 

Claire Trott is head of pensions strategy atTechnical Connection