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Review of the Minimum Funding Requirement
Danny Wilding looks at the possible short and long-term future of the Minimum Funding Requirement test on funding for UK occupational defined benefit schemes following the publication by the DSS of proposed changes to the test. For more details contact Danny Wilding in the London office.
The DSS published the long-awaited Minimum Funding Requirement (MFR) proposals on 14 September 2000 entitled "Security for Occupational Pensions", alongside a report prepared for the DSS by the actuarial profession which puts forward proposed changes to the MFR basis of calculation, both in the short-term and the long-term. This article summarises briefly the main issues and adds my own views as to the best way forward.
The current MFR
MFR applies to all defined benefit (final salary) occupational pension schemes. Currently it governs minimum individual transfer value calculations, and the minimum level of benefits to be provided on a winding-up. These are useful benchmarks to ensure fairness and consistency between pension schemes.
The MFR funding level must be checked by the scheme actuary at each triennial valuation. Schemes below 100% MFR must set employer contributions at least equal to those necessary to reach 100% over five years (and, if necessary, to reach 90% within a year). Many schemes are finding this requirement interferes with their funding plans, and some would argue it places undue pressure on employers to fund to overly-cautious levels.
The current MFR test is based on gilt yields for pensioners, but based on UK dividend yields for non-pensioners. The dividend yield test needs changing because shifts in corporate distribution policy have rendered it an inadequate measure of investment market returns. Generally the financial basis is too cautious.
The fact that MFR notionally "matches" all of the post-retirement liabilities to gilt assets is in itself unrealistic and too cautious. In practice it has caused some pension schemes to increase their gilt holdings at the expense of equity assets more likely to provide beneficial long-term investment growth.
The current life expectancy assumption underlying MFR is out-of-date (derived from survey data relating to the period 1967 to 1970) and needs updating. The inadequate mortality assumption currently offsets the over-cautious financial basis to a certain extent.
The new MFR proposals
The proposed new MFR basis is based on bond yields, with an explicit allowance made for equity outperformance above the bond yield. This objective methodology would be welcome in place of the current broken test.
The proposed equity outperformance allowance of 2% per annum is on the cautious side when compared to historical statistics. (Historical market data suggests +2% happens 9 times out 10, +3% 3 times out of 4 and +4% half the time. I would expect a minimum test to be more like a 50:50 test, ie +4% not +2%. Setting it at the 9 out of 10 level is far more prudent.)
For most schemes a proposed reduction in the equity return of 1% per annum to allow for investment expenses will seem excessive (especially for those managed passively).
No allowance is proposed for equity investment in the calculation of MFR liabilities for pensioners which is too cautious.
I support the proposed allowance for improvements in life expectancy, although I would prefer to see the use of more up-to-date mortality tables rather than ad hoc adjustments to the existing out-of-date tables.
I welcome the proposed extensions to the MFR deficit correction periods which would bring the MFR more into line with typical funding practice in the UK.
I believe the "short-term" changes proposed (but not to be implemented before the end of next year!) are unnecessary and that MFR should be moved straight to the new basis as soon as possible. In any case, the proposed short-term fix does not go far enough to correct the recent failings in the current MFR model.
Central Discontinuance Fund
As a potential alternative to all or part of the new MFR proposals the idea of a Central Discontinuance Fund (CDF) is resurrected. This would be a pool in to which schemes in wind-up could put their assets and liabilities, with some reassurance from the CDF that any shortfall of assets will be made good and the accrued benefits will be provided for (either in full or up to a pre-agreed level). The key to the CDF idea is the guarantor. Government has made it clear it is not keen to assume this role but thinks the pensions industry can arrange this internally. This is a fundamental flaw, as it would require well-funded schemes and responsible employers to agree to bail out poorly-funded schemes and irresponsible employers, which would neither be fair nor enforceable.
Without a State guarantor a CDF could never be more than a "winding-up club" arranged between a closely guarded group of consenting employers. The scope of such an arrangement would be insufficient to be of any practical use, and it is therefore not a helpful alternative to MFR.
Concluding remarks
The review timescale proposed would be too slow for trustees and sponsoring employers, many of whom are facing real difficulties arising from the current broken MFR model.
Most worrying of all, the DSS seems to think that the main problem with the current MFR model is that it is not a strong enough test. They seem to have lost sight of the fact that it is a minimum funding test, not a scheme solvency test. If pension scheme members think MFR is a solvency test then we should be educating members better. An overly cautious approach that requires employers to stump up pension contributions sooner than necessary will not serve to encourage proper defined benefit pension provision.
There is clearly a lot of work to be done during the consultation process! Responses may be submitted to the DSS up to the end of January 2001.
Danny Wilding, September 2000.