Estimated reading time: 4 minutes
Partner and experienced pension actuary, Danny Wilding, shares some thoughts on managing legacy defined benefit (DB) pension promises - following on from his speaking slot at the Professional Pensions Risk Reduction Forum.
I think there is an aspect of past DB pension promises that employers should certainly be allowed to revisit; pension increases in payment.
Historical pension increase promises were driven by a mixture of legislative requirements, peer practice, paternal instincts, and wanting to be fair between different generations of pensioners. However, with very few DB schemes having been set up in the last decade or two, pension increase promises were generally made during times of much higher price inflation. Furthermore, fixed increases were often substituted for inflationary increases because they were easier to administrate. Also, when some elements of pension increases became a statutory requirement, past discretionary pension increase policies often became hard-coded. This was generally done for simplicity, as opposed to having a separate guaranteed element and a discretionary element. This also reflected higher average funding levels during times of higher long-term interest rates.
A related point is that many private sector schemes have become tied to the Retail Price Index (RPI) definition of price inflation due to their historical rule wording, and cannot now switch to a more appropriate Consumer Price Index (CPI) inflation measure (as State and public sector pensions have done).
"In my view, UK schemes should now be allowed to move to a more modern and more appropriate pension increase policy. "
If a DB scheme were designed in the current economic environment, pension increase policy would be very different - with higher life expectancy and low long-term interest rates significantly increasing the cost of pension escalation. Guaranteed increases would be limited to statutory requirements - which may well be zero if the government actually wanted to encourage DB schemes. Increases would instead be provided under a discretionary policy, targeting price inflation (based on CPI, and capped) rather than a fixed increase, and with provision being reviewed from year-to-year based on scheme experience. Increases would be deferred in years of adverse investment performance (or other financial or demographic experience) and cancelled if poor experience persisted. This would be much closer to the way that DB-style schemes operate in the Netherlands, which has been a much more successful and sustainable model than DB schemes in the UK.
In my view, UK schemes should now be allowed to move to a more modern and more appropriate pension increase policy. This would strike a fairer balance between future pensioner benefits and funding costs for employers - and would provide greater security for the redefined benefits.
If we were starting from scratch, DB schemes - past and future - would be allowed to operate a fully discretionary pension increase policy. However, existing schemes should be subject to some controls to reflect the fact that, for the various reasons set out above, historical pension increase promises have been made.
The first control should be that increases in line with those provided by the Pension Protection Fund (PPF) would serve as a statutory minimum for accrued benefits. This should ensure that no pensioner could be worse off staying in an existing DB scheme than transferring to the PPF following scheme insolvency.
A second control would be that pension increases should continue to be allowed for within scheme funding plans in line with historical practice. A related point would be that no payment could be made from schemes back to sponsoring employers in future unless historical pension promises had been reinstated and provided for in full. Similarly, future individual transfer payments would need to reflect both PPF pension increases as a minimum, and also higher increases in line with the historical policy to the extent consistent with the scheme’s current funding level.
A third control would be that the new pension increase policy should be agreed between employers and scheme trustees, and trustees should be responsible for managing the future policy.
One key benefit of this approach would be that schemes would retain greater flexibility in their investment strategies for longer, and this flexibility should lead to higher overall scheme returns and higher member benefits over time.
In my view, schemes should also be allowed to buy-out under similar terms in future – for example by buying a bulk annuity policy that provided PPF pension increases as a guaranteed minimum, and additional discretionary increases on the basis of a ‘with-profits’ annuity.
There are other aspects of historic DB pension promises that employers would want to be able to revisit - such as normal retirement age; schemes could be allowed to increase pension age in line with life expectancy, as the State pension now does. However, pension increases should be the first priority, and a sensible policy along the lines set out above would go a long way to rescuing the funding strategies of hundreds of insolvent DB schemes. It would greatly reduce the number of future PPF transfers and would ensure that DB pensioners would receive higher overall pension payments as result.