12 May 2016
The hazards of pension protection
by Frank O’Nomics
News of the failure of BHS, and the consequent takeover of a pension fund that is £571 million in deficit by the Pension Protection Fund, raises questions which go to the very essence of the way in which PPF operates. To begin with, is it right that younger members of company pension schemes should be effectively subsidizing those who have retired, by forgoing wage rises so that the pension fund deficit can be closed? Then there is an important debate as to how scheme deficits are measured, given that the current conservative approach exacerbates the need to commit ever greater sums for investment in assets which only produce moderate returns. The answer to these questions is certainly not straightforward, but of the 6,000 schemes that come under the potential remit of the PPF almost 5,000 are currently facing a pension fund deficit. The size of this deficit is close to £800 billion and, even if you reduce that to closer to £250 billion (given the reduced pensions that would be paid to schemes of companies in default), you still come up with a number that dwarfs the current assets of the PPF (around £23 billion).
The PPF exists to provide compensation to members of eligible defined benefit schemes (schemes which provide pensions based on final salaries) when their employer suffers an insolvency event and there are insufficient assets in the scheme to cover its liabilities. The PPF funds itself from annual contributions from all eligible schemes, the recovery of money from insolvent companies and the returns it can generate from investing the contributions. It can put pressure on the Pension Regulator to be, as the CEO recently put it, “as robust as possible on scheme funding”. However, it does not seem to have had great success given that, despite the size of the BHS deficit, the company paid £414 million in dividends over a four year period. Indeed, following this week’s testimony to the Treasury Select Committee, it seems that the Regulator has not used its powers to intervene in any of the 18,000 recovery plans that have been submitted to it (schemes have to be submitted every 3 years). BHS had proposed a 23 year recovery plan to close its pensions deficit at its last review, a doubling of the time proposed only 3 years earlier.
The size of a pension fund deficit depends on the assumptions made about future investment returns, the level of interest rates and for how long participants will live. The assumptions currently used are very conservative and hence tend to accentuate the size of deficits, which might seem very sensible at first glance but can be self-defeating as they encourage funds to go into low risk, low yielding bond markets rather than equities, thereby negating the possibility of economic growth helping to eradicate the deficits by generating better investment returns. Thus the only way that economic growth supports the process is that it helps profitable companies to add greater sums to their pension funds, so that assets may ultimately reach the level of liabilities. Here lies a problem. If a company is pushing profits into it pension fund, it is doing so at the expense of shareholders (who do not receive dividend increases) and/or employees (who do not get pay rises). For the work force this is particularly galling as current employees are unlikely to be part of a defined benefit pension scheme (most have been rightly closed as being too expensive) and will be in a defined contribution scheme that, by definition, cannot have a deficit. Put simply, current employees are sacrificing pay to subsidise retirees – another woe for generation Y (to add to not getting onto a defined benefit scheme, having to pay for their university education and missing the housing boom). In the case of BHS 11,000 employees are at risk of losing their jobs partly because of the need to continue to fund the 20,000 BHS pensioners (who now face a cut in their pension income).
Another issue is the size of the potential burdens on the PPF when compared with the amounts recoverable from receivers and administrators . Take a company which has a reasonably profitable business but is saddled with a huge pension deficit due to the scheme having a significant number of retirees, perhaps dwarfing the number of existing employees. Suppose it goes into receivership. The pension liabilities will pass to the PPF, as will so much of the amount received for the business on its sale by the receivers as is not absorbed by creditors with prior claims. Often the business will be a very attractive proposition, given that it will now be free from the obligation to channel revenue into the pension fund, but it will be being sold in a fire sale and the purchaser may need the cooperation of management, both things which point to a sale at a relatively low price, possibly to a management dominated consortium. Although the PPF may be able to claim some of the money realised, it will not participate in future growth if the business goes on to become a success. One way or another therefore the recovery by the PPF will seldom be substantial compared to its outlay. We would not need many of the aforementioned 5,000 companies to go through this process to generate an economic mess for the UK. We would also have a large cohort of pensioners who would suddenly see their pension incomes drastically reduced as that is what the PPF would be compelled to do.
How can all this be resolved? Given a fair economic wind, time should produce the solution. A more robust approach from the Pensions Regulator to ensure that profitable companies set more aggressive timescales for closing their deficits should help reduce the numbers forced to go to the PPF, but not those who will forego wages rise or dividends. For the PPF, its levies can build up over time to give it sufficient capital to ensure that it can provide for schemes that go into default. The PPF has set itself a target of getting to self-sufficiency by 2030 and, although this may be difficult if we have many more events like that at BHS, it has a good chance of getting there.
For the problem of the restrictions to shareholders income and workers pay, time will also be a key factor. There are very few new entrants to defined benefit schemes. Many of those that have been in them are being shifted to defined contribution schemes and the numbers of pensions-in-payment will inevitably decline as members die off. However, this will take a whole generation and will be of little consolation to those who are forced to subsidise their predecessors.
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