Cicero Policy Briefer

Issue 23, April 2008

Understanding Pension Guaranty Insurance

By Con Keating, Head of Research, BrightonRock

One of the declared objectives of this government is the maintenance of good defined benefit (DB) pension schemes. This may be considered sound policy as they are in principle far superior to alternatives such as defined contribution schemes. Unfortunately the value-for-money proposition associated with this form of scheme is now so low that the finance directors of many sponsor enterprises wish to curtail their commitment.

This is in large part a cumulative effect of government action over time. Legislation has progressively added to the liability burden: preservation of early leaver benefits, limited price inflation increases in entitlements and spouses’ benefits are among these additions. Simultaneously, government concessions in the form of tax and social security treatments have been progressively reduced: among these are the reductions of the ‘contracted out’ National Insurance rebate, and the effective abolition of the advanced corporation tax benefit. This has also been accompanied by a reduction of the corporation tax rate from more than 50 per cent in the 1970s to today’s 28 per cent, which of course raises the effective cost of a pension contribution to a shareholder.

Until the 2003 enhancements to the ‘debt on employer’ legislation, and the subsequent Pensions Act 2005, curtailment was a simple and usually inexpensive process. The introduction of the Pensions Regulator and the Pension Protection Fund (PPF) have added significant cost to curtailment, and also significant costs to sponsors who wish to continue offering this voluntary form of benefit to their employees. Effectively the only way to achieve full curtailment now is to engage in a bulk annuity purchase, a process which requires the scheme to close, cease all benefit accrual and wind up. It typically costs some 20 to 30 per cent more than the FRS17/IAS19 accounting liability—an exit expense introduced ex-post for voluntary schemes.

At the same time revisions (which are still contentious) to the accounting standards have focused attention upon pension issues, and have arguably increased the pressure on DB schemes to close.

For ongoing schemes, the costs of PPF membership must be added as scheme expenses. The latter include levy costs, funding level costs and compliance expenses, such as the S179 valuations. In addition, the PPF has suggested that it may increase its levy income by reflecting asset allocation in the risk-based levy, and also that it may raise levy income yet further in order to build up reserves - as if it were an insurance company, rather than the compensation fund that it is. The level of over-funding that the PPF requires for exemption of a scheme from the risk-based levy, which has just been raised to 140 per cent of the S179 valuation, may be used to indicate the potential long run cost of the levy—with interest rates at 5 per cent, this is an annual premium equivalent cost of greater than 2 per cent.

Indeed, the PPF is an excellent illustration of poor institutional design. It promises to pay, at best, 90 per cent of the entitlements of the members of schemes whose sponsor has failed. In individual cases the compensation offered by the PPF may be as little as 60 per cent of the entitlement. At first sight this appears to be a form of deductible with which we are all familiar from our household and motor insurances. The rationale in the world of insurance for the presence of a deductible is that it mitigates a problem of moral hazard—namely, that we may not be as diligent and careful after insuring as we were before; it is recognised as an optimal form of risk-sharing. However in the case of pensions insurance, the situation is different: the insurer (the sponsor/scheme) and the beneficiary (the member) of the insurance are not the same person. The deductions from full entitlement no longer function to modify behaviour, but simply function as another device to lower the consequence to the PPF of a sponsor failure. Full cover insurance of pensions is both feasible and theoretically sound. The PPF has incidentally stated that it covers just one-fifth of the full risk DB schemes face from their sponsor’s failure.

Sound risk management principles can help us greatly in understanding pension guaranty insurance. The risk of an event is the product of the likelihood of the event and its consequence. So in order to reduce risk we may take action either (or both) to reduce the chance of the event or to mitigate the consequence of the event. There is a sequential order here; if we eliminate the possibility of the event then we rightly have no concern with mitigation of the consequence of the event. The economically efficient approach to risk management is foremost to prevent claims occurring, not to minimise the severity of the consequent claim. This latter approach is particularly inefficient when there are many schemes where claims may never occur.

This distinction also helps us in understanding why it would be inappropriate for the EU to subject many pension funds to the same solvency regime as insurance companies. The regime is indeed appropriate for insurers - as it results in a reduction of the likelihood of the adverse event (insolvency). But in the case of pension funds, where it serves solely as a risk mitigant of the consequence of insolvency, it does nothing to reduce the likelihood of insolvency and, indeed, it may even increase it.

The distinction also enables us to see why the Pensions Regulator and the PPF are operating inefficiently, both from their own standpoint and from that of the corporate sector. For there is little that they can (or for that matter should) be doing with respect to the likelihood of insolvency of a private sector company. They must consider this insolvency risk as exogenously given and focus solely upon the consequence after insolvency. The economically correct approach would be to consider scheme and sponsor finance jointly—and that can lead to very different results (and costs) from those that result from the current regulatory regime.

The PPF is principally concerned with the protection of its financial position and the limitation of its own liabilities. It has just two tools at its disposal—the amount of the levy and scheme funding. The PPF can and has altered the amount of the levy quite markedly, but has never yet achieved its mandated target that 80 per cent or more of revenues be risk based. The volume of alterations to levy rules and amounts has been the subject of much criticism by scheme sponsors and trustees.

The use of excess funding as a risk mitigant is a very blunt instrument which frequently results in higher risk to both beneficiaries and shareholders. It is, other than the quantum of the levy, the principal, and effectively only, mitigant available to the PPF, and this past year has seen it used excessively. Crude over-funding targets may bring protection to the PPF but their effectiveness needs to be considered in light of their economic and fiscal impact on the whole economy, as well as their value-for-money for participating schemes and their members.

Private sector insurance of pension schemes against the insolvency of their sponsor is intrinsically superior to the current regime. For a scheme with insurance to be granted exemption from both the risk and scheme based PPF levies, the current regulatory position requires it to be closed and in wind-up. Surprisingly the guidance notes which accompanied the draft of the relevant statutory instrument indicate a far broader intent than the final text. At present the best that can be achieved for an ongoing insured scheme is exemption from the risk based levy under the PPF contingent assets regime. This is an economic nonsense, since once fully insured, the scheme represents no risk to the PPF. The scheme would also have to continue to comply with many of the other regulations and practices whose sole purpose is to protect the PPF, incurring otiose costs.

BrightonRock recently met with the Minister for Pension Reform, Mike O’Brien, to discuss the possibility of amending the regulations to reflect the intent of the guidance notes in order that insured schemes would avoid unnecessary expense. The Minister declined to advance such amendments at this time. The expressed reason was protection of the PPF due to its relative youth.

Unfortunately the passage of time is unlikely to increase confidence in the security and sustainability of the PPF, at any reasonable cost, since its structure and method of operation is intrinsically short term and volatile, as may be seen immediately from the fact that its levy is based, inter alia, upon scheme deficits—a difference statistic. Like all such figures, the difference between two large, varying amounts (scheme assets less liabilities) is very volatile.

The Department of Work and Pensions, the drafters of the legislation and designers of the current institutions, issued a press release after the meeting, which also expressed an inchoate concern with “cherry-picking”. Such a practice would obviously not be socially desirable, but it is also neither practical nor good insurance practice.

Subsequently the Minister also requested a short report as to how an insurance policy such as that to be offered by BrightonRock might assist in prolonging the provision of defined benefit schemes in the UK. Both this and a report dealing with the question of cherry-picking are available for download from the BrightonRock website.

Several observers have picked up on the competition aspect of the Minister’s decision, among them The Actuary, which on 1 April published the article ‘PPF Monopoly in Operation’, which also observed: “No doubt readers will be able to explain the logic of the government position.” The Minister is doubtless well-positioned to judge whether there are competition issues among UK pension schemes (a largely domestic concern), but the relevant question is whether he as well-positioned to make judgements about the provision of insurance across European frontiers to pension schemes and their sponsors. For that of course we also have the history of government-sponsored export credit guarantee agencies in a European context to offer some guidance.

Details of the BrightonRock policy and copies of the two reports to the Minister are available from www.brightonrockgroup.co.uk.

Con Keating is the Head of Research at BrightonRock and can be contacted here.

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