AARP: Policy and Research Information for Professionals in Aging
Global Report on Aging
Spring 2006
World Perspectives
Insuring Occupational Pensions
One measure of a civilized society is the way it cares for its older members. It can only be fair that pension scheme, or plan, members receive the security in retirement they have been promised.
Defined benefit pension schemes have never been so valuable to members. At the same time, they have never been so costly for employers. This is something of a paradox as the bad news-that they are costly-is caused by the good news: that we are living longer in a low interest rate environment that is supportive of business growth and the creation of wealth.
The UK Pension Protection Fund, of which I am chairman, celebrated its first anniversary in April, 2005. It was created to provide affordable and sustainable protection for scheme members against the personal tragedy of destitution in old age caused by the failure of their employer's pension promise. We are not defending the interests of a small number of people-around 25 percent of people in the UK have a stake in a defined benefit pension scheme.
We have achieved a lot in our first year. We have dealt with a number of very high profile cases including Sheffield Forgemasters and MG Rover (it's worth noting that MG Rover became insolvent just days after we opened for business).
In addition to the schemes named above, 50 schemes with over 25,000 members are being assessed for entry into the Pension Protection Fund. It had been predicted that we would be assessing 250 schemes in our first year, but thankfully this prediction was wide of the mark-the fewer cases we deal with the better.
In June 2005, the Board published its 'Statement of Investment Principles', setting out the principles and policies governing the investment of the 2005/6 initial levy, or premium, that schemes eligible for Pension Protection Fund protection had to pay. The Statement demonstrates the Pension Protection Fund's commitment to managing its assets effectively and appropriately to protect the interests of both levy payers and beneficiaries of compensation.
But there is no escaping that providing pension scheme members with protection has to be paid for. The greater pension deficits are, the more risk the Pension Protection Fund is exposed to, and we have to fund our operations accordingly. The Pension Protection Fund is not responsible for this risk but has acted as the messenger, reporting back to business the price for the risk the business is collectively running. While deficits have fallen from their record highs just a few years ago, the total deficit measured on a Pension Protection Fund basis is estimated to be £100bn.
The truth is that only business can reduce this risk-no one else. We are not adding to costs, as some would claim; we are merely making explicit the cost of risk already implicit in the system.
One of the most challenging pieces of work carried out by the Pension Protection Fund, over the past 12 months, was to draw up the more-advanced risk based levy. This was a world first-no other pension protection scheme in the world charges a risk based levy.
The aim was to create a levy that was:
- fair - ensuring that schemes pay an appropriate amount towards the levy reflecting the risk they pose;
- proportionate - ensuring the levy is proportionate between schemes and its impact on individual schemes and;
- simple - applying effective and simple mechanisms and solutions for collecting the data required to set the levy.
The levy is calculated by looking at a scheme's funding position and measuring the likelihood of the sponsoring employer becoming insolvent.
Stakeholders made it clear they wanted the risk-based levy to be introduced at the earliest opportunity. To achieve this and to demonstrate that we are an open and transparent organization, two consultations were held and the pensions industry invited to comment on our proposals.
In light of the responses we received through the consultations, we were able to develop a powerful set of incentives, which could reduce their levy bills. The incentives include:
- Contingent assets would be taken into consideration when calculating the levy. In the event of a scheme's failure, the following contingent assets would be taken into consideration; a group company guarantee, security over cash, security over real estate (England and Wales), security over securities, a letter of credit or a bank guarantee.
- Any scheme that is over 125 percent funded on a Pension Protection Fund basis would not pay the risk-based element of its levy.
- The proposed number of insolvency bands (the measurement used to estimate the insolvency of the sponsoring employer-the higher the score, the lower the insolvency risk) was increased from 10 to 100 so the risk a sponsoring employer posed could be measured more accurately.
- Special cash contributions paid into the pension scheme would be acknowledged.
Broadly speaking, industry recognized what we were trying to achieve and the pressures upon us. We had given pensions schemes the opportunity to reduce their levy by paying special contributions and pledging contingent assets.
It is, of course, in the Board's interest to ensure that schemes' funding position improves over time. With this in mind, the board proposed a 0.5 percent percentage cap on the risk-based levy as a proportion of a scheme's Pension Protection Fund liabilities.
We believe this is consistent with the Pension Protection Fund Board's objective of allowing time for schemes and employers in distress to work their way out of their difficulties, setting and meeting recovery schemes as part of the Pensions Regulator's new scheme funding arrangements.
In the first year of operation, we deliberately chose not to build up reserves against extreme risks because the cost to business would have been too high. We believe this strikes the right balance between security for scheme members and affordability for the levy payer.
With the risk based levy now set, we must look to the future. Arguably, 2006 will be an even bigger year for us as the first pension schemes will formally enter the Pension Protection Fund and we will start making compensation payments. This is exactly what the Pension Protection Fund was created to do, and it will be a major milestone when those first compensation checks are written.
Until now, we have largely worked with industry as we have established our operations. In the months to come we will increasingly deal with members of the general public as we compensate people for pensions they would otherwise never have received.
There will almost certainly be change to the risk based levy as it adapts to the risk in the system. There will be further debate about asset allocation-something that was ruled out of the levy calculation for the 06/07 financial year because of the complex nature.
The approach we have taken-and will continue to take-is to put the emphasis on working with industry to develop solutions. We have adopted an inclusive approach and embraced the insights and innovation of the City (the UK financial services industry) and the capital markets to come up with creative responses to an intractable problem. Risk management solutions hold the key to a business-driven agenda of deficit reduction. While the problem of scheme underfunding cannot and does not need to be solved overnight, we need to reduce the current level of risk in the system at a faster pace. This is both in the interest of pension scheme sponsors and pension scheme members.