One of the sharpest moments in George Eliot's novel Middlemarch is when Mr Farebrother, a wise country parson, encounters Dr Lydgate, an ambitious young doctor whose spendthrift habits have brought him close to bankruptcy. Gambling, warns the parson, comes from 'being in want of money'; but the doctor bitterly responds, 'there's not money-getting without chance'.
Something of this conversation can be found in recent debates within the UK pensions industry. UK pension funds, according to the Association of Consulting Actuaries (ACA), are in want of money: it estimates current deficits to be £130 billion. But have the big players in UK pensions, like the good doctor of Middlemarch, lost their moral bearings?
Witness the arguments over the Pension Protection Fund (PPF). Along with the Pensions Regulator, this was created by the British government to address a national scandal: the brazen UK culture of occupational pension deficits and defaults.
But now, the Confederation of British Industry says it is alarmed about the size of PPF liabilities, which it estimates at £600 million, and will be covered from next year by means of a risk-based levy. This, says the CBI, "will not deliver increased security for pension scheme members at an acceptable cost for employers". It warns that employers will be forced to close defined benefit (DB) schemes as a consequence.
Other UK pension worthies have chimed in. The National Association of Pension Funds warned that the PPF will force DB schemes to close, and the Cass Business School's Pensions Institute agreed. Even the ACA's chairman was quoted saying how dangerous the PPF was.
Are these dire warnings well founded? True, 58% of DB schemes are closed to new members and a sizeable proportion want to reduce costs, which may mean more closures. There are also outstanding problems in the way the levy is calculated, in particular the treatment of asset allocations and credit enhancement. But keep things in perspective: the £600 million PPF figure is being shared out among schemes with a total of £800-900 billion in assets, which translates to an average 'haircut' of less than 0.1%. As a mutually beneficial insolvency risk reserve, the PPF is arguably cheap at the price. Such low average cost comes from its ability to aggregate risk, and limit its exposure with the help of the Pensions Regulator. This is why the PPF used the language of collateralised debt obligations in the last issue of this magazine, and why it emphasised that it only offered a first-loss layer of protection to scheme members.
The critics are utterly wrong to blame the closure of DB schemes on the PPF. For a start, the biggest schemes have closed already. And the reason for such closures is the presence of deficits, which forces schemes to close to new members in order to climb out of their hole. Schemes that hedged their interest rate and inflation risks while still fully funded, have kept their schemes open. Those schemes are like Dr Farebrother who "has no need to hang onto the smiles of chance", while those in deficit gamble their way out of trouble with mismatched portfolios.
Of course, there were plenty of critics who attacked mark-to-market valuation of liabilities back in 2001, when risk management might have made a real difference between deficit and surplus. That was the year that Turner & Newall, whose 40,000-member scheme is likely to join PPF, went into administration. Had the UK pensions industry addressed its own funding crisis then, it wouldn't be in so much trouble today, and the PPF might not be necessary. But the industry blew it.
Ironically, the NAPF just published a study in conjunction with Oxford University showing that most UK pension fund trustees lacked a basic understanding of probability. Perhaps NAPF chief executive Christine Farnish should improve her own knowledge of probability and risk before attacking the PPF.
The week on Risk.net, July 14–20, 2017Receive this by email