The UK's Pensions Regulator has warned that poor governance of defined benefit (DB) and defined contribution (DC) pension schemes poses a growing challenge to its objectives. The warning, made in a report outlining its medium term strategy, comes amid continuing debate over the Regulator's scheme funding requirements, aimed at rectifying DB pension deficits.
These deficits, estimated at over £100 billion on a FRS17 basis and £300-400 billion on a buyout basis, against total assets of £600-650 billion, are the Regulator's "most immediate challenge" according to the report. The Regulator points out that equity bull markets are incapable of single-handedly eliminating the deficits without a concurrent return to interest rate levels associated with high inflation, and an absence of mortality improvements.
While this observation suggests strong regulatory support for risk management or liability-driven investment by pension schemes, the Regulator denied that what it calls "prudent assumptions for valuing the assets needed to cover liabilities as they fall due" amount to a new minimum funding standard or that schemes were required to change investment strategy.
According to the Regulator's head of strategy, John Ashcroft, adoption of these assumptions was part of the "statutory reporting duty of actuaries and auditors". The Regulator has said that while it will use FRS17 or Pension Protection Fund (PPF) based funding levels as a trigger for regulatory action, it will not use buyout valuations.
Scheme funding would remain a plank of the Regulator's medium-term strategy, it said. This was due to the timescale of recovery plans, but also because the 2004 Pensions Act only required the new standard to replace the old, far more lenient Minimum Funding Requirement (MFR) as schemes completed their triennial actuarial valuations from September 2005 onwards.
In practice, most larger DB schemes have moved to some form of annual actuarial valuation, prompted by FRS17/IAS19 accounting rules and the annual calculation of the PPF's risk-based levy. Yet these changes may have left smaller schemes lagging behind, a governance shortfall which appears to have alarmed the Regulator.
While stopping short of naming and shaming individual trustees or schemes, the Regulator cited three case studies of schemes involving 25-100 members. In each case, a managing director trustee or corporate trustee appointed by the employer had abused a conflict of interest regarding funding levels. By publishing the studies, the Regulator highlighted the importance of independent trustees and the positive role of whistleblowing by actuaries or auditors in protecting scheme members.
Another governance concern for the Regulator was the growing importance of DC schemes, prompted by the continuing closure of DB schemes in the UK to new members. While this trend has been controversial, the Regulator has taken a neutral standpoint, insisting that new funding measures had simply "revealed the cost of DB to employers".
However, the transfer of investment risk to scheme members left trustees with important responsibilities regarding administration and communication with members. One example highlighted by the regulator was the need for information about annuity choices. "Trustees shouldn't mis-sell DC schemes", warned Ashcroft.
Some observers have argued that the assumption of investment risk by DB sponsors traditionally gave these sponsors an important policing incentive with respect to poor performance by fund managers or consultants. For example, Unilever sued Merrill Lynch Investment Management (MLIM) for underperformance and obtained a substantial settlement in 2000.
Such incentives are less evident in trust-based DC schemes, and arguably missing completely in contract-based group personal pension (GPP) schemes, where individual employees contract directly with insurance company providers. The Regulator is likely to examine such concerns when it embarks on a forthcoming consultation on DC occupational pensions later in 2006.
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