Employers need more regulation like they need a collective hole in the head. Yet it never stops them being burdened with additional compliance and governance requirements.
Nowhere is this truer than in the area of occupational pensions. Things are likely to get a lot worse as the government has now indicated the future direction it intends to take with regards to the regulation of defined benefit (DB or final salary) pensions.
So what, you might say. The future is now defined contribution (DC) under the auto-enrolment regime and most DB schemes have been closed, and only 19 FTSE 100 companies still had one open in 2017.
However, the problem of running them, and running them properly, hasn’t gone away. Most of these closed schemes have deficits and so cannot be wound up and they represent an ongoing headache – and let’s not forget cost – to businesses.
The government expects trustees to raise standards of governance within DB pension funds and giving The Pensions Regulator (TPR) greater powers to ensure this is achieved.
A white paper from The Department for Work & Pensions entitled ‘Protecting Defined Benefit Schemes’, sets out those expectations.
Employers must already agree with TPR how they intend to reduce deficits (recovery plans), but the paper proposes the introduction of a criminal offence for “wilful or reckless behaviour” that may undermine a scheme’s funding.
This is a thorny subject. It would be difficult to prove and expensive to press home in court. However, TPR will be able to fine employers and this is a power the regulator has already exercised within the DC arena.
Company boards already have a duty to notify TPR if a corporate action will result in a change of control, but this will be extended to all actions. This is a broad brush and there are no helpful checklists; boards may become circumspect about corporate actions without achieving clearance and this could make businesses with a legacy DB fund less attractive to potential partners.
DB funds must now also demonstrate, with the introduction of a statement from the chair of trustees, that they are offering good value for money to their members. DC schemes have been providing these for the past two years.
This will make running and funding DB schemes not only more difficult but more expensive.
Size does matter
The white paper says the primary purpose of the changes is to raise standards of governance. Higher standards will increase members safety and reduce the risk of a scheme falling on the mercy of the Pension Protection Fund (PPF), the lifeboat scheme for funds of insolvent employers.
The paper says that larger schemes have better governance and in turn, this may result in better investment returns and lower costs. This is because larger schemes will probably have more engaged trustees, hold more frequent trustee meetings, and maintain a good working relationship with the employer.
It is common sense that a small scheme will struggle to find sufficient resources to be confident of delivering the best possible service to its members. That doesn’t mean that they are not well run or not well-intentioned, but that won’t necessarily pass muster when the chair of trustees must affirm that they have done a good job.
Walking the walk…
In the past, solvent employers have been faced with the binary choice of carrying on funding the scheme, or securing each individual’s benefits with an insurance contract. While the former may be unattractive, the latter has been beyond the means of all but a few.
However, the white paper makes it clear that there is a third way for smaller schemes and that is to throw their lot in with a consolidator scheme, such as a DB Master Trust operator. It says: “…a potential consolidator, which would be a large scheme by nature, has a higher probability of being well governed. And we have some evidence that better governance leads to higher investment returns or lower costs.”
This is important because consolidation should not only be seen as an opportunity to drive down costs but to drive up the quality of governance. Better governance improves every element of a scheme’s infrastructure, building from the bottom up by giving them access to the kinds of resources they didn’t have before. That includes access to advice, better administration, better communication, and, potentially, better investment returns.
Bigger schemes allow a longer-term view of investment strategies, providing smaller schemes access to asset mixes, alternative return streams and levels of diversification and yet with reduced volatility they could never have afforded in the past.
What’s the alternative?
In reality, we are not talking about small schemes at all, but any scheme that realises it is struggling to be able to, hand on heart, say it is offering members value for money. Even schemes of more than £1bn may not have sufficient assets to achieve economies of scale in certain areas, such as investment.
The introduction of statements from the chair of trustees of DB schemes may prove to be a powerful motivator for smaller schemes to look at what they have achieved and consider whether they might achieve better results as part of a larger group under the umbrella of a DB Master Trust.
Consolidation has been available to pension schemes for some time, but few have taken advantage of it. Some of this is down to British stiff upper lip, a commitment to the members or a lack of awareness of how far short the governance process was falling.
Consolidator schemes will need to have significant expertise in governance, administration, actuarial, investment, covenant and so forth, to meet the standards that The Pensions Regulator sets.
The endorsement for the consolidator model is set to be a catalyst for most schemes in the sub £1bn market to finally accept there is no shame in seeking help and that by joining with others they can be stronger and serve members better.