Risk & Economy » How the pensions lifeboat works for the common good

In May this year a joint Business, Energy & Strategy and Work & Pensions Select Committee inquiry into the collapse of Carillion concluded that the senior board had made ‘consistently and resolutely derisory’ proposals to fund an £800m deficit across its 13 pension schemes.

Yet despite this, when the business became insolvent in January this year, members of the underfunded pension schemes learned they would still be in receipt of benefits as they transferred into the Pension Protection Fund (PPF).

Pensioners will receive their payments in full, while those yet to reach retirement age will receive 90 per cent of what they were promised, subject to a cap which impacts 0.5 per cent of members.

In pre-PPF times, thousands of members would have been left with no pension because – in the select committee’s words – ‘honouring pension obligations over decades to come was of little interest’ to the Carillion board. Instead, as members of the PPF they will have financial security in their retirement.

Far from receiving ‘watered down’ benefits, PPF members are part of a robust, professionally run and extremely well financed scheme. As, at the end of March 2017, the PPF was 121.6 per cent funded and had reserves of £6.1bn.

Not for profit

To provide this level of compensation to the 940 schemes we have taken on board since 2005, and to be able to cover future claims, the PPF relies on several sources of funding.

Readers of this magazine will be aware we charge a levy on all eligible schemes, but we also recover money from insolvent employers and take on scheme assets. This income is then invested prudently and effectively in an innovative strategy, targeting a return designed to meet our payment obligations today and in the future. We recently brought much of our investment management operations in house, which means we can respond quickly and efficiently to changing market conditions. In the year to March 2017, the PPF exceeded its targets and delivered a total return of 16.0 per cent.

The PPF receives no taxpayer funding and we are a separate entity from government. We are a non-profit making organisation – we have no shareholders and no long-term incentive plans. Every penny we generate goes towards paying compensation to members and ensuring that we can absorb any new insolvencies as they arise.

Our strategic ambition is to be self-sufficient by our funding horizon – currently estimated at 2030. Achieving our funding horizon would mean the PPF has sufficient funds to pay current and future members compensation when it falls due with less of a reliance on the collection of PPF levy from DB scheme sponsors.

At present, we have estimated that the total risk-based levy for 2018/19 will be £550m. This is 10 per cent lower than the £615m estimated levy for the previous year, and reflects an improvement in overall UK defined benefit scheme funding.

It is also important to understand the levy in the context of the payments made by the PPF to our 236,000 members. The fund paid out more than £700m in benefits in the last financial year and absorbed deficits from new claims well in excess of £1bn.

Taking responsibility

We are cognisant of the pressures on finance directors in the UK today, and it is imperative the levy appropriately reflects the amount of risk inherent in the DB system.

Consequently, the risk-based levy is calculated on the scheme funding level and the likelihood a company will become insolvent. This means that the companies that pose the biggest risk to the PPF pay a higher levy. However, the overall levy calculation reflects the amount of risk in the entire system, meaning the smaller the total risk, the lower the levy for everyone.

Conversely, the more companies that neglect their schemes, have poor corporate governance, or fail to consider DB funding as a priority, the greater the levy every sponsor will have to pay.

Recent comment in this magazine by Nathan Long, Hargreaves Lansdown, suggested that ‘if Carillion had paid more into the pension it may just have ended up with more assets passing over to the PPF. This is not a bad thing, but when all boiled down, would not necessarily improve things for the thousands of Carillion pension members who will be affected’.

This misses the point. Sponsors have an obligation to ensure their members’ benefits are honoured. Pension contributions are, after all, deferred pay and employees are effectively creditors of the company even though they may not consider themselves to be so; and they should be treated as such. A well-funded scheme at the point of a sponsor’s insolvency will increase the likelihood of being able to buy out benefits for scheme members at above PPF levels of compensation, and removing altogether the burden on levy payers.

Second, the PPF makes no profit and assets that pass to us will only be used to pay compensation. Any additional payment which had been made by Carillion into its pension funds would be for the direct benefit of all other PPF levy payers.

Finally, finance directors can use funding arrangements to reduce their risk to the PPF, which will both secure members’ benefits and see their levy payments reduced. Contingent assets – such as parent guarantees, security over cash or assets, or letters of credit – can reduce the risk that an insolvency will result in a claim on the PPF, or at least limit its size.

These arrangements make it possible to improve scheme funding without jeopardising the business in the process, while simultaneously reducing individual levy payments and limiting risk in the system overall.

It is true that the PPF ‘acts as a backstop for failed schemes’ but that should not present an opportunity for FDs to sidestep their pension obligations. Sponsors have both an individual responsibility to their own schemes, and to the DB system as a whole, to reduce risk and manage their deficits effectively.

The PPF works hard to ensure the levy is fair and proportionate, which means if risk increases the levy will inevitably follow. The more proactive employers can be in securing their schemes, the better the ramifications for other levy payers, scheme members and society as a whole.