Since the 1995 Pensions Act came into force on 6 April last year, onets pensions sideways. It will get worse in a bear market. of the more noteworthy changes has been the rethink over the actuarial measurement of the Minimum Funding Requirement (MFR). Another has been the way the government has delayed publication of the Pensions Review, keeping everyone guessing over the details of its much publicised concept of ‘stakeholder pensions’ for the less well off.
The MFR was introduced by the Goode Committee in its review of pensions law as a new test of minimum solvency for pension funds. As Andy Green, head of investment consultancy William Mercer’s Edinburgh office, explains, the actuarial model underlying the MFR assumes that all, or most, of a company’s value derives from its future dividends.
There was a basic agreement among actuaries and the government that a fund’s ability to meet its liabilities to its members who had not yet reached retirement was linked to stockmarket performance. But since actuaries tend to feel that dividends are a steadier measure of the market than the FTSE All-Share index, it seemed natural to choose future discounted dividends as the measure. However, when the government decided to wipe reclaimable ACT off pension dividends, it reduced the future dividend stream by about 20%. This had the effect of driving up the MFR by the same amount, pushing funds closer to the danger level where they would need to be topped up.
Matters have been further exacerbated by the fact that during the course of the last year, companies have shown a marked tendency to reward shareholders through other means than dividend payouts. Share buybacks have much the same effect for shareholders as a dividend, but they don’t show up for MFR purposes. “We have seen buybacks totalling around 1% of all share transactions over the last year, which is a massive total. This is enough to distort the MFR measurement,” Green notes.
The government and the actuarial profession have responded with commendable swiftness to this distortion in the MFR. With effect from 15 June a new, short-term measure came into force that has the effect of counteracting the lost 20% and adding a further 10% by value to schemes measured under the MFR (thus countering the alternative dividend syndrome as well as the lost tax relief).
Bob Scott, a partner with consulting actuaries, Lane Clark & Peacock explains the adjustment as follows: “What the model used to say was that the normal dividend yield is 4.25% and if the All-Share index yields the same, then market values are in accordance with actuarial long-term views and fund assets can be brought in at 100%. What we found was that the dividend yield fell to 2.8%, which was way out of kilter with normal expectation.
It meant that for every #100 of liability, a pension fund would be required by the MFR to hold #150 to compensate.
“To counteract this, the new MFR model amended the dividend yield target figure to 3.25%, and instead of the old system of treating the 4.5% figure as the normal gross yield, it said that 3.25% would be the normal net yield (after the abolition of ACT). The upshot of all this playing with figures is that where FDs might have suffered a few palpitations as their company funds slid towards the danger mark on the MFR, they can now relax again – provided the market stays reasonably buoyant.”
However, Scott stresses that the adjustment arrived at by the actuarial profession should be viewed as no more than a working patch to what was always an oversimplified model. “The whole idea of the MFR was to set a floor to the funding level that most well-run schemes would be able to pass quite comfortably. The change in tax treatment and changes in corporate approaches to rewarding shareholders caused the model to break down. Actuaries differed widely as to what the right way of fixing the problem was and this represents an acceptable short-term compromise,” he says. However, Scott warns that the adjustment made in the present instance can’t be endlessly tweaked to meet future problems without the whole scheme losing credibility.
All this talk of the MFR, revised or not, is enough to make FDs nervous.
As Johnny Campbell, investment director of Scottish Widows Investment Management, observes, most FDs like to know what their costs are ahead of the game. This is perhaps the major reason for the continued rise in popularity of defined contribution money purchase schemes, as against the traditional final salary or defined benefit scheme.
The problem with a final salary scheme from the employer’s point of view, Campbell notes, is that it is precisely when the economy nosedives and the stockmarkets undergo a dramatic adjustment that FDs are likely to face a sudden demand from their fund actuaries for cash to top up the defined benefit fund. The one certain bet for FDs, in other words, is that the moment they are absolutely strapped for cash, they’re likely to hear the company actuary banging on their door bearing tales of woe.
Not many FDs will have much patience with this scenario when the attractive alternative of the money purchase option lies to hand.
Moreover, Campbell points out that the changes in the pipeline concerning the way pensions are accounted for are also pushing FDs towards the relative surety of defined contribution schemes. The International Accounting Standards Committee is keen to see pensions accounted for at market value on the balance sheet – much that today can be kept off balance sheet will soon be available for shareholders to pick over. “With much higher visibility for pension schemes and much more accountability, the fixed costs of a money purchase scheme are going to look better and better to FDs,” argues Campbell.
Yet another impetus pushing these schemes along is the pronounced European preference for them. Initially, the US multi-nationals were the ones making all the running in money purchase, until UK companies caught on. The Europeans, however, have been gathering a head of steam on this for some time. The French government likes the idea and the nation already uses money purchase in some 40% of supplementary schemes, compared with 15%-20% in the UK (according to The Mercer Quarterly). Denmark is up at a staggering 95% of schemes using money purchase, while even Spain and Portugal are at 20% and over.
In many ways it is still far too early in the life of the Act to judge the impact of all the changes it brought into effect. One of the cornerstones of the Act, for example, was the formalisation of the duties and responsibilities of trustees. This, together with new provisions for the introduction of member trustees was generally welcomed.
However, industry experts expressed their fears that the new requirement for trustees to formalise a Statement of Investment Principles would govern the fund would cause trustees to be overly prescriptive, thus hampering fund manager performance. In reality it will probably be a few years yet before the relationship between anything other than a bland boiler-plate statement of principles and performance becomes widely understood.
As Green points out, one of the most tangible consequences of the trustee provisions in the Act is that the need to undergo an election process has tended to focus the minds of trustees on their responsibilities and duties to fund members. Member-elected trustees are not obligatory under the Act, since members of the fund have the option of leaving the existing trustee arrangements in place if they are happy with them. Nevertheless, the company has to get member agreement for this retention of the status quo.
However, in many companies the members have shown a willingness to exercise their right to elect trustees. The upshot of the arrival of member-elected trustees, Green notes, has encouraged a whole new breed of trustee to take up office. “Where some trustee bodies might have run in tight conjunction with the company, there is now much more of a sense of trustees formulating policy that is distinct from the company’s own interested view,” he says.
In addition to the complexities of choice already dealt with, the government is contemplating another piece of pensions engineering – the stakeholder pension, due to be introduced in 1999. The basic motivation for this rather odd concept is to provide a private, as opposed to state, pension mechanism for the low paid, for the self-employed and for those whose chief form of employment is short contract work.
In theory, this category of pension should not be of great interest to FDs, since the basic idea is to provide an option for those who would not normally be eligible for an occupational scheme. However, the government has muddied the waters somewhat in its consultation document, by suggesting that the stakeholder pension might also be appropriate for younger employees or those who change jobs frequently.
Ken Reid, director of business development in Ernst & Young Financial Management, is one of many experts who point out that the stakeholder concept has some enormous challenges to overcome. But he argues that it is something that FDs should keep an eye on since there may be some impact on occupational schemes. “In a sense, the stakeholder concept echoes Sir Keith Joseph’s State Reserve Scheme proposal of 25 years ago,” he says.
“That, too, was designed to provide a second-tier pension on a modest, funded basis, but it never came to fruition. Many in the industry think that we won’t see a fully functioning stakeholder pension structure in place much before 2004.”
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