Response to DWP Green Paper consultation May 2017 Making Sense of Pensions
Security and Sustainability in Defined Benefit Pension Schemes Response to Green Paper Consultation This is a response to the DWP s consultation document issued in February 2017 regarding the Security and Sustainability in Defined Benefit Pension Schemes. This letter represents the views of Xafinity plc. Consolidation of small schemes Xafinity believe that more can and should be done to help small schemes. We are concerned about the very large number of small UK pension schemes who appear to be over charged and under serviced. This point is clearly acknowledged by the Government and we welcome the opportunity to help find a better way of running such schemes. Firstly it is worth noting that we do recognise the issue and agree that consolidation in some form can be a solution in many cases. Small schemes struggle to leverage economies of scale, and the Green Paper refers to the difficulties smaller schemes face in being able to secure discounts from asset managers. Cost savings and economies of scale will of course be a key driver of consolidation for many, but not the only driver. We believe that through consolidation schemes could obtain better quality advice, be better governed and have access to a more effective and appropriate range of assets whilst at the same time reducing their costs. The PLSA DB taskforce also referred to the potential benefits of consolidation with estimated potential aggregate savings of 1.2 billion per year. These issues will only become more prevalent as schemes mature and focus moves away from legacy defined benefit schemes towards defined contribution. We therefore believe the Government (or the Regulator) should to do more to encourage and assist those smaller schemes in considering their options. Larger schemes have access to innovative solutions, which help in reducing risk and improving outcomes. However the investment of time and resources is generally disproportionate to the benefit where small schemes are concerned. We do not see any significant shortcomings or problems within the existing regulatory and legislative environment which prevent schemes from consolidating. The fundamental structure is sound, and is sufficiently flexible to allow many schemes to access more appropriate solutions. In our opinion the two biggest barriers to this process are: Lack of transparency charging structures are often opaque, and trustees simply don t understand what they are paying and what they could reasonably expect to receive for that money. It is extremely difficult to compare the value offered by different solutions. Inertia this is arguably the greatest challenge that the UK pensions industry currently faces and all the more so for smaller schemes. Too many schemes continue with the status quo because that is all they know. However this is no longer good enough in a constantly developing market. Making Sense of Pensions Page 2
In order to ensure that they are acting in members best interests, all trustees need to be challenging their advisors and ensuring that they are getting high quality advice and value for money. Consolidation is key for small schemes to achieve this, provided it is done in the right way. There has been a lot of talk in the press about DB master trusts and whether these can provide an effective solution for small schemes. Whilst we believe that master trusts have a significant role to play in the future of DC pensions provision, we do not believe that the same can be said in the DB environment. Whilst offering significant advantages, DB master trusts have a number of potentially major drawbacks. The biggest of these is that transferring to a DB master trust requires a fundamental change to the legal structure of a pension scheme, and it therefore effectively becomes an irreversible decision. To illustrate why this is a problem, consider an example small scheme (a real life case study we have seen) which was sponsored by a private equity firm. For many years at a time, a consolidated vehicle is appropriate for this scheme. Reducing costs and a lighter touch but higher quality governance model makes sense. But when a transaction came, that changed suddenly the scheme needed bespoke in-depth support. The arms-length master trust model simply doesn t work for this. We think schemes need a structure that is reversible, so you can have all the benefits of consolidation for many years and a more individual structure when it s needed. Our view is that the significant advantages offered by a DB master trust efficiency, economies of scale, improved governance can just as easily be obtained whilst retaining future flexibility. Models of sole professional trustees across multiple schemes, with commercial agreements to leverage the combined purchasing power of these schemes, can achieve all that master trusts can achieve in a better way. We urge the DWP to look at DB Sense, which we strongly believe to be a better consolidation model for small schemes: http://www.xafinity.com/theme/www.xafinity.com/consulting%20services/db%20sense/830xc_ Xafinity_DB_Sense_May_2017_Web.pdf. For a number of reasons we do not consider it practical for the Regulator to make consolidation of small schemes mandatory. There are smaller schemes out there who are prepared to do the right thing and who are acting appropriately, so it would seem unfair to those well run schemes to impose consolidation on all. However we believe that a programme of targeted challenge from the Regulator would be beneficial for many smaller schemes. Our experience with our own offering DB Sense, and we understand the experience of others offering consolidation vehicles, is that inertia is huge and vested interests block moves to structures that objectively offer better governance and better long term outcomes. Xafinity believe that the Regulator s focus should be to encourage a culture of challenge and education amongst trustees of smaller schemes so that they understand the alternative options are available and are able to make meaningful comparisons. Member protection Regarding the issue of member protection, our view is that the current regulatory framework is sufficiently robust, clear and flexible to enable the majority of well run schemes to function effectively. We don t believe that any additional clarity is required in this area. Making Sense of Pensions Page 3
That said, the Regulator does need the facility and flexibility to be able to use its powers more frequently and more effectively in the right circumstances. There continues to be circumstances where trustees and/or sponsors are unwilling to engage with the pension scheme. We believe, however, that the issues in this regard relate more to governance in particular the influence of conflicts of interest than the regulatory framework itself. Effective trusteeship ought to resolve the majority of those issues, and we think there is a strong case for the compulsory introduction of professional trustees especially in cases where governance is evidently poor. We have evidence across our client bank that professional trustees have made a material positive difference to schemes. (As an aside, we note that the compulsion of professional trustees would likely provide an additional incentive for small schemes to look at consolidation structures, which as above we support.) We see the recent consultation on 21st Century trusteeship as clearly being a step in the right direction in improving member protection and we believe the Regulator should continue to encourage industry wide improvement in this area. It would be helpful if the Regulator were able to provide additional assistance to trustees in negotiations with the scheme sponsor, in particular at an earlier stage of the process. This might be in the form of provision of guidelines (eg level of dividends versus deficit contributions), or direct correspondence with trustees and sponsor to help both sides fully understand both their responsibilities and the consequences for not meeting those responsibilities. We also have feedback from our trustee clients that they would like to see consideration to pension schemes given preferred creditor status in distressed situations; this would in many cases improve member outcomes but also likely reduce future calls on the PPF. Current valuation measures The consultation poses some interesting questions about current valuation measures, and whether they are appropriate. Is there sufficient flexibility in the regulatory framework for the way in which discount rates can be calculated? In our view, yes. Are those flexibilities being used appropriately? The evidence would suggest not. There is a significant (and relatively narrow) focus amongst many actuaries and trustees towards a gilts plus approach to setting discount rates. We acknowledge that whilst there are various theoretical arguments as to why gilts plus is adopted by the majority of UK pension schemes, and also reasons why it may not be appropriate in some circumstances. During our ongoing discussions with trustees and sponsors, often their biggest frustration is an actuary who turns up to each valuation, informs them of falls in the gilt curve since the previous valuation and moves swiftly on to a discussion about the resulting rise in deficit and to increasing pension contributions without considering any of the possible alternatives. The key focus in funding a scheme ought to be its long term strategy and objectives. We believe schemes should be encouraged to have a much longer term view to funding, to set long term horizons and objectives, and actively manage the scheme with a view to meeting those objectives. Trustees and sponsors should focus less on the triennial valuation process and think more proactively about the longer term. Dictating the future of a pension scheme based on a snapshot of Making Sense of Pensions Page 4
the funding position is outdated. Computing power is such that funding strategy can be managed in real time; modelling tools are now available to allow trustees to make better decisions more quickly to positively influence the future of every scheme. There is currently very limited focus from the Regulator on such longer term considerations. On a related note, we also believe that the current 15 month timeline for completing a valuation is unnecessarily long. The technical aspects of a valuation can be completed quickly in the majority of cases, which suggests the timescale for completing valuations could be reduced significantly, to say 6 months or even less. We know many trustees who feel like they are almost constantly in a valuation cycle no sooner has one ended than the next one is coming up. If valuations were done more quickly, Trustees would spend much more of their time focusing on what matters where the scheme s assets are invested and how they are managing risk than looking backwards at a snapshot date a year ago and debating with the employer what analysis at that date means. Shorter valuations would drive a virtuous cycle - a much greater focus on the long term strategy as suggested above will set the framework for discussion in advance and reduce the need for a drawnout ongoing debate. Real time monitoring of a scheme s funding position and longer term objectives, with trustees and sponsors managing their schemes proactively, will mean the triennial discussions become part of an ongoing process rather than being a huge one off event. Investment options The consultation poses an interesting question about investment choices for UK pension schemes and whether the Government could do anything to address this. There is undoubtedly a significant supply and demand issue for gilts, in particular long dated index linked gilts. This supply and demand issue is driven by UK pension schemes, and is distorting the market. With yields already at historic lows it appears unlikely that this market could change for a considerable length of time unless the Government chooses to intervene in some way. We see this as being driven by the mark-to-market valuation methods, in particular the gilts plus approach previously discussed. The issue is potentially self perpetuating unless there is a fundamental change in approach in the industry. UK pension schemes use gilts to de-risk, since this is considered to be the lowest risk asset class. However if yields were to rise, more schemes would hit their de-risking triggers, prompting further demand for those long dated gilts (and subsequent falls in yields). Without intervention, or changes to the way in which the vast majority of UK pension schemes value their liabilities, we do not see a material change in this area for the foreseeable future. There is a herding culture within the pensions industry; a do what you did last time culture. At Xafinity we believe in encouraging our clients to think differently, to challenge the norm, and to really understand why they take the decisions they do. For schemes where buyout might be the long term target, a gilts-type discount rate might be appropriate since schemes are effectively targeting a buyout price which is likely to be linked to gilts in some way. Where buyout is not an aspirational target, gilts plus is not necessarily the answer; there are different ways of valuing liabilities. Cashflow matching, for example, is a great example of Making Sense of Pensions Page 5
fundamentally changing the way in which a scheme is funded. If a scheme were to invest its assets in corporate bonds, matching income with expected outgo, the subjectivity in the discount rate assumptions is vastly reduced because that bond income is contractual in nature. Trustees will know, subject to making a prudent allowance for any defaults, the income they will receive and can budget accordingly. Any move towards a different approach will require trustees, sponsors and advisors to think differently. This will be achieved much more efficiently with regulatory intervention on an industry wide scale. Compulsion is unlikely to be appropriate, but we believe the Regulator should work closely with the Actuarial Profession to encourage schemes to reconsider the way they approach their scheme funding and investment strategy. We look forward to seeing the outcome of the consultation in due course. Paul Cuff Co-Chief Executive Officer Xafinity Consulting Limited. Registered Office: Phoenix House, 1 Station Hill, Reading, RG1 1NB. Registered in England and Wales under Company No. 2459442. Xafinity Consulting Limited is authorised and regulated by the Financial Conduct Authority. Making Sense of Pensions Page 6