The Tata Steel UK (TSUK) and British Steel Pension Scheme (BSPS) problem is a wake-up call to the looming pension crisis and highlights the fact that we are seriously lacking in solutions. The tacit recognition of this problem, acknowledged in the DWP consultation paper, is hopefully the beginning of a process that sees UK pension law change to allow much greater flexibility in situations where the sponsor cannot afford to stand behind the pension promises that were once made. Below is a summary of the main points that we have made in our response to the consultation paper.
The British Steel Pension Scheme (BSPS) is a cautionary tale for the pensions industry. As with most cautionary tales there are some lessons to be learned, especially for trustees who have the responsibility to navigate their DB schemes through uncertain times in a world with such unpredictable financial markets.
We believe there are three core lessons that could have a salutary effect on the way pension schemes are run:
See things for what they really are
Focus on the true economic valuation of benefits (as opposed to Technical Provisions) to make sure that your balance sheet risks are better measured and managed. In the BSPS case, the Technical Provisions indicated a deficit of £700m which is less than 10% of the buy-out value (£7.5bn). Creative accounting may hide the problem, but it will not solve the problem.
Don’t consume future returns before they have been realised
Almost all pension funds assume they will earn returns above the risk free rate – that of gilts or swaps. This is despite the fact that for the last 20 years, almost all pension funds have actually earned returns below the risk free rate. A closed fund that is paying out pensions based on assumed future returns, will end up eroding solvency if the returns don’t materialise.
Avoid the sinking giant effect
The perfect storm, that can sink a pension scheme, forms when the funding gap is large and the sponsor is weak. In such cases, paying out full pension benefits is a wealth redistribution from active to retired members unless the sponsor option is rock solid. BSPS is a clear cut example of this where the sinking giant effect will become the harsh reality for its members.
What can trustees do?
To avoid the potential destiny of BSPS, it is a good approach to remove unwanted risks and take risks in a controlled way.
There are four key principles we advocate:
Ensure predictability and control of assets relative to the liabilities - Steady, incremental growth in the funding ratio produces outstanding results over time.
Avoid unaffordable risks - Protect the portfolio from the impact of financial shocks ensuring that you are not blown too far off course and incur losses you just can’t afford.
Always plan for the unexpected - Don’t just rely on the good times - build portfolios that can benefit from different economic circumstances.
Adapt over time - Adjust the levels of risk, both increasing and decreasing, when the time is right, given the opportunities available.
Following this approach creates a more stable growth in solvency over time than the classical approach with a static investment mix consisting of stocks and bonds.
If you would like to diagnose your fund or want to learn more on how to avoid the BSPS situation, please contact Phil Redding, Head of Business Development.