The Dead Zone: the sinister side of the Pensions Act 2004

The latest analysis from the Pensions Regulator (tPR) includes a bar chart of the distribution of scheme funding level as a percentage of FRS17^†.  The mode – the largest bar – is for the range 100-110%. 

All well and good you might think, the dark days of deficit are behind us.  The Scheme Specific Funding legislation appears to be having the intended effect.  True, this is on the accounting measure and pension scheme trustees may desire a higher level of security.  The cost of securing the pension liability with an insurer – a bulk pension annuity (BPA) – is around 125% of FRS17 so on this basis deficits still remain.  However, if we look closely at the dynamic introduced by the Pensions Act 2004 we uncover something more sinister. 

The key risk faced by a defined benefit pension scheme is surviving longer that its sponsor.  That is, it is the longevity of the sponsor that is paramount, not the longevity of the members of the pension scheme.  If a pension scheme is supported by a viable sponsor then members’ pensions will be paid in full.  It is failure – insolvency – of the sponsor that leads to reduction of pensions and where protection is necessary. 

 The diagram above shows schematically the level of benefit cover upon sponsor failure.  The status of pension scheme funding is measured by FRS17 and shown along the horizontal axis.  At 90% funding members will get 90% benefits, ie Pension Protection Fund (PPF) benefits, and this is the level of benefit coverage for funding levels below 90%.  But PPF benefits extend above 90%, to around 110% scheme funding.  It is only at this level of scheme funding that the private sector – insurance companies – can replicate PPF benefits, with tPR consent.  At 125% a full BPA buyout is possible, and any funding excess is usually, dependent on the Trust Deed, returned to the sponsor.  Between 110% and 125% the private sector can offer PPF‑enhanced level of benefits, for example restoring indexation that the PPF removes. 

What we see is pension schemes, upon failure of their sponsor, with funding level in the range 90%-110% transfer more assets to the PPF than the PPF requires to provide its level of benefits.  The excess assets are a contingent levy upon pension schemes to supplement the normal levy charged each year.  Perhaps it is not a surprise that the average pension scheme lies in this “Dead Zone” between 90% and 110% FRS17 funding.  Certainly the construct of Scheme Specific Funding will mean this is where many negotiated compromises between sponsor and trustees will reside.  Trustees will argue for 125% representing full security whereas sponsors will argue for 90% representing the optimal level in terms of benefit efficiency. 

There is way to achieve full security and target a funding level in the dead zone in an optimal manner, and bring other benefits too.  It is the BrightonRock Insurance contract which guarantees that pensions will be paid in full upon failure of the sponsor.  Such an insurance contract represent a new form of security alongside that brought by the cash funding of the pension scheme.  With the BrightonRock contract in place the sponsor/trustees can target a funding level of 100% FRS17, which can in certain circumstances be reduced to as low as 90%.  In addition BrightonRock will not impose constraints on the investment strategy: trustees can decide what asset allocation and manager selection is best to meet the long-term pension obligations.