Jeremy Hunt's Mansion House speech on 10 July, combined with a flurry of consultation papers and calls for evidence published the following morning, has marked the start of the most high-profile overhaul of the pensions regime for many years. The proposals under consideration cover a wide range of issues across both defined benefit (DB) and defined contribution (DC) schemes (albeit with some common themes), and with the Chancellor stating that all decisions will be made ahead of his Autumn Statement, the next two to three months look set to be an intense period.
So why is the Chancellor so interested in pension schemes? In short, he's trying to generate higher growth for the UK economy and drive down inflation. Monetary policy isn't going to help growth in the near-term and, after last September's 'mini budget', fiscal policy is constrained, so the Chancellor is having to use regulatory policy to fuel his agenda. The proposed changes affect many parts of financial markets, but with £1.7tn of assets in the nation's pension schemes it's not hard to see why they are a key part of the Government's proposition.
In a nutshell, the UK Government has set its sights on increasing the level of pension scheme investment in domestic productive finance assets (see unlock more), whilst trying to avoid a damaging stampede away from gilts.
What is productive finance?
Equity capital and finance for businesses in the UK including start-ups, infrastructure, and private equity, as well as longer-term investments, typically in illiquid assets.
Such top-down regulatory change generally focuses on changing the number of players in a market and their incentive structures – for example the 1980s privatisations or changes to the structure of the banking industry after the credit crunch. The Treasury's proposals for DB schemes are no different, pushing the consolidation of schemes and freeing up investment strategies, which we cover in this article.
Consolidation of DB pension schemes
The Chancellor's speech made reference to a 'fragmented' DB landscape; there are over 5,000 schemes, with the Pension Protection Fund's (PPF) statistics showing that over 70% of these have assets of less than £100 million and with the top 3% of schemes holding over 60% of total DB assets.
The Government's concern is that smaller schemes simply don't have the asset base, governance or expertise to invest in productive finance. Creating a landscape with fewer, larger schemes should therefore help to drive the economic growth they are looking for whilst also delivering better outcomes for both members and scheme sponsors by generating higher investment returns. There are, of course, no free lunches in the investment world, so those higher returns are associated with higher risk, but more of that later.
We are pleased to see that our white paper has influenced the questions in the Government's call for action.
So how is the Government looking to achieve some level of consolidation? They have fortunately steered clear of mandatory consolidation on a mass scale as proposed by some, instead opting for a voluntary regime that they hope will make it easier for trustees and sponsors to access and evaluate a range of consolidation vehicles.
For schemes that can afford an insurance company buyout within the foreseeable future (which Department for Work and Pensions (DWP) regards as around five years), there will be little change. Schemes can run off under their own steam or consolidate through a buyout. It's for those schemes that can't afford to buyout where things get more interesting.
The first option is a private sector or 'commercial consolidator', which could be a master trust or a 'superfund'. Looked at purely from the perspective of increasing fund size and accessing governance and investment expertise, both master trusts and superfunds achieve much the same thing. However, to break the link with the existing sponsor, superfunds require capital backing which the Government sees as a potential source of investment in the UK. This capital requirement also provides a direct incentive for the superfund to seek higher investment returns to generate profits for the capital providers. Those higher investment returns could in part be generated by productive finance assets, in line with the Government's growth agenda.
Superfunds are clearly positioned by the Government as less secure than a buyout (with the consultation response signalling that a 2% chance of not paying out benefits in full is acceptable). However, with entry prices potentially around 10% less than buyout, they provide an interesting option for some schemes, even if they aren't going to be the right solution for everyone.
A key challenge for Government will be setting the framework for consolidators so that they are sufficiently attractive to grow quickly.
A second option and very much the 'new kid on the block' is the idea of a public sector consolidator, which is floated in the Government's call for evidence. No substantial details of how the Government envisages this working are provided in the papers published to date, but you can see the attraction. Many smaller schemes or those that are less well funded are unlikely to be an attractive proposition to a superfund. If a public consolidator can hoover up those schemes, deliver better outcomes to members than the available alternatives and provide a large enough asset base to invest in productive finance, it's a potential win-win. But there are many challenges to be overcome before that becomes a reality, and the Government will also need to tread carefully to avoid any unintended consequences for the buyout or commercial consolidation markets.
A key challenge for Government will be setting the framework for consolidators so that they are sufficiently attractive to grow quickly and in parts of the market where consolidation yields the results the Government is looking for. That won't be an easy task, but implemented correctly, it should be a useful tool to provide the best possible outcomes for members alongside the alternatives of run-off or buyout.
That said, consolidation feels like a long play in terms of achieving the Government's aim – without a very significant push, it's difficult to see funds growing to a size that facilitates large-scale investment in productive finance over the next few years.
Freeing up DB scheme investment strategies
It seems to us that the bigger potential win is through changing the incentive structure to encourage larger DB funds to target higher levels of investment return. In our recent White Paper: WTW calls for six pension policy changes to fuel UK economic growth, we set out six regulatory changes that would encourage exactly this through a 'new deal' for pensions which would enable surplus to be shared efficiently between members and a sponsor:
- Allow use of DB scheme surplus to benefit DC members in a different scheme
- Reduce tax rate on refunds of surplus to an employer, ideally to align with corporation tax rate
- More readily allow refunds of surplus from ongoing DB schemes
- Remove some tax barriers to sharing surplus with members
- Ensure that regulations do not push schemes into excessive de-risking and that they allow open DB schemes to thrive
- Review TPR's objectives to encourage a more holistic approach to DB regulation
Implementing these regulatory changes would immediately provide a potential upside for risk taking in pension schemes for the principal stakeholders. We are pleased to see that our white paper has influenced the questions in the Government's call for action.
Key to making this work is careful calibration of the package of reforms across the board – too much incentive to take risk could result in a hurried sell-off of gilts – thereby breaking one of the Chancellor's 'golden rules' which is to 'prioritise a strong and diversified gilt market' – whereas too little would not change percentage allocations sufficiently, given the underlying headwind of closed schemes shrinking in size.
Equally, implementing only one or two of these six changes is unlikely to make the most of what might prove to be a once in a generation opportunity to reshape the pensions landscape to deliver better outcomes for all stakeholders.
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