Consulting Actuaries

"Where are you goin' to? Do you know?"

Neil Walton

26 October 2018

Obviously they have been playing Diana Ross’s 1975 hit in the DWP offices and the chorus above has struck a chord. We don’t yet have very much detail on how DWP or tPR intend to improve the operation of the scheme funding regime - Chapter 2 of the recent DB White Paper. However, one of the ideas outlined was that all employers and trustees should set out an agreed long term funding objective for their scheme.

This long term funding objective is not the Statutory Funding Objective (SFO).  The DWP sees the long term funding objective as an additional objective that sits over the scheme at a strategic level.  To prevent any confusion let’s call it the Strategic Over-arching Funding Aim, or SOFA for short.

The aim of a SOFA is to provide comfort to DWP, tPR, trustees and sponsors that all parties understand what they are trying to achieve and that they are all working together to achieve it. Schemes would have to publish what their SOFA is.

The White Paper outlined 4 example SOFA models;

  1. To run-on with employer support;
  2. To reach self-sufficiency with a low-risk investment strategy and run-off with minimal call on the sponsoring employer;
  3. To buy-out by a set time; and
  4. To enter a consolidator vehicle within an agreed timeframe.

Few commentators would argue that knowing where you are trying to get to is a bad idea, or that these examples are not reasonable SOFAs. However, the possibility of unintended consequences needs to be considered before you choose a particular SOFA.

The White Paper envisages that your SOFA will drive the funding actions of the scheme in the future.

 

In particular, trustees and sponsors will agree and set the funding assumptions at each actuarial valuation in line with the SOFA. For example;

 

  •  if you choose a buy-out SOFA then the discount rates and mortality assumptions should reflect insurance company costs, i.e.  Technical Provisions should reflect the estimate of solvency – as a consequence scheme deficits will explode.
  • if you choose a buy-out  or consolidator SOFA incorporating a specific target date, then the length of any recovery plan will be constrained by that target date, and will get shorter at each actuarial valuation.
Similarly, if you choose a run-on SOFA, then building the employer covenant into the discount rate assumptions and investment policy will be crucial.

 

The White Paper envisages that your SOFA will last forever.

 

The problem with this is that the world is not preserved in aspic; it changes continuously.  In investment circles and in business many would consider the long term as 5-10 years. In politics the long term may just be until the next election.  Regulatory regimes seem to last only about 10 years before governments and their ideas change. Is it reasonable for regulations to trap schemes into continuing with a particular SOFA, just because the trustees and sponsor thought that was the best SOFA available at the time?

 

Consider a scheme that chose a self-sufficiency SOFA, with a low risk investment strategy. Over the last few years a “low risk investment strategy” would have meant investing in Gilts or high quality bonds. If global interest rates are going to be driven up by the Central Banks then bond investments may be the wrong place to be for the next decade!

 

Could the choice of SOFA have consequences for the corporate world?

 

Under some accounting standards, e.g. IAS19, contribution agreements in respect of a DB scheme may  have to be reflected in the sponsor’s accounting disclosures. Could choosing a buy-out SOFA lead to inflated balance sheet or P&L disclosures?  Would larger, SOFA driven, recovery plan payments cause higher GAAP deficits, hindering the sponsor’s participation in corporate activity?

 

If schemes choose a buy-out SOFA or perhaps a consolidator SOFA could this affect the degree of competition in these markets?  For example, if a number of large schemes choose a buy-out SOFA with a date of 2025 then insurance companies could logically adjust their premium rates to reflect this known additional demand.  After all, price is really just the balance between sellers’ demand and buyers’ supply.  Perhaps by choosing a more unpopular date the seller could achieve a very attractive offer.

Overall, a SOFA could be a useful idea for the pensions world though we do not actually know what SOFA models tPR and DWP will come up with. However, I think it would be very wise to remember the whole of Diana Ross’s refrain above; to think about the consequences before any decisions are made and to remember that DB liabilities could last for the rest of this century so flexibility is essential.