UK DB Pensions 1997 : 2030 - History Lessons

How Excessive Derisking Came to Stimulate Economic Growth

In 1997 after years of steady growth in a high inflationary environment, most UK DB pension schemes were strong financially – almost too strong.  Some took contribution holidays.  Companies with large pension surpluses were acquisition targets.
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• Advanced Corporation Tax (ACT) credit provided a subsidy and had been material to the strength of UK pension schemes.  ACT was first cut back and then abolished in 1997.  The years of plenty were over.
• Actuaries’ valuation techniques using dividend yields for UK schemes’ liabilities made no sense once the credits went.  Change was required. 
• From 1995, Minimum Funding Requirements had already encouraged market pricing to be used.  Gilts were used post-retirement and equities pre-retirement.  By then accountants were pushing for schemes to lower equity risk and use high quality ‘AA’ bonds to value liabilities.  They also wanted DB schemes to be on the balance sheet.
• In a turf war with accountants, actuaries switched to using gilts plus a slither of added return as the discount rate to value liabilities making them more aligned to insurers.  Accountants did not follow.  So rival valuation systems were introduced which have cost pension schemes ever since.
• The idea of matching (good) and return seeking (risky) assets emerged.  The more matching the better.
• For companies, pension became a volatile accounting issue and a cost as actuaries responded to the long, fixed income bull market by asking for more money to feed their new valuation technique.
• The Pensions Act 2004 made it clearer that schemes had to fund more strictly.  TPR was created to drive for risk reduction to protect the new safety net – the PPF.  Funding to buyout levels became a requirement from 2005 in certain circumstances.  Section 75 debts and accounting volatility of schemes and cash contributions made Boards want to keep their distance from pensions.
• From 2007 onwards the idea of using derivatives and LDI rose with an influx of fixed income sales teams from investment banks (led by Redington) coming to the pension sector.  And finding consultants amenable and the markets lucrative.
• Derisking (meaning sell equities, especially UK equities, and buying more protection against interest rate falls) took hold.
• After a false start, Pension Investment Corporation and Rothesay led a new wave of life insurance vehicles intent on psyching trustees into extending investment derisking into “Risk Transfer Solutions”, which handed schemes’ responsibilities, in whole or part, over to them.
• TPR and PPF proved remarkably successful initiatives.  Governance improved; cash contributions by sponsors were remarkably high and investment portfolios were derisked.  PPF became well funded and very efficient.
• TPR and the pension consultancy industry came to believe that life insurers provided a “Gold Standard” and all should work to achieve it.  As with the Gold Standard in 1920’s, that had serious negative consequences.  Systemic risk in leveraged LDI when interest rate cycles turned and the concentration risk with a limited number of insurers was underestimated.
• Longevity trends had changed from 2011.  That suggested “wait and see” was a good approach, but by now the risk transfer industry was in a hurry to get hold of assets, so that was largely ignored.
• And so policy adjustments were needed after the great cash collateral crisis of 2022.
• Successive Chancellors started to encourage run-on and then to require schemes to evidence they looked at “Credible Alternatives” to buyouts.
• Corporate sponsors who had adopted a “get rid ASAP” approach saw HR, ESG and financial advantages in embracing their schemes and providing contingent third party back up.  They then ran the schemes on to benefit all stakeholders.  The chance to fund / improve current pensions was taken up.
• Trustees, seeing that PPF insurance covered ever more of pensioners’ accrued pensions, started looking at how a healthy scheme could add discretionary improvements in members’ best interests.  Discretionary improvement packages became common and Government added to flexibility.
• Trustees and sponsors agreed to reactivate schemes on a modernised (collective) defined contribution basis.  Members old and new benefitted from schemes allocating surpluses to them.
• Government saw that revived pension schemes were bringing more funds to invest in the UK economy and in productive asset investments.  They provided a tax incentive to encourage a new trend back to recycling money into the UK economy to great effect, revising the London Capital Markets.

The crisis of 2022 proved a wake up call.  Yet it actually highlighted that the UK had dealt rather well with the high liabilities arising from traditional DB schemes by early and firm action after 2004.  A bounce back from excessive derisking provided an opportunity.  TPR reset.  It also showed that, with straightforward Government policy and corporate mindset adjustments, it was possible for all stakeholders to benefit.  And they have.