19 May 2009

Lord McKenzie of Luton

Parliamentary Under Secretary of State (Lords)

Financial Times Buyout and De-risking Summit ‘The impact of financial turmoil on the market’

Tuesday, 19th May 2009

[Check against delivery]

Introduction

1. Good morning everyone.
2. We are living in difficult economic times. So far as the pensions environment is concerned – especially the Defined Benefit (DB) environment – this is evidenced by falling and volatile equity markets, by falling and historically low interest rates, (for gilts exacerbated by quantitative easing), by declining profitability and impaired corporate cash flows.
3. And of course this is happening against a backdrop of increasing longevity. It is also happening in the context of increasing unemployment and the reality, especially now, of the significance of flexible labour markets and the recognition that a job for life on which the DB model was founded being less and less the norm.
4. If we look at the PPF 7800 series, just over 18 months ago around the time of Northern Rock, in August 2007 the aggregate assets of DB schemes amounted to £823 billion and liabilities to £796 billion - an aggregate funding position of £27 billion surplus. But by April 2009 the aggregate funding position was a deficit of £188.5 billion. 
5. However, through all this volatility we must continue to assert that pension funds are long-term investment vehicles; it’s the long term return that’s important for pensions.
6. And it is the company finance directors, pension scheme trustees and industry experts gathered here this morning who are at the forefront of these testing events. So with that in mind, I want to thank the FT for organising today’s conference.
7. The volatility in the markets has undoubtedly affected the confidence of investors, workers and pensioners alike. And the downturn has placed increased demands on scheme sponsors, trustees and pension providers.
8. Extraordinary market developments require unprecedented levels of response.
9. The de-risking we are focused on at this event relates primarily to the risks of sponsoring employers and trustees, but we should not forget that issues of investment returns and longevity do not disappear for DC schemes. They are borne by individual members and annuity providers. Indeed de-risking is as much about redistributing risk as eliminating it.
   

   What is the Government’s role in all of this?

10. I do not propose to dwell on the Government’s broader responsibility for addressing macroeconomic issues, save to say that actions for a fiscal stimulus and to ensure adequate capitalisation of the banking system, and support for capacity to help a return to proper lending are a necessary prerequisite of addressing some of the financial turmoil we have encountered.
11. But of course, we do have a clear role in ensuring that the regulatory and protection system is fit for purpose.
12. The existing regulatory regime for occupational pension schemes is designed to help employers provide pensions for employees on the understanding that the employer will stand behind the pensions risk. It is built on the assumption that the employer will provide ongoing support. Part of its focus therefore might be said to de-risk matters for scheme members.
13. At the same time as ensuring that members’ benefits are protected, the Government’s intention is to allow markets to thrive by ensuring regulation is transparent, proportionate and appropriately targeted.
14. We saw last year how some proposed new models were outside the scope of FSA regulation, including the capital adequacy rules, and outside the scope of the Pensions Regulator.  
15. This would have created a risk to member benefits, to the Pension Protection Fund, and to those responsible for paying the PPF levy.
16. We therefore made proportionate and appropriate changes to the Pensions Regulator’s anti-avoidance powers in the 2008 Pensions Act to address the risk highlighted by these models.
17. But our priority as ever, remains maintaining the vital balance between easing regulatory burdens on industry whilst maintaining adequate protection for members benefits.
    

    Scheme Funding

18. The Pensions Regulator has a key role to play in the pensions protection framework.
19. It is a risk-based regulator and continues to focus on key risks in the system to help ensure that pension promises are upheld.
20. A key change introduced by the 2004 Pensions Act was the scheme funding regime.
21. The funding requirements for Defined Benefit occupational pension schemes came into force from December 2005 and implemented the funding provisions of the European Pensions Directive.
22.  The regime was designed to operate in difficult as well as benign market conditions. Pension scheme trustees are responsible for ensuring schemes have agreed deficit recovery plans in place, and for submitting these plans to the Pensions Regulator.
23. The Regulator in recent months has issued two statements, first to trustees setting out its position in relation to current market conditions, and in February to employers who sponsor schemes.
24. The guiding principle is reasonable affordability – trustees and the regulator are aware that deficits vary over time and will continue to act appropriately. These recent statements have made clear the flexibility available in recovery plans and have regard to reasonable affordability and current cash flow constraints on sponsoring employers.
25. The key is that trustees should set realistic funding targets, making prudent assumptions on the key issues. And as I know many do, they should continue to engage in a positive and open dialogue with their sponsor, using the principle of reasonable affordability to set payment schedules.
26. But where an employer believes that an existing recovery plan is at serious risk of jeopardising the company’s future development or solvency, that will be a matter for discussion with the trustees.
27. These discussions may result in longer recovery periods being proposed, possibly back end loaded, recognising the emerging pressures on company cash flows and affordability.
28. The Regulator has demonstrated a pragmatic approach. This has been welcomed by industry bodies such as the CBI, who stated that “Giving employers longer to manage their pension deficits will give them the breathing space they need for the economy and financial markets to recover.”
29. I mentioned earlier the changes we made in the Pensions Act 2008 to address the risks that could arise from some of the new developments in the market.
30. And the Regulator has worked hard to provide clarity for business on the use of the material detriment power and has provided a Code of Practice required under the 2008 Act.
31. The purpose of this material detriment code is to provide a degree of certainty for business on the use of the new power, whilst giving the Regulator the flexibility to respond to new developments in the market that present risks to members’ benefits and the Pension Protection Fund.
32. The code was laid in Parliament on 5 May and should be brought into effect in late June, subject to Parliamentary approval.
33. And just last week, the Regulator announced that it would be holding free workshops throughout the UK this summer to reaffirm the approach to DB scheme funding in the downturn. We hope that these prove a useful opportunity to engage directly with the Regulator, and I know that the proposed London dates are already over subscribed.
34. As the Regulator acts as one half of our protection system to maintain the balance of regulation, so the other half must function to compensate those who have become victims of misfortune.
    

    The Pension Protection Fund

35. The Pension Protection Fund protects nearly 12 million members in over 7000 Defined Benefit schemes.
36. With around £3 billion under management, and a levy intended to raise £700 million in 2009/10, there is no doubt that the PPF has the liquidity to pay a monthly compensation bill currently of around £4 million.
37. Around 31,000 people are receiving compensation or will do when they retire. And the average yearly compensation payout is £4,700 per person.
38. But importantly, under even the most taxing economic scenarios which have been tested, the PPF could continue to pay compensation for at least 20 years into the future.
39. But it is right that we should be vigilant, and we and the PPF continue to monitor its position very carefully.
40. It is the Government’s responsibility to maintain the balance between adequate protection and ensuring industry is able to operate innovatively and effectively.
41. That is why we strengthened the Pensions Regulator, and set up the Pension Protection Fund. These make up the vital framework of support. This system, equips the UK Pensions Industry, more so than it has ever been, to deal with the demands of this downturn.
    

    DB schemes

42. But of course we acknowledge that these are difficult times for occupational pensions and for Defined Benefit schemes in particular.
43. Rising deficits, challenges of accounting standards and schemes being closed are all too familiar. Between 1997 and 2007, 1,110 DB schemes closed to future accruals and 3,063 closed to new members.
44. But Defined Benefit schemes do remain an important part of the pensions landscape.
45. The reality is that DB pensions are in long term decline, but there are still:
    

    – 2.7 million people actively accruing rights in private sector DB schemes.
    – 8 million DB memberships – belonging to people either currently contributing or who have left their scheme;
    – And 5 million DB pensions are currently in payment.

46. So I want to emphasise that the Government is absolutely committed to helping scheme sponsors through this demanding time...
    

    Deregulatory Review

47. …And we have made every effort to do so through our ongoing deregulatory review.
48. The review examines how the regulatory environment can be made simpler, and less burdensome and we began work on this review in the May 2006 Pension Reform White Paper.
49. Over its course we have worked closely with industry to come up with options and consider the areas which are top of their agenda – particularly in this economic climate.
50. However, it is also important that industry does not underestimate what is already available to schemes. A wide range of options to enable risk sharing, to lighten the load on schemes, and to save on costs is in existence, and have been for some time.
51. For example, one option for employers looking to manage the cost of their DB schemes is to introduce cost-sharing arrangements between employers and members.
52. Another option is to implement a career average DB scheme, where benefits accrue based on the member’s salary in each year rather than on final salary.
53. A career average scheme could provide some comfort that the employer will continue to provide some guaranteed benefits. And for some employees, such as those on flat salaries or those who are phasing their retirement, a move to a career average scheme could be a positive change.
54. Other measures include hybrid schemes, cash balance schemes and increasing normal pension age. And of course schemes can take advantage of  the statutory override which came into force on the 6th April this year, allowing changes to scheme rules, where trustees agree, to reflect lower revaluation and indexation caps.
55. But of course, every scheme is different, and although we are aware that not all of these options are being taken advantage of – the objective must always remain that any changes to schemes should be consulted upon and ought to take due account of members’ needs.  
56. And we should acknowledge that as these changes are focused on future accrual, the impact on scheme sponsor liabilities will be gradual.
57. The deregulatory review has also led to measures in the Pensions Act, for example, to reduce the revaluation cap from 5% to 2.5% for future accruals...
58. …Something that has the potential to save employers around £250 million a year, on average, in the longer term.
59. Last year, we consulted on risk sharing, and within that, we seriously examined the case for conditional indexation and further, the case for removing the requirement to index altogether.
60. Unfortunately, we were unable to reach a workable consensus on those issues. Responses were varied. No clear, and agreed path forward was presented. And we remain to be convinced that such moves would reinvigorate Defined Benefit provision, to outweigh the clear loss in benefits to members.
61. In November 2008, we also consulted informally on the ‘employer debt’ legislation and associated regulations in section 75 of the 1995 Pensions Act. This is the amount that the employer must pay into the pension scheme – if there is a shortfall between assets and liabilities – in order to relinquish responsibility for the scheme.
62. Following the informal consultation, we are currently considering whether the employer debt rules should be modified so as not to hinder legitimate corporate restructuring unnecessarily.
63. Stakeholders have explicitly expressed concern around the security of members’ benefits, so any proposed modifications are taking us time to investigate thoroughly.
64.  And if we do decide that amendments to the employer debt regulations are needed, we will consult on draft regulations in due course.
65. You may also be aware that responses to our disclosure review consultation closed on 6th May. We are currently considering around 60 responses.
66. Our proposals on the disclosure review are to streamline the DWP regulations governing disclosure by pension schemes.
67. We aim to consult again later this year on draft regulations which will take account of the responses we have received and the general shape of reform.
68. I trust this gives you a flavour of the scope of our review. Demonstrating not only its wide remit but also that we are responsive to industry’s needs.
69. There is no ‘magic bullet’ or ‘easy answer’ in today’s increasingly complex financial markets. However, our door is always open. And where possible we will always seek to assist and to encourage sponsors and trustees to look closely at existing options and how these could prove beneficial.
    

    The buyout market

70. The so called ‘buy out’ market covers several types of arrangements including insured buy outs, and buy ins, synthetic buy outs as well as non insured buy outs.
71. These have varying consequences for where the risks end up, the ongoing role of trustees and future accruals for members.
72. During 2007 and 2008 the market witnessed significant growth in insured buyouts of Defined Benefit liabilities. Up to September 2008, prices in the buyout market remained competitive. The entry of new competitors to the market drove prices down. However, with recent economic events, including the collapse of Lehman Brothers, this was replaced by uncertainty and a loss of confidence across all markets.
73. The Pensions Policy Institute recently put the size of scheme liabilities at £1 trillion. Industry sources have estimated that buyouts account for £10 billion of this potential market – around one percent – and we are continuing to see innovation in the market.
74. The Government welcome innovation in the management of Defined Benefit pension risk. Responsible solutions can be of great value to sponsor employers and scheme members – and of course, the market is ever inventive.
75. But equally, we are and will always remain committed to ensuring that members’ benefits and the Pension Protection Fund are adequately protected.
76. Pension scheme trustees have a challenging role in relation to the market and I appreciate the important function that they carry out, often in difficult circumstances, and none more so than now.
77. This can be of particular importance when considering any form of buy out. Trustees need to consider how any particular deal serves members’ interests and act in the interests of all members. They need to seek professional advice where appropriate, and they must also consider a fair price. It is important that trustees fully understand the products they purchase.
78. In respect of insured buyouts, the Financial Services Authority regulatory regime, and the Financial Services Compensation Scheme provide security for members. The insurers of traditional buyout products are also subject to the solvency standards set by European legislation.
79. So deals are still taking place and we are continuing to see innovation in the market. For instance, last week we saw that the Babcock scheme had used a longevity swap as way of controlling risk.
80. This is just one of a range of de-risking techniques available. The longevity swaps market, is of course small at present and not particularly liquid. The key issue is that firms hold capital against the risks they run.
    

    FRS 17

81. Before I conclude, I want to add a few words on FRS 17. We recognise that many in the industry have raised concerns about FRS 17 and the recent proposals put forward by the Accounting Standards Board.
82. The ASB is currently re-examining their proposals on the financial reporting of Pensions and we await the results with interest.
83. Let me be clear, it is not the role of Government to set accounting standards, but we do want to encourage those who use balance sheets to make commercial judgements to fully understand the nature of these provisions.
    

    Conclusion

84. The Treasury Select Committee recently concluded that the downturn was due in part to excessive risk taking in the financial system.
85. We must learn the lessons of this crisis by maintaining a fine, vital balance between an innovative and competitive marketplace and the protection of scheme members rights. Because ultimately, those rights can equate to comfort in old age.
86. Whilst we work to meet the demands that the markets present us with we must also ensure that we are catering to the challenges and opportunities that will be presented over the longer term.
87. Pensions are after all, a long term investment.
88. Longevity is changing rapidly across the world.
89. In the UK alone, it is now not uncommon for people to spend a third of their lives in retirement.
90. And indeed, the UK’s first 120 year old ­ a woman of course ­ will come of age in 2063.
91. That means she is now 65 and already drawing her State Pension.
92. The Government has introduced radical reforms to the Pensions system, both State and Private to meet the needs of our changing demographic.
93. And it is up to industry to develop products that will meet the needs of longer living, and that make realistic assessments about longevity.
94. Although there is uncertainty at present in the financial system, we must continue to work together to meet these demands, responding quickly and flexibly.
95. Because beyond that, longer living presents the pensions industry with a multitude of opportunity. So let’s continue to work together, to position pensions as the best, and the only way to provide for security in retirement.
96. With that goal in mind, I believe we have every reason to start strengthening our confidence in the UK’s financial system.