Game over for DB pensions?

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The Pension Protection Fund’s Purple Book — the UK’s almanack of private sector defined benefit pensions — dropped on Wednesday. While it is always worth a read in full, we’ve pulled out some key parts.

The big headline is that DB pensions are pretty much done. Yes, done in the sense that they are almost all closed to new entrants — that’s not really news. What’s more remarkable is that they are pretty much done in the sense of job done, mission complete. For the first time, the UK private DB system is in buy-out surplus.

What does this mean? When a scheme’s corporate sponsor pays an insurance company to fully assume the obligations of the scheme they ‘buy-out’. They effectively hand over the keys and walk away. Some argue that buy-out is the gold standard outcome for DB pensions. Sponsor risk goes to zero (as long we pretend that the risk of an insurer going bust is zero). However, the price of buy-out has been so high that it has always looked beyond reach of most.

The global rise in bond yields, and gilt yields specifically, has changed the calculus. A key input in the price of buy-out is the long-term discount rate, aka bond yield. Rising bond yields reduce the present value of future cashflows, and the fact that pension schemes were not perfectly LDI’d and equities and private assets have done okay means schemes have been thrown into surplus. This much we’ve known. But a buy-out surplus is new.

Not every scheme has flipped into buy-out surplus, but from what we can tell, the aggregate system surplus isn’t driven just a few schemes accruing mega-surpluses. In fact, it’s now more common than not that schemes are in buy-out surplus, regardless of scheme size.

What else is new? Asset allocation continued to shift away from equities, with the market-weighted proportion falling from 19.5 per cent to 18 per cent. The UK equity component of this shrinking slice fell from 9.9 per cent to 7.6 per cent, meaning that average total allocation to UK stocks dropped from 1.9 per cent to 1.4 per cent — around a quarter of the average allocation to property. Looks like Richard Buxton timed his exit well.

Some of this is just schemes getting old mature. The new Purple Book breaks down asset allocation by scheme maturity for the first time. This shows what practitioners all know: more mature schemes more closely match assets and actuarial liabilities, and have less appetite for what the government calls ‘productive finance’.

So will schemes all buy-out? According to the parliamentary testimony of the insurance industry there are absolutely no capacity problems, no really, none at all, promise promise, cross my heart and hope to die. This declaration tends to elicit chuckles from pension scheme trustees, and the PPF submitted in their response to the call for evidence around the question of a public sector consolidator reckoned that “there is very likely to be a multi-year queue” for buy-out given very real capacity constraints.

Handily, the Purple Book has started to keep track of buy-outs, as well as buy-ins and longevity swaps. The pace has picked up, but has not exactly leapt.

So if schemes can afford to buy-out, but aren’t buying out, is this a big deal? Yes.

To see why we need to jump over to the ONS’s quarterly Financial Survey of Pension Schemes (bear with me). Since 2009, when the ONS started collecting data, private sector defined benefit sponsor ‘special contributions’ have averaged at around £14.5bn per annum. For a mid-sized economy this is no small beer. What are these ‘special contributions’? They are almost entirely ‘deficit reduction contributions’ — payments that sponsors make to … reduce deficits.

You don’t have to spend much time with UK company executives to hear them talk about these deficit reduction contributions like a tax draining their ability to invest for the future. With most DB pension schemes now in buy-out surplus, we’d expect these deficit reduction contributions to shrink rapidly. Whether firms will, in fact, choose to invest the freed-up billions in the future, pay it away as dividends, or maybe pass it on to workers in the form of higher wages is to be seen.

Further reading
— Slicing and dicing historical equity returns