Addressing the challenge of charity pension scheme deficits

It is clear that for many charities their defined benefit pension schemes are becoming a significant burden. Charities now have an average deficit (on an FRS102 basis) of 16% of their unrestricted reserves (prior to deducting the pension deficit); a figure at odds with the FTSE350 where the average deficit is only 1% of a company’s market capitalisation.

The research shows that charity schemes are typically underfunded (with an average FRS102 funding level of 86% compared to a FTSE350 average of 95%). More significantly, charity schemes are taking more investment risk than other private sector schemes (an average allocation to growth assets of 60% compared to 40% for the FTSE350). When markets stutter these underfunding and investment risk aspects amplify each other. This makes the average charity scheme considerably more risky than its private sector counterparts.

The question is, how should charities respond? Here are some suggestions:

ADOPT A "LOWER RISK FOR LONGER" STRATEGY. In many cases charities are taking more investment risk in their pension schemes than they need to. Clearly, scheme assets should work hard enough to free up other resources for charitable activities. However, there is no point in aiming higher than you need to and exposing the charity to unnecessary risk.

Reshaping the investment risk

Defined benefit schemes are often run on the basis of taking material investment risk today, with an aspiration to take little to no investment risk in the future. Instead, consider taking a lower level of investment risk and maintaining it for a longer period of time. This reduces volatility today, enabling a slow and steady path to full funding over time, without putting undue stress on the charity. It may mean that a longer recovery plan can be used, and does not mean a need to increase the deficit – it simply reshapes when you take your investment risk.

FOCUS ON THE CASHFLOWS RATHER THAN THE DEFICIT. One way to enable a "lower risk for longer" strategy is to focus on paying off the future cashflows rather than paying off the deficit. Much has been made of falling gilt yields pushing up pension liabilities and deficits. But the projected pension payments themselves are not linked to gilt yields and have remained very stable in recent years (if anything they have reduced with falls in life expectancy).

Quantitative easing and falls in yields mean that asset returns have been very strong, and if anything schemes are arguably better placed to meet these future pension payments than they were a few years ago.

Required return on assets

A simple and informative piece of analysis to run for your scheme is to work out the required return on the scheme assets (and future contributions) to pay all the future pension payments in full over time. Using this analysis, for many charities it will turn out that the required return is often surprisingly low, typically around 3% per annum. If you design an investment strategy to deliver this amount of return (but no more) with sufficient confidence, this will give you a framework for a "lower risk for longer" strategy.

Interestingly, if you take this approach, you can even conclude that you do not need to invest materially in gilts (or LDI - liability driven investments which address interest rate and inflation risks) because you are no longer concerned about hedging yield risk. By investing primarily in credit and illiquid asset classes where most of the return is stable income rather than volatile capital growth, you achieve confidence that future cashflows will be paid and avoid being a forced seller of assets at the wrong time. It can even reduce costs as the leverage to fund the LDI is no longer required.

Adopting this approach makes it increasingly important to get the projected cashflows right. Based on longevity data, it is reasonable to prescribe a 12 year range to life expectancy depending on individual member characteristics. This means it is possible to produce accurate pension projections and strip out hidden margins that exist with more approximate methods.

Running quarterly valuations

Technology has improved to the point where one can now run full valuations quarterly at the push of a button. This reduces costs, increases the speed of decision making (by over a year compared to traditional triennial pension valuations) and most importantly increases confidence. Keeping up to date with membership movements is particularly important now that more members are transferring out of their DB scheme to take advantage of their Freedom & Choice options.

KEEP UP WITH EMERGING DEVELOPMENTS. There are a range of emerging developments (some of which are specific to the charity sector) which you should keep on top of in order to understand the likely impact on your scheme. Some interesting opportunities to reduce cost and risk include:

MANAGING INCREASED PPF LEVIES FOR CHARITIES. The Pension Protection Fund has reviewed its methodology for setting the annual levy payable by all defined benefit schemes. This is expected to lead to an increase in PPF levies for some charities in 2018. The PPF ran analysis recently and the charity sector sector was one of the only ones where actual insolvency rates were higher than anticipated under their current model. It is addressing this with the new methodology, and a higher insolvency risk translates into a higher levy.

Reducing your PPF levy

In the meantime, planning for these higher costs and taking all the available steps to reduce levies is well worth doing.

DEFERRING SECTION 75 DEBTS. Many charities are "trapped’ in multi-employer schemes, unable to exit (or in some cases even turn off future DB accrual) for fear of triggering very substantial “Section 75” debt payments. A DWP consultation is now out which proposes the ability to defer payment of a Section 75 debt which is otherwise triggered when your last employee leaves a multi-employer scheme.

In practice this means you could carry on paying ongoing deficit contributions over time, rather than the large upfront Section 75 debt. Keep on top of this consultation and engage early with your multi-employer scheme when it comes into force. As well as the more obvious action of ceasing defined benefit accrual where this was otherwise not possible, it also frees up options for defined contribution (DC) pensions as you do not need to be tied to your multi-employer provider for DC for fear of triggering a DB Section 75 debt.

INCREASING FUTURE SERVICE COSTS. For charities which are still open to future accrual, future service contribution rates at the next triennial valuation are likely to be eye-wateringly expensive. Plan for this, and if appropriate, consider closing to future accrual to stop the defined benefit problem getting any bigger.

Easier ceasing accrual

Many of the sector’s multi-employer schemes, including the Universities Superannuation Scheme and the Social Housing Pension Scheme, have triennial valuations this year. Ceasing accrual may become more straightforward if deferring Section 75 debts becomes possible.

CHANGES FROM THE GREEN PAPER ON THE FUTURE OF DEFINED BENEFIT. It’s possible that the Green Paper on pensions published earlier this year could lead to some changes for DB schemes for charities. These are likely to be limited, and mainly apply in distressed situations, but it may be possible to reduce indexation or suspend pension increases if this saving enables the scheme to carry on and ensure a better chance of delivering all members pensions over time.

Scheme consolidation is also proposed, which could reduce running costs and provide access to asset classes that are otherwise not available for smaller schemes. These are all things to watch.

Ultimately, the opportunities are there for the taking - to plan for proactive charities to manage their scheme funding and investment more effectively; planning for their future and more importantly the futures of their members.