Lord Flight is Chairman of Flight & Partners Recovery Fund, and is a former Shadow Chief Secretary to the Treasury.
The Pension Schemes Bill is currently starting its life in the House of Lords. It is a useful piece of legislation providing a sensible regulatory regime for Master Trusts. I suspect few know anything about Master Trusts, which have been a positive case of the market providing what is needed. Master Trusts provide low cost trustee, investment management and administration services, mostly for the employees of small firms’ auto enrolment pension schemes. Master Trusts have already some five million members and over £8 billion in funds. 50 per cent of employers have chosen Master Trusts for their auto enrolment needs.
There are four major Master Trusts out of a total of 84: major consolidation is inevitable in the future as many will be too small to be viable long term. In particular, the Pension Schemes Bill provides for the Pension Regulator to require that Master Trusts are adequately capitalised in order to avoid the risk of closure costs having to be borne by pension scheme members. In practice, this is unlikely to be an issue anyway, as larger Master Trusts will welcome taking over other Master Trusts, since they will benefit from having the additional funds to manage.
Master Trusts normally provide only one general investment fund, broadly similar to default funds under Group Personal Pension Schemes, for which the investment management charges are competitive. Master Trusts will also have a low, capped charge for those wishing to exit their pension fund. With the completion of the introduction of auto enrolment pensions and the inclusion of large numbers of small companies, the assets managed by Master Trusts are likely to grow substantially over the next decade.
There is, however, a crucially important issue which government has so far not addressed, which I will call FRS17, although it is now known as both Accounting Standard FRS102 and IS19. This is the accounting standard which determines the rate of interest at which future defined benefit pension fund liabilities are discounted to present value, and thus the extent to which pension schemes are judged to have deficits.
When FRS17 was introduced by the accountancy profession, its discount rate formula of the yield on gilts plus a margin was a reasonable rate to take, although even then conservative. Since then, QE has produced gilt yields which are artificially low in a longer-term context. For example, the gilts’ discount rate formula applying to a pension fund, of which I am a trustee, is approximately half the average return which the pension fund has achieved over the last decade, taking both bad years for equity markets post the 2008/09 financial crisis, as well as recovery years.
The crucial point here is that the resulting, reported deficits of pension funds are hugely exaggerated by using such a gilt-based rate to discount pension fund liabilities; the rate is generally far lower than the returns which pension funds achieve. We read of aggregate pension fund deficits of in excess of £700 billion or more, but if appropriate rates are taken to discount pension fund liabilities, the likely reality is that there are no overall deficits. We need to know what are the real deficits of pension funds.
In the meantime, employer companies sponsoring defined benefit pension schemes are being required to make good deficits which may not exist. In several cases, the amounts involved are huge. There is also evidence that, this, in turn, is reducing corporate investment and so damaging productivity growth.
What I would suggest would be a sensible approach is to require the actuaries of pension schemes to determine an appropriate rate of interest at which to discount liabilities, based on the returns achieved by the pension fund over the last decade or so and its investment policy.
The easiest way to achieve this would be to persuade the accountancy profession that FRS17 (now IS19 and FRS102) are out of date as a basis for determining an appropriate discount rate – essentially because of the effects of QE. If this cannot be achieved, the government should intervene.
Here the stock political response is that government should not interfere with the accountancy profession. This strikes me as a nonsense if the accountants have got it wrong. In the US, Congress has had no such qualms about overruling the profession. Where self-evidently the rates used for discounting liabilities are far too low, and thus produce hugely exaggerated pension fund deficit figures, which in turn damages productive investment, there is a clear, national interest argument for government intervention. There is, moreover, the additional issue that, when gilt yields return to normal, many defined benefit pension funds may find themselves with substantial surpluses they cannot use, especially where employer sponsors have made good current FRS17 deficits.
I raised this issue in the Pension Schemes Bill 2nd Reading debate on 1st November and was pleased to get a government response that an inquiry is being set up into this issue.