The cost of funding final salary pension plans has, for some time now, proved a considerable problem for many employers who sponsor a defined benefit occupational pension plan. This is due to a combination of factors such as changes in markets, low interest rates, greater life expectancy, stricter legal regulation of pension plans and a tendency for the trustees who run pension plans to take an increasingly risk-free approach in a desire to ward off member or regulator criticism, thereby pushing up the costs to the employer (as any deficit in a defined benefit pension plan must be met by the employer).
One cost saving solution which is often mooted by employers is to close their defined benefit pension plan to any further accrual of benefits and transition members to a less costly defined contribution pension plan. However, in assessing the affordability of defined benefits, this does beg the question of what exactly the funding deficit is and how it has been measured. That is not as straightforward as is it may sound.
The USS Dispute
A recent dispute involving the Universities Superannuation Scheme (USS) has brought into focus how sensitive these issues can be; on the one hand the employer has a financial burden to fund defined pension benefits which it considers unsustainable while, on the other, employees value the certainty of a guaranteed level of pension in retirement. By contrast, defined contribution benefits are cheaper to provide but, from a member's perspective, are less generous and offer no certainty.
The USS is the UK's largest private sector pension plan providing defined benefits but, in 2017, it could potentially have been on the brink of closure to future accrual. Its multi-billion pound deficit was seen as unaffordable by the higher education sector employers who participate in it, with defined contribution benefits seen as a more viable future alternative. However, affected employees objected strongly and a series of disruptive strikes were staged involving academics, lecturers and other higher education staff.
Many members of the USS were also leading mathematicians, statisticians and experts in other fields, who challenged the calculations underlying the estimated deficit figures. They did not agree that the USS was in such dire financial trouble as was being portrayed, pointing to the income received by the plan from contributions and asset returns which arguably stacked up well against the outflow to pensioners. On one measure, the USS was in fact in surplus rather than in deficit.
A panel made up of employer and employee representatives, chaired by an independent person, was charged with reviewing the assumptions which had been used to calculate the plan deficit. The panel highlighted what it saw as a flawed assessment of that deficit and of the strength of the employer support (or 'covenant') standing behind the USS.
The panel claimed that this assessment was partly influenced by the Pensions Regulator's negative assessment of the financial strength of employers in the higher education sector. In addition, the trustees of the USS had reacted with prudence and an aversion to taking any kind of significant investment risk in case the employers were not strong enough to provide back up if investments did not perform as expected. However, lower risk investments attract lower returns and therefore result in increased plan deficits. The estimated deficit figures were therefore seen by many members as artificially inflated, albeit in compliance with legislation and actuarial practice, rather than as a genuine measure of the plan's financial health and the employer covenant. Following the challenge staged by the panel, the USS currently remains open with a lower estimated deficit than in 2017, although contribution rises for employees are still possible.
While the particular circumstances of the USS may be quite unusual, they are not necessarily unique. Any member who is affected by the changes could scrutinise an employer's proposals to close its pension plan, given that employers are required to consult on changes to the pension plan by UK pensions legislation. A member may well have the experience and expertise to challenge the reasons provided by the employer to justify the changes that are proposed. We have seen a spate of cases in recent years of 'member power' forcing a change in the employer's strategy in relation to the plan, or forcing the employer to enter the law courts.
Employers should not assume that their workforce will simply accept their proposals for change without question, and should be prepared to back up their reasons with hard evidence, by having a robust business case to support the changes. The USS dispute may mean that more members are prepared to go even beyond the employer's business case and challenge the maths underlying the alleged poor funding position of the plan.
The USS dispute is a timely reminder of the importance of:
- in formulating a package of changes, making sure that there exists a robust business case to justify the changes, and a full consideration of other alternatives that could address the business case
- carrying out a full and thorough consultation where pension changes are being proposed, particularly where changes are being driven by valuation figures
- as part of that, finding a balance in terms of providing affected members with enough information to enable them to scrutinise the reasons for, and impact of, the changes for themselves.