1)  We welcome the publication of the consultation document on security for occupational pensions and the accompanying report to the Secretary of State for Social Security by the Pensions Board of the Institute and Faculty of Actuaries.

2)  We consider that Annex B to the consultation document, setting out questions for feedback, raises all the key issues relating to the Minimum Funding Requirement and we have responded to those questions on pages 3 to 7 of this letter. However, our main proposal is that MFR has proved to be an inappropriate means of enhancing security in occupational pension schemes and that it should be replaced by measures focussing on the funding of particular schemes. We set out our proposal in more detail immediately below.

3)  The letter from Paul Myners to the Chancellor of the Exchequer and the Secretary of State for Social Security, dated November 8th, 2000, recommended a transparency statement as an alternative to MFR. Whilst we agree with the principle, and largely share his criticism of MFR, we believe some of the detailed suggestions are in practice too difficult to implement. Instead, we would suggest that the trustees should be required to prepare a statement setting out their policy on the funding of the scheme, which could be called a Statement of Funding Principles.

4)  The trustees would have to ensure that there was prepared, maintained, and from time to time revised, a written statement of the principles governing decisions about the funding of the scheme.

5)  Many of the details would require much wider consultation, but the statement would cover the trustees' policy about

• the funding objectives for the scheme; and
• the level of security to be provided for the various categories of member and the various types of benefit

taking account of

• the current and likely future investment policy for the scheme;
• the return expected on scheme investments; and
• the contributions which are expected to be paid to the scheme.

6)  It could also include:

• details of the valuation methodology and how the valuation basis is to be determined, and a statement from the actuary on the impact on wind-up of the trustees' funding policy.
• a comment on the suitability of the investment policy, taking into account the nature and term of the liabilities.

7)  The trustees would have to, before preparing or revising the statement,

• obtain and consider the written advice of the scheme actuary; and
• consult the employer

8)  If the trustees and the employer cannot agree, then it should be up to the employer to put forward a revised Statement, covering in particular the level of contributions which it is prepared to pay. However, in that case, the trustees must have the right not to accept new members into the scheme, or to end or reduce future accrual of benefits.

9)  We believe that the trustees, by having to write down their policy, will give the consideration of funding a higher priority. We believe this is not dissimilar to the Statement of Investment Principles which has given a higher priority to trustees' investment policies.

10)  The advantages of this approach are:

• It is scheme specific, and so avoids distorting investments
• It allows flexibility, so removing the pressure caused by MFR for employers to discontinue defined benefit schemes
• It treats funding in the same way as investment
• It is consistent with current practice
• It would make it easier to foster realistic expectations amongst members
• It allows flexibility to cope with changes (e.g a move to market value valuation methods)

11)  There are other parts of occupational pension legislation linked to MFR. These include the regulations covering minimum transfer values, those governing the debt on the employer when a scheme winds up and the provisions in S.73 of the Pensions Act 1995 on priorities when a scheme winds up.

12)  It would be possible to replace the MFR, as we suggest, and to retain the parts of it relevant to these three areas of legislation. We suggest, however, that this might continue to influence the funding of schemes to such an extent that MFR itself would effectively remain in place. It would, therefore, be better to explore ways in which these three areas could operate in the absence of any of the provisions of MFR.

13)  For transfer values, we suggest that a statutory minimum should no longer apply. In practice individual transfers between defined benefit schemes have been rare for some time because of uncertainties arising from whether GMPs for men and women must be equalised and, if so, how. In addition, schemes are normally unwilling to accept transfer values, which might not reflect full equalisation, without an indemnity from the transferring scheme. Transferring schemes are usually unwilling to provide such indemnities. However, while transfers were still being made in significant numbers, we believe that disclosure of actuarial transfer value assumptions was already leading to their greater convergence. The link to MFR has effectively imposed uniformity with a lowest common denominator. We suggest that it would probably be possible to achieve an acceptable outcome on transfer values by relying on reasonably detailed actuarial guidance, coupled with regular surveys by the actuarial profession, which would highlight assumptions which significantly deviated from the norm.

14)  In determining the debt on the employer, our suggested statement of funding principles points to a way forward. The unpaid instalments of future contributions, as set out in the most recent statement of funding principles, could constitute the debt.

15)  A number of options on S.73 priorities would merit consideration. One possibility would be to allow the trust deed and rules to govern the priorities. Another would be to treat all schemes as money purchase once they move into wind-up. The aim would be to determine an equitable share of the assets between different classes of member, rather than to define different levels of security for different classes of members. We would strongly recommend further consideration of this approach.

Question 1 - How great a level of assurance does the MFR provide to the members of defined benefit occupational schemes either in the immediate or long term? In the light of time limits allowed under the MFR for restoring underfunding, is it expected that schemes will be better funded in future on winding up?

16)  The current MFR falls between two stools. It is strong enough to cause well documented difficulties for employers sponsoring defined benefit schemes, but it is not strong enough to provide the absolute guarantee of benefits on a scheme wind up which members often mistakenly believe it provides.

17)  The answer to the question, on whether it is expected that schemes will be better funded in the future on winding up, will differ from scheme to scheme. Some schemes can meet the current MFR comfortably and will probably continue to do so. They might remain funded at the same level whether or not MFR exists. In such cases MFR has no relevance to funding levels. In other cases the sponsoring employer might decide that it is not feasible to continue to provide defined benefits under the current MFR and move provision to a greater or lesser extent to money purchase, for which MFR is irrelevant. Other employers might continue to provide defined benefit schemes and strengthen their funding to meet MFR.

18)  The process, whereby the schedule of contributions is certified as at a later date than the MFR valuation, is cumbersome, requires approximations and introduces considerable volatility into the setting of contribution rates. Added to this, the timescales for restoring underfunding are too short. Experience has shown that the additional contributions can be significant relative to the normal contributions because of the short timescales, and this is causing many more employers to give serious consideration to closing their final salary schemes. This may well bring forward the winding up of schemes and do nothing to increase benefit security when that happens.

Question 2 - Does the current MFR affect pension schemes' investment decisions?

19)  The current MFR does affect pension schemes' investment decisions, although it is not clear how much of an effect there has been and how great the effect will be in future. For example, large private sector defined benefit schemes are subject to MFR and large local authority schemes are not. There is, however, no evidence, of which we are aware, of significant differences in the investment approach of the two types of schemes. This might be because both types tend to increasing maturity, and are for this reason to some extent moving away from investment in equities towards investment in fixed interest, so as to reduce potential funding volatility should markets move the wrong way.

20)  While some schemes have sought to match their equity/bond liability profile, there remains a significant element of investment risk due to the MFR's notional match to UK equities and gilts, whereas most pension schemes invest a proportion of their assets overseas. We have not seen any significant change in this policy yet.

21)  In general, we suggest that, the closer the funding level is to MFR, the greater the influence MFR has on investment decisions. In practice, this normally means that the pressure to invest in bonds will progressively increase.

22)  It is not clear how much of an effect the current MFR might have on future investment decisions. Schemes which currently have a funding cushion relative to MFR might not always have it. MFR would then probably have a greater influence. Additionally, the transitional provisions leading to the full effect of MFR have yet to expire and the influence on investment decisions might be greater when they have expired.

23)  MFR is a disincentive to pension fund investment in venture capital.

24)  With specific reference to insured schemes subject to MFR, a with profits approach has become more difficult to sustain, unless the spread of investments within the with profits vehicle approximates to the spread of liabilities in a particular scheme. However, as with profit vehicles often hold a high proportion of fixed-interest type investments, they might become more appropriate as schemes further mature.

Question 3 - What problems have been found in using the current MFR? What would be required to make it work more effectively?

25)  The report by the Pensions Board comprehensively sets out problems in using the MFR.

26)  One additional problem, which we would expect to become more pressing once the transitional provisions have expired, is an increasing need for schemes to have emergency valuations. These could cost smaller schemes more than the extra contributions required as a result.

27)  A major administrative cost under the current MFR is the annual re-certification of schedules of contributions. We view this re-certification as a legacy of MFR's origins as an intended solvency standard, which became a funding standard. A further undesirable side effect of the re-certification requirement is that it engenders spurious accuracy. In some circumstances it can produce very mis-leading results. If the existing requirement, not to include a Market Value Adjustment on re-certification, was dropped, the existing certificate could normally be allowed to run a three or four year course, unless a major event gave rise to a need for re-certification.

Question 4 - In respect of the basis for the valuation of pension liabilities (paragraph 4.5.3 of the Actuaries' Report) could an appropriate composite gilt/bond index be devised? What problems might there be in the use of such an index?

28)  The difficulty in devising an appropriate index is that corporate bonds do lose their investment quality status. Therefore any index would need to be regularly reviewed and, as the Actuaries' report indicates, this could cause practical problems for schemes and their sponsoring employers.

29)  There is also the possibility that the index could effectively become a proxy for buy out rates, which are currently causing well known problems of their own.

30)  The introduction of the index would have to be accompanied by a change in the one year/five year correction period, to three years/ten years, as suggested in the Actuaries' Report.

Question 5 - In respect of members who are not yet pensioners, what would be the practical effect of introducing the alternative MFR approach together with the longer deficit correction period and the removal of annual certification, proposed in the Actuaries' report?

31)  The proposed longer deficit correction period would be welcome as a means of spreading over a longer period the extra contributions which the alternative MFR approach might require. However, actual volatility arising from MFR valuations would be likely to increase. The longer deficit correction period would not reduce the effect which that would have on volatility of contribution rates required in the schedule of contributions (the back-testing results in the Actuaries' report are relevant).

32)  A longer correction period could mean that transfers values were reduced for longer, but the probability of a scheme wind-up was also reduced

33)  A possibility could be to allow a longer correction period for an immature scheme, (with many members some considerable way from their expected retirement date), than for a very mature scheme with very few members in this category, i.e a correction period linked to the average age of the membership

34) We would support the proposed removal of annual certification.

Question 6 - Are there any other ways in which the existing MFR could be redesigned to provide a more appropriate and reliable test which would secure members' interests no less effectively?

35)  Our overall view is that modifying MFR will not fully secure members' interests without increasing costs to a level which employers would find unacceptable or unsustainable.

Question 7 - Should all of the proposed interim changes be made to the current MFR test in advance of any changes arising from a wide ranging debate? Is the case stronger for some rather than others? If so, which? What effect would the increased funding requirements have on employers' willingness to continue to provide defined benefit occupational pension schemes?

36)  We do not see a case for introducing some of the proposed interim changes to MFR rather than others. The overall effect of those changes is to strengthen the MFR test. Given that the test is already a factor in reducing the willingness of employers to sponsor defined benefit occupational pension schemes, any strengthening would further reduce that willingness. Perhaps the most serious criticism of the proposed interim changes is that they would tend to increase employers' costs and increase volatility in funding levels, but will not ensure that members' benefits can be fully secured by buying out on winding-up.

37)  The introduction of the interim changes should only be contemplated if accompanied by the longer deficit correction periods proposed in the Actuaries' Report. Any interim changes should be reviewed before they are made, to ensure that they are still relevant (e.g the change to the equity market value adjustment). The proposal in the Actuaries' report on the nett dividend yield should be linked to 2.75%, not 3%.

38)  The best option would be to make fundamental changes arising from a wide ranging debate sooner rather than later, to avoid the complication of introducing a modified version of the existing MFR followed relatively quickly by a possibly entirely new approach

39)  Rather than introduce the proposed interim changes to the current MFR test, it would be better to extend the transitional period for the full introduction of the current MFR.

Question 8 - Would any of the approaches mentioned in paragraph 43 to 52 work more effectively. If so how and why? How would their costs and benefits compare with existing arrangements?

40)  We believe, with reference to paragraph 44, that it would be possible to incorporate a measure of equity returns in discounting certain liabilities, to avoid the potential problems identified in the Actuaries' report. However, a longer spreading period would be a better way of dealing with volatility.

41)  The Actuaries' report (section 6.4) contains some outline proposals on redefining winding up benefits. We strongly support the recommendation that the initial work in this area should be followed up.

42)  We believe that the arguments in the Actuaries' Report against insolvency insurance are persuasive.

Question 9 - Are there other ideas for providing protection for defined benefit occupational scheme members' rights which should be considered?

43)  Existing MFR attempts to provide a compromise between members' expectation of benefit security, and employers' resistance to higher pension costs. As mentioned in our response to question 1, MFR fails on both counts - members do not understand that it does not provide full security, but employers still find it an onerous requirement to meet.

44)  We suggest that it would be useful to look at the reasons why employers are unwilling to provide the level of security that members expect. There are a number of areas where legislation could be amended to encourage a high level of funding rather than penalise it.

45)  A key issue is that if the employer turns out to have contributed too much by reference to MFR, it can only make use of the excessive contributions through benefit improvements or, in very limited circumstances, through a refund subject to tax at 40%. On the other hand, the employer is expected to meet any deficits. One of the main reasons for an employer to operate a defined benefit scheme is that the employer can bear the risks more easily than each individual employee, but that reason is removed if the employer faces a one-way bet.

46)  The following changes could be made if there is a surplus on winding up:

• the employer should have the statutory right to refuse permission for benefit improvements.
• refunds of surplus (perhaps after adding a margin to the liabilities in the case of an ongoing scheme) should be permitted without any tax penalty - i.e they should be treated as company earnings and subject to ordinary corporation tax.

47)  Additionally, consideration could be given to raising the priority of the debt on the employer.

Question 10 - Would it be better to develop a combination of the approaches in paragraphs 43 to 52?

48)  No. This could not be done without considerable extra complexity and would provide a further disincentive to employers sponsoring defined benefit provision

Question 11 - Should there be different approaches for different sizes of schemes? Where should the dividing line be drawn?

49)  No. We would expect difficulties in practice in defining different approaches which dealt with changes in scheme size

50)  We would also be concerned that the practical outcome of approaches differentiated by size of scheme might be an unwarranted weakening of the requirement for large schemes and strengthening for smaller ones.

51)  The only area in which there might be justification for differentiated approaches is that of expenses, on the basis that, all things being equal, larger schemes are less expensive to run than smaller ones.

Question 12 - Should the treatment of pensioners in defined benefits schemes be changed to reflect developments in the defined contribution market? If so, how?

52)  Yes. Paragraphs 7.6 and 7.7 of the Actuaries' Report outline some possibilities which could usefully be further explored.

Question 13 - Are there reasons why there should not be disclosure to members of the scheme's solvency position and what this might mean should their scheme cease? How might such information be best communicated to members?

53)  No, but the disclosure would need to make clear that the solvency position, however measured, can be volatile and might have changed since the date by reference to which the solvency is measured. In principle, however, we support disclosure.

Question 14 - What might be the broader economic impact of the policy options discussed?

54)  We are not equipped to offer detailed economic analysis of the policy options discussed, but we suggest that the following might be among the consequences of retaining the current MFR

• There will continue to be a number of people claiming means-tested benefits because their pension scheme failed to provide the promised defined benefits in full.


• Less investment in equities.


• A continuing disincentive to venture capital investment.


• Fewer defined benefit schemes and therefore fewer people contracted-out. This would lead to less stability in State finances, as lower short-term expenditure on contracting-out rebates was followed by higher expenditure on State benefits