Financial risks and the Pension Protection Fund: Can it survive them?

Basel Committee on Banking Supervision (1988) ‘International convergence of capital measurement and capital standards’, Bank for International Settlements, Basel.

Dowd, K. (1997) ‘The regulation of bank capital adequacy’, Advances in Austrian Economics, Vol.4, pp.95–110.

Jackson, P., Maude, D. and Perraudin, W. (1997) ‘Bank capital and value at risk’, Journal of Derivatives, Spring, pp.73–89.

The denominator of the new ratio is the sum of the risk-weighted assets and 12.5 times the market risk capital charge (where 12.5 is the reciprocal of the minimum capital ratio of 8 per cent). The numerator of the second ratio is the sum of the banks tier 1, tier 2 and tier 3 capital. Tier 3 capital could be used solely to meet the market risk capital charge, while tier 1 and tier 2 capital could also be used to satisfy the market risk capital charge once the credit risk allocation had been met in full. At least 50 per cent of the banks qualifying capital, however, had to be tier 1 (with term subordinated debt not exceeding 50 per cent) and the sum of tiers 2 and 3 capital allocated to market risk, not exceeding 250 per cent of the tier 1 capital allocated to market risk (so that at least 28.57 per cent of market risk capital had to be tier1).

Crouhy, M., Galai, D. and Mark, R. (1998) ‘The New 1998 Regulatory Framework for Capital Adequacy: Standardised Models versus Internal Models’, in Carol, A. (ed.)Risk Measurement and Analysis. Vol. 1: Measuring and Modelling Financial Risk, Chapter 1,Wiley, Chichester. See also Basel Committee on Banking Supervision (1996) ‘Amendment to the capital accord to incorporate market risks’, Bank for International Settlements, Basel.

Kupiec, P. and O’Brien, J. (1995) ‘The use of bank trading risk measurement models for regulatory capital purposes’, FEDS Working Paper 95-11, Federal Reserve Board, Washington.

Standard & Poors (1996) ‘Bank Ratings Comment: Market Capital Rules’, Standard & Poors, New York.

Basel Committee on Banking Supervision (2003) ‘The new Basel capital accord’, Bank for International Settlements, Basel.

Jackson, P. (2001) ‘Bank capital standards: The new Basel accord’, Bank of England Quarterly Bulletin, Spring, pp.55–63.

Jackson, P. (2002) ‘Bank capital: Basel 2 developments’, Bank of England Financial Stability Review, December, pp.103–109.

http://www.globalriskregulator.com/ .

This section draws heavily on this document, together with Consultation Paper 195 (Enhanced Capital Requirements and ICAs for Life Insurers) released in August 2003. See also Financial Services Authority (2004) ‘Integrated Prudential Sourcebook for Insurers', Policy Statement 04/16, June( http://www.fas.gov.uk/pubs/policy/ps04_16.pdf ).

Financial Services Authority (2003) ‘Enhanced Capital Requirements and Individual Capital Assessments for Life Insurers’, Consultation Paper 195, August.

There are also important accounting issues to consider. In 2005, the International Accounting Standards Board introduced ‘fair value’ international accounting standards. Insurers, however, are required to use the fair value standard for assets from 2005 but the fair value standard for liabilities (which replaces the book value measure) is to be used from 2007. The FSA believes that fair-value accounting is a necessary concomitant of risk-based solvency regulations: in order to ensure that firms match their capital more accurately to the risks they face, they need to measure both their assets and liabilities in a fair and transparent manner, in contrast with the opaque valuation methods that were commonly used. Needless to say, there has been intensive debate on the impact of ‘fair value’ accounting, and the main argument against is the concern that it might lead to excessive spurious earnings volatility.

Underlying regulatory thinking here is the ‘prudent person’ principle. To quote para. (31) of the Preamble to the new European Union Pension Fund Directive16: ‘Institutions are very long-term investors. Redemption of the assets held by these institutions cannot, in general, be made for any purpose other than providing retirement benefits. Furthermore, in order to protect adequately the rights of members and beneficiaries, institutions should be able to opt for an asset allocation that suits the precise nature and duration of their liabilities. These aspects call for efficient supervision and an approach towards investment rules allowing institutions sufficient flexibility to decide on the most secure and efficient investment policy and obliging them to act prudently. Compliance with the ‘prudent person rule’ therefore requires an investment policy geared to the membership structure of the individual institution for occupational retirement provision’;.

European Union Pension Fund Directive (2003) ‘Directive 2003/41/EC of the European Parliament and of the Council of 3 June 2003 on the Activities and Supervision of Institutions for Occupational Retirement Provision’, Official Journal of the European Union, 23rd September, 2003.

The predecessor to TPR between 1997 and 2005.

The Goode Report,19 which led to the 1995 Pensions Act that established the MFR, recommended that pension funds should be subject to a solvency standard, but this recommendation was watered down into a much weaker funding standard by the time the Act was passed.

Goode, R. (1993) ‘Pension law reform: Report of the Pension Law Review’, Committee, CM 2342-I, HMSO, London.

Faculty and Institute of Actuaries (2000) ‘Review of the Minimum Funding Requirement’, Edinburgh and London, May.

Myners, P. (2001) ‘Institutional Investment in the United Kingdom: A Review’, H M Treasury, 6 March.

Occupational Pension Schemes (Scheme Funding) Regulations 2005 (S.I. 2005/3377).

The Statement of Funding Principles sets out trustee policy for meeting the Statutory Funding Objective and should include: • funding objectives and the trustees’ policy for meeting it; • the schemes investment policy;• whether the Regulator has given any direction in relation to the scheme;• the calculation basis for measuring assets and technical provisions;• how often actuarial valuations will be obtained;• how cash equivalent transfer values will be calculated.

The Statutory Funding Objective states that the scheme must have sufficient and appropriate assets to cover its technical provisions. The technical provisions are an estimate, made using actuarial principles, of the assets needed at any particular time to make provisions for the benefits that have already accrued under the scheme, including pensions in payment, benefits payable to the survivors of former members and those benefits accrued by other members which will be payable in the future. The technical provisions are calculated using an accrual benefits funding method and assumptions all chosen by the trustees, after taking the actuarys advice and obtaining the employers agreement (Pensions Act 2004).

The FSCS replaced eight existing schemes each of which provided compensation if a firm collapsed owing money to depositors, policyholders or investors: the Deposit Protection Scheme, the Building Society Investor Protection Scheme, the Policyholders Protection Scheme, the Friendly Societies Protection Scheme, the Investors Compensation Scheme, the Section 43 Scheme (which covers business transacted with listed money-market institutions), the Personal Investment Authority indemnity scheme, and the arrangement between the Association of British Insurers and the Investor Compensation Scheme Ltd for paying compensation to widows, widowers and dependants of deceased persons.

Financial Services Authority (2001) ‘Financial Services Compensation Scheme Funding Rules’, Policy Statement, September.

See Pension Benefit Guaranty Corporation website http://www.pbgc.gov/ .

Utgoff, K. (1993) ‘The PBGC: A costly lesson in the economics of federal insurance', in Sniderman, M. (ed.)Government Risk-Bearing’, Kluwer Academic, Norwell, MA, and Dordecht, pp.145–160.

McCarthy, D. and Neuberger, A. (2005) ‘The Pension Protection Fund’, Fiscal Studies, Vol.26, pp.139–167.

Certainly for risk-based premiums to have the desired effect of increasing the funding level, the premium must be greater than the cost to the sponsor of borrowing funds to reduce the deficit.

Gebhardtsbauer, R. and Turner, J. (2004) ‘The Protection of Pension-Covered Workers and Beneficiaries: An Analysis of the UK Legislation Establishing the Pension Protection Fund', prepared for Age Concern UK, March.

There is in fact a fourth risk that the PPF is also subjected to: political risk. For example, financially weak companies could exert pressure on the politicians in the constituencies where they are located to press for a reduction in the premiums that they face. There is also a risk that the Government limits contributions into the pension scheme in good economic times in order to limit its tax loss and in doing so limits the surplus that provides a cushion against later falls in equity markets. In fact, the 1986 Finance Act did precisely this and limited pension scheme surpluses to 5 per cent of liabilities.

In 2005 however, the PPF did buy 10 per cent of insurance broker Heath Lambert in return for bailing out its pension scheme.

This is precisely what Norwegian shipping group Aker Kvaerner did in the case of its UK subsidiary. Just days before the new pension regulatory regime came into force in April 2005, the subsidiary was sold to its management for £1, thereby breaking the link between a profitable parent and a loss-making subsidiary. At the time, the subsidiary had a pension scheme deficit of £245m on liabilities of £1.2bn. The Pension Regulator eventually pressurised Kvaerner into paying £101m into the fund before 2012, but this was still not enough to cover the full deficit.

Bodie, Z. (1996) ‘What the Pension Benefit Guaranty Corporation can learn from the Federal Savings and Loans Insurance Corporation’, Journal of Financial Services Research, Vol.10, pp.83–100.

Sharpe, W. (1976) ‘Corporate pension funding policy’, Journal of Financial Economics, Vol.3, pp.183–193.

Treynor, J. (1977) ‘The principles of corporate pension finance’, Journal of Finance, Vol.32, pp.627–638.

Langetieg, T., Findlay, M. and da Motta, L. (1982) ‘Multiperiod pension plans and ERISA’, Journal of Financial and Quantitative Analysis, Vol.17, pp.603–631.

Marcus, A. (1987) ‘Corporate pension policy and the value of PBGC insurance’, in Bodie, Z., Shoven, J. and Wise, D. (eds.)Issues in Pension Economics, University of Chicago Press, Chicago, pp.49–76.

Lewis, C. and Pennacchi, G. (1999a) ‘The value of Pension Benefit Guaranty Corporation insurance’, Journal of Money, Credit and Banking, Vol.26, pp.733–753.

Lewis, C. and Pennacchi, G. (1999b) ‘Valuing insurance for defined benefit pension plans’, in Boyle, P., Pennacchi, P. and Ricken, P. (eds.)Advances in Futures and Options Research, Vol. 10,JAI Press, Stamford, CO, pp.135–167.

Vanderhei, J. (1990) ‘An empirical analysis of risk-related insurance premiums for the PBGC’, Journal of Risk and Insurance, Vol.57, pp.240–259.

Pensions Regulator (2006) ‘The Regulators statement: How the pensions regulator will regulate the funding of defined benefits’, May.

Pension Protection Fund (2006) ‘Statement of investment principles’, October.

Farr, R. (2005) ‘The power of the new pensions regulator’, Pensions Week, 9 May.

For a critique of VaR, see Dowd and Blake.47

Dowd, K. and Blake, D. (2006) ‘After VaR: The theory, estimation, and insurance applications of quantile-based risk measures’, Journal of Risk and Insurance, Vol.73, pp.193–229.

Danielsson, J. (2003) ‘On the feasibility of risk-based regulation’, CESifo Economic Studies, Vol.49, pp.157–179.

Blake, D . (1998) ‘Pension schemes as options on pension fund assets: Implications for pension fund management’, Insurance: Mathematics & Economics, Vol. 23, pp. 263–286.

At the time of writing this paper, these were the type of headlines that were common: ‘Funding regs trigger higher costs’ (Pensions Week, 30th October, 2006) and ‘Pensions safety net levy rises by 50 per cent’ (Daily Telegraph, 28th October, 2006).

Standard & Poors (2005) ‘Study of Potential Claims on the PPF’, Standard & Poors, London.