“As long as the music is playing, you’ve got to get up and dance.”
– Charles “Chuck” Prince, Citibank CEO, 2003-2007
They say history rarely repeats itself, but it often rhymes. This week Parliament launched an inquiry into the collapse of BHS, a fixture on the British high street for the better part of the past fifty years. While MPs will hear from a number of the key players, the crux of the inquiry will be to understand how BHS shareholders managed to extract over £400 million in dividends, while leaving the company’s pension scheme, which now stands on the cusp of entering the Pension Protection Fund (PPF), to founder under a 23 year recovery plan.
We all know that defined benefit pensions are in crisis, but it’s a crisis unfolding in slow motion. The Pensions Institute and Cass Business School recently published a report that estimates of the roughly 6,000 defined benefit pension schemes in the UK, around 1,000 are at risk of entering the PPF over their life, if things continue as they are. Even those schemes not at risk of falling into the PPF will find these numbers alarming, as they imply that PPF levies will continue to increase and healthy schemes will, in effect, have to subsidise (bailout) someone else’s poor decisions or bad behaviour. In the case of BHS, the PPF estimates that the cost to the fund will be £275 million.
Although BHS may feel similar to the Robert Maxwell affair a generation ago, it also shares similarities with the more recent Global Financial Crisis of 2007-2009 (GFC). In both, you can find examples of lax oversight, weak governance, compliant boards and poor accounting – the consequences of which only became obvious with the benefit of hindsight.
As Chuck Prince captured in his quote on the GFC, crises have a tendency to sustain themselves for far longer than they should and will keep going until something fundamental changes. In the case of the GFC, the music stopped when house prices in the US stopped rising. With defined benefit pensions, I believe that it will be time that fundamentally changes our industry. As schemes continue to mature, close to accrual and become cash flow negative, kicking the can down the road and deferring hard decisions are no longer options.
In their inquiry into BHS, Parliament will surely ask tough questions: how did this happen, where was the Regulator, what were the trustees thinking, what were the Scheme Actuary, the auditor and other advisors saying? These are important questions, but I also hope that the inquiry will probe what changes can be made in the pensions industry to avoid this situation being repeated and ensure that the estimate of another 1,000 pension schemes entering the PPF does not become a reality.
In my opinion, there are three changes that would be proportional to the situation and would make defined benefit pension schemes more resilient, help us avoid more instances like BHS and encourage better decision making in an industry that is increasingly running out of time.
1) Standardised accounting – I propose that a standardised technical provisions rate based in economic reality, such as the gilt curve without a spread, be applied across the industry. This way, all stakeholders – from trustees to sponsoring companies to the Regulator – will have a common understanding of schemes’ financial positions, while the “scheme specific” aspects of our regulatory regime can still filter through in terms of the time horizons, sponsor contribution amounts, covenant assessments and investment policies within each scheme’s funding or recovery plan.
There are simply too many different measures of liability valuations. While the IAS19, funding, economic, PPF and solvency bases all serve a purpose in their own right, the sheer number of these measures causes confusion among stakeholders when decisions need to be made. In the case of BHS, it is not difficult to imagine that trustees, advisors and even the Regulator were essentially asleep at the wheel, because either no one truly understood or everyone was working off different understandings of what the financial position of the scheme was at the critical moments fateful decisions were made.
2) Standardisation of the assumptions underpinning models – I also propose that advisors standardise the assumptions underpinning the investment and risk management models that they use to provide advice and help trustees and companies make decisions on funding and investment policy. The pensions industry has made great strides in risk management over the past ten years, but one of the main lessons of the GFC is that financial models are only as good as the assumptions underpinning them and within pension VaR analyses, journey plans and risk dashboards, there is still too much variation, particularly around expected investment return assumptions and the mean reversion of interest rates, that can lead to poor or inconsistent decision making. All we have to do is look at public plans in the US to see what an overly optimistic view of future equity returns can lead to in terms of solvency and funding policy.
3) Mandatory clearance from the Pensions Regulator for schemes in deficit – Finally I propose that it become mandatory that all M&A transactions or other significant corporate events that involve a pension scheme in deficit be cleared by the Regulator. Currently clearance is optional and the Regulator has stated that it learned of the sale of BHS for £1 “in the newspapers”. This is remarkable and if we want to avoid repeats of BHS, then we need a regulatory framework that is not designed to put the Regulator on the back foot.
So, where does this leave us? It is important not to lose sight that this is about better securing and protecting the promises that were made to members and that the PPF is there as an insurance policy, not as something to be abused. In every crisis, there comes a point – a turning point – where the penny drops and everyone realises that the old way of doing things needs to change. In the GFC, that moment was when Lehman Brothers collapsed. I hope BHS will be ours.