In March 1999 the Faculty and Institute of Actuaries were asked by the Government to review the Minimum Funding Requirement (MFR) test. In their report (delivered at the end of May 2000, but only published [PDF] last week), the Pensions Board of the Faculty and Institute of Actuaries said:

• the MFR test needs to be related to the cost of buying out benefits on winding-up;
• members should be told, via an additional "security measure", what chance there is that they actually would get their full accrued benefits if the scheme wound up;
• there is no objective valuation method which depends on equity returns;
• a revised MFR test should be based solely on bond yields, derived from an index comprising a wide range of fixed interest gilts and investment grade fixed interest corporate bonds;
• this revised test would be similar in strength to the current test yet produce a more stable level of security for members' benefits, but result in a more volatile funding level for most schemes;
• to cope with this increased volatility, schemes should be given longer to correct a deficit in meeting the MFR, eg 3 and 10 years (instead of 1 and 5) to meet 90% and 100% of MFR respectively;
• all this will require extensive consultation, but meanwhile to restore the original strength of the test some changes to the current MFR basis are justified now, to reflect the following developments:
  • already pensioners are living two years longer than expected in 1995;
  • inflation and interest rates have fallen sharply, but when prices fall pensions are not in practice reduced;
  • the relationship between the dividend yield and the capital value of the FTSE All Share Index has significantly altered (the 'Vodafone factor'), ie dividend yields have fallen.
  
  These changes would require a "typical" scheme currently funded at the 100% level to increase its asset value by up to 5%, to maintain the 100% level.

In response, a joint DSS/Treasury consultation document entitled "Security for Occupational Pensions" was published simultaneously - pdf file (81KB). This document is also available on the HM Treasury website as an HTML web page. In it, the Government said:

• adjustments to the existing MFR could probably be implemented towards the end of 2001;
• achieving the more consistent level of security offered by the revised MFR test for the members' benefits would in practice cost more - and extending the deficit reduction period alone would probably not fully offset these additional costs;
• even if the MFR test was redesigned as the Actuaries have recommended, it would still "fall a long way short" of providing "the full guarantee that many people assume exists";
• the long-term security of pensioners and the interests of other pension scheme members nevertheless should be protected [meaning possibly "full protection" for pensioners but just "reasonable expectations", ie an "even chance" of receiving the same benefits on transfer as a deferred member if the scheme was ongoing, for the rest];
• issues wider than the basis of the MFR calculation itself should be explored to see whether this could be done more effectively or more reliably, eg by a combination of an amended MFR test coupled with compulsory insurance, a central discontinuance fund (CDF), or supervision of schemes;
• any changes must not damage the long-term future of defined benefit pensions or risk reducing the benefits they provide.

In Annex B of this consultation document the Government posed the following questions for feedback:

Current MFR

1. How great a level of assurance does the MFR provide to the members of DB 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?
2. Does the current MFR affect pension schemes’ investment decisions?
3. What problems have been found in using the current MFR? What would be required to make it work effectively?
4. In respect of the basis for the valuation of pensioner 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?
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?
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 scheme members’ interests no less effectively?
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 DB occupational pension schemes?

Other approaches

8. Would any of the approaches mentioned in paragraphs 43 to 52 work more effectively? If so how and why? How would their costs and benefits compare with existing arrangements?
9. Are there other ideas for providing protection for DB occupational scheme members’ rights which should be considered?
10. Would it be better to develop a combination of the approaches in paragraphs 43 to 52?
11. Should there be different approaches for different sizes of schemes? Where should the dividing line be drawn?
12. Should the treatment of pensioners in DB schemes be changed to reflect developments in the defined contribution market? If so, how?
13. Are there any reasons why there should not be disclosure to members of the scheme’s solvency position and of what this might mean should their scheme cease? How might such information be best communicated to members?
14. What might be the broader economic impact of the policy options discussed?

Aries comment

It should be worth stepping back to the origins of the MFR, ie the Maxwell scandal and the subsequent Goode Report, White Paper and 1995 Pensions Act. The Goode Committee's proposals for a minimum solvency requirement were watered down, to the point where use of the term 'solvency' became completely untenable and was replaced in the Act by 'funding'.

Defined benefit schemes are carrying a significant excess regulatory burden today essentially because Parliament failed to understand that Maxwell was a complete aberration. The rampant fear of a re-run gave birth to the sledgehammer Pensions Act, of which one of the central pillars is the MFR.

Only recently, in the light of the consistently dominant position in Opra's casebook of late contribution reports, has it apparently dawned that insofar as there are problems with UK pension schemes they lie very largely with smaller, mostly money purchase, schemes - to which the MFR does not apply.

So we are entitled to go further than the Government appears to want us to, and ask whether on balance DB scheme members might be better served if the MFR was scrapped altogether.

It seems to be generally accepted that at the very least, the MFR has created extra costs for the employer, and that any reasonable adjustment such as the Actuaries propose in the interim will add to this burden. Some go further and argue that the disadvantages of the MFR on balance outweigh the advantages, or even that the MFR has been pretty well an unmitigated disaster for everyone concerned (the adverse effect of the MFR upon the gilts market and indirectly on annuity rates is only part of the story).

It is said that the aim of the MFR is (or was) to offer DB scheme members' benefits more protection than they would otherwise enjoy. Yet if the effect of the MFR is to drive employers to wind up their DB schemes - or close them to new employees - and replace them with DC schemes, as is evidently happening, have the members gained or lost?

Arguably, in the light of surveys showing that employer contributions to DC schemes are consistently lower, the members are probably going to be worse off. Add to that the usual absence in DC arrangements of death benefits, ill health early retirement, discretionary pension increases and so on, and the superior nature of DB schemes becomes all too obvious - as most industry figures generally acknowledge.