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A Recent History of UK Pension Provision

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This article on the occasion of the thirtieth anniversary of Pension Funds and their Advisers (PFA) provides an historical overview of the evolution of occupational pension provision and the setting of pension fund investment policy over the past thirty years. Although it provides reasonable coverage it does not aim to be comprehensive. Rather it attempts to identify main trends. It first provides historical context by comparing the rise of occupational pension provision in the 1950s with more recent decline. It then identifies three primary trends in regulation, accounting and risk management. Finally, it uses material from PFA directories to discuss these changes.

Historical background

The 1950s saw accelerated provision of occupational pension funds in the UK. The active membership of private sector pension funds rose from 1.6 million in 1936 to 3.1 million in 1953, reaching a peak of 8.1 million active members in 1967¹. This was associated with a shift in benefit design from defined contribution to final salary defined benefit. The popularity of defined contribution and of average salary defined benefit provision in the 1930s declined from the 1950s to the 1970s. In 1979 final salary defined benefit pension funds composed ninety two percent of all pension funds, versus only twenty three percent in 1963².

More recently, these trends in provision and in benefit design have reversed. The 2005 survey of the Government Actuary’s Department shows that forty one percent of all active employee members of the largest defined benefit schemes, or sections of such schemes with more than ten thousand members, were in schemes or sections that were closed³. The first report of the Pension Commission estimates; ‘the number of active members in open [defined benefit] private sector schemes … is unlikely to stabilize above 1.6 – 1.8 million’⁴. The closure of defined benefit pension funds has been accompanied by a proliferation in benefit design and in a shift towards the defined contribution and average salary defined benefit scheme designs that characterized pre-War provision.

Trends in provision and benefit design are also related to trends in investment policy. The rise of occupational pension provision and the standardization of benefit design around the defined benefit final salary form was associated with the adoption of an equity investment policy by defined benefit pension funds. In the 1930s pension funds invested predominantly in fixed income. An early survey conducted by the Radcliffe Committee found that in 1957 pension funds allocated twenty one percent of their assets to equities, with thirty five percent of new assets being allocated to equity investment. In contrast, by 1962, forty seven percent of pension fund assets were allocated to equities⁵.

The accelerated closure in the past several years of defined benefit schemes and the increasing variety in the types of benefit design have been associated with the re-emergence of the fixed income investment policy that prevailed in the pre-War period. At the peak in 1993, the average allocation of pension funds to equities was eighty one percent. A recent survey shows that twelve percent of large pension funds have adopted a matched fixed income investment policy for some of their assets in the last few years, that thirty nine percent of funds state that they expect to increase allocation to index linked gilts and that eighty percent of pension funds are significantly re-evaluating their investment policy⁶.

Evolving conceptions of pension governance

The period beginning in the mid 1970s saw the emergence of a conception of pension fund governance that differed significantly from that which characterized the previous thirty years. The emergence of an equity oriented investment policy in the 1950s was associated with the emergence of inflation. Inflation eroded the value of pensioners’ retirement income, which was provided in nominal terms. There was an eruption of claims for discretionary increases in order to make up for the falling real value of retirement income. Pension funds sought, to a limited degree, to protect the real value of members’ benefits by increasing these on an ad hoc basis, depending on the finances of the pension fund and the sponsor. The pension fund manager’s work, conducted with the actuary, consisted in the assessment of how much of the sponsor’s capital needed to be committed in order to meet demands for discretionary increases by the membership. The pension fund manager is best conceived of as using his autonomy to mediate between these two principals. The previously tightly drawn contractual arrangements between sponsoring firms and members were dissolved. The magnitude of pension fund liabilities became ambiguous.

In the context of such discretionary allocation of assets between the sponsor and the membership, fixed income investment is ineffective, as outlined by the actuarial text book of the day; ‘An even more compelling objection to this [fixed income] policy arises on practical grounds. As explained in previous sections, the emerging liabilities are not of known amounts.’⁷ The investment of the pension fund in equities was associated with an objective of maximizing returns in order to meet future claims that were expected to escalate in unknown ways due to the discretionary application of professional judgment to reconcile the claims of shareholders and members. The equity investment policy required actuarial valuation to be attentive, through the application of actuarial discretion, to the investment logic used by the pension fund manager. Actuarial techniques of the 1950s valued assets and liabilities in reference to the long term performance of the asset classes in which the pension portfolio was invested, rather than the change in the value of actual securities held by the pension fund.

In contrast, the past thirty years have seen in an almost linear trajectory of initiatives increasing transparency and clarifying the contractual obligations of the parties engaged in pension fund management, for example with respect to indexation and transfer rights. This is very clearly reflected in three inter-related trends relating to legislative change, financial reporting and risk management taking place from the 1970s onwards.

Legislative change

Since the mid-1970s we have seen increased regulation of pension provision. The 1973 Social Security Act and the 1975 Social Security Pension Act strengthened the contracting out framework introduced in a basic form in the 1959 National Insurance Act, by introducing the Guaranteed Minimum Pension (GMP). The GMP was the first time that a guarantee was provided with respect to the adequacy of pension funding, which was monitored by the Occupational Pensions Board (OPB). Nevertheless, the assessment of solvency associated with the 1975 Social Security Pension Act, did not typically cover more than twenty percent of the buy-out value of the liabilities^8.

The 1986 Finance Act introduced regulations restricting the magnitude of surpluses that could be carried by pension schemes. The 1985, 1986 and 1990 Social Security Acts strengthened the position of early leavers⁹. The Barber case instituted equalization of benefits for men and women. The 1990 Social Security Act stipulated that a sponsor could only take a contribution holiday if it linked the benefits of early leavers in all its pension funds to retail price inflation capped at five percent. The 1995 Pension Act introduced mandatory limited price indexation of pension benefits for private sector pension schemes.

The 1995 Pension Act, prompted by the Maxwell affair, also led to the introduction of the Minimum Funding Requirement (MFR) and the replacement of the OPB by the Occupational Pensions Regulatory Authority (OPRA). Nevertheless, as with the solvency requirement introduced in the Social Security Pensions Act 1975, the calculation of solvency continued to be less stringent than calculations used to assess contribution rates¹⁰. Initially the MFR covered between seventy and eighty percent of the liabilities, but following changes between 1998 and 2002, in 2004 is estimated to cover around fifty percent of the buyout value of the liabilities¹¹. A pension scheme meeting the MFR could therefore be wound up, but not have sufficient assets to meet the accrued benefits of members. Since pensioners were paid first the deficiency was disproportionately borne by the active members.

The winding up of the Maersk pension scheme in 2003 appeared to exploit precisely this type of discrepancy and prompted the issuance of regulation specifying that in the case of a winding up the sponsoring firm is liable for the buy-out value of the pension fund. This was strengthened in the 2004 Pensions Act. The new risk-based framework implemented by The Pension Regulator, which replaced OPRA, eliminates the discretion that was previously available with respect to actuarial valuations, which now provide an indication of the funding of the pension fund on a buy-out basis.

Financial Reporting

The establishment in 1970 of the Accounting Standards Steering Committee (becoming the Accounting Standards Committee (ASC) in 1975), introduced quasi-mandatory accounting financial reporting standards, requiring companies to justify any departure from generally accepted accounting practice. The establishment of the ASC marked a step-change with respect to intrusiveness of financial reporting in actuarial practice and in pension fund management¹². The establishment of the Pension Research Accountants Group and the Pension Management Institute in 1976 was a response to these developments.

This was further reflected in the emergence of actuarial guidance notes (also prompted by increasing regulation) and in the codification of actuarial terms in the early 1980s leading to the promulgation of a pension accounting standard; Statement of Standard Practice 24 in 1988. Still, SSAP24 was sufficiently opaque that Lane, Clark & Peacock’s (LCP) 1994 survey of pension reporting by FTSE 100 companies notes; ‘It is barely possible for an informed pensions specialist to interpret the information currently provided with any confidence. The investment analyst or shareholder stands little chance.’¹³

The establishment of Accounting Standards Board in 1990 introduced fully mandatory financial reporting requirements and important changes in the accounting standard consultation process, associated with the adoption of fair value approach in pension accounting. The review of SSAP 24 led to the introduction of Financial Reporting Standard 17, with two implications. Firstly, FRS17 was the first time that a mandated standard was more stringent than the typical basis upon which actuarial valuation was conducted. Secondly, FRS17 introduced transparency to the extent that a variety of metrics can be determined with respect to the size of the pension fund in relation to the size of the sponsor, and so on. The promulgation of FRS17 was concurrent with the shift in investment strategy at the Boots pension fund, from a balanced portfolio to one investing exclusively in fixed income¹⁴.

Risk Management

The mid-1970s saw the establishment of services monitoring the performance of fund management firms; most notably the Combined Actuarial Performance Service and the competing WM service. Performance measurement served to highlight the role of advisers in pension fund management. The creation of rankings of advisers and of pension funds was a powerful tool for the implementation of internal control and the allocation of responsibility between those involved in pension management. It was therefore associated in different ways with the increasing salience of the trustee board and the Finance Director within the setting of investment policy. More recently, the introduction of fair value pension accounting has been associated with heightened internal control, reflected in a partial way by the concerns of the Turnbull Report.

Pension Funds and their Advisers and the specialization in investment advice

The creation of the PFA directories reflected the cusp of change taking place in the mid-1970s. PFA directories both provide a record of the way in which these trends influenced the selection of advisers and played an active role in these changes. As noted above, the background to the establishment of PFA was one in which there was not only lack of provision of information with respect to pension fund management, but also one in which this lack of transparency was considered an important aspect of the prevailing approach to pension fund risk management. For this reason, the creation of PFA and the provision of information regarding the selection of advisers such as actuaries, fund managers, auditors and lawyers; and regarding the asset allocation of pension funds, was initially perceived to counter the dominant conception of appropriate pension fund governance.

PFA directories record the emerging foundational distinction between strategic and tactical advice and the associated specialization in investment management. Subsequent legislation such as the 1986 Financial Services Act or ‘Big Bang’ was, arguably, a result of these changes in the provision of investment advice. The shifting division of labour between consulting actuaries, investment consultants, fund management firms and stock brokers is recorded by the PFA directories through capturing both the changing terms used to categorize advisory work and the different ways that advisers are selected.

Categories of investment management advice

In 1981 the term ‘investment adviser’ was used to denote an adviser combining the provision of strategic asset allocation and stock selection advice. The change in the use of this term is highlighted, for example, by the BBC pension fund. In 1981 the BBC fund records having seven ‘investment advisers’, all of them recognizably fund management companies. In 2001 the BBC pension fund distinguishes between one ‘investment adviser’ (Watson Wyatt) and eight ‘fund managers’. If the meaning of ‘investment adviser’ was taken to be unchanged, this would entail not only that there were seven advisers concerned with strategic aspects of investment in 2001, but also that no-one was managing the pension fund on a daily basis in 1981. Rather, we must say that the use of the term ‘investment adviser’ shifted over this time, as the nature of investment advisory work changed. More recently, the categories distinguishing between strategic and tactical have been breaking down again, as noted below.

Notably, the two pension funds, amongst the largest fifty pension funds in 1981, distinguishing between their ‘investment adviser’ and ‘fund manager’ were IBM and Ford, two pension funds sponsored by US companies.

Organizational change

PFA directories also highlight the increasing specialization as fund management was outsourced to external fund management firms. Graphs 1 and 2 provide frequency tables outlining the number of fund management firms hired by the largest fifty pension funds in 1981 and 2006.

Graph 1 -External Fund Management Firms Hired by theLargest Fifty Pension Funds (1981)

In 1981 twenty-two of the largest fifty pension funds were entirely internally managed, versus five in 2006. In addition, a mixed model has been adopted by some large pension funds in which an internal consulting or fund management capability, or both, is combined with the external provision of such advice.

Similarly, there has been an increase in the number of fund management firms hired by pension funds. The IBM, Ford and BBC pension funds were those hiring the greatest number of fund management firms in 1981. They hired seven fund management firms. In 2006 twenty-five pension funds; half of the sample, hired seven fund management firms or more, with the Electricity scheme (an industry scheme) hiring thirty-two fund management firms and the Sainsbury pension fund eighteen.

Graph 2 - External Fund Management Firms Hired by theLargest Fifty Pension Funds (2006)

These significant shifts in governance and in the institutional framework have only been marginally reflected in change with respect to the leading advisers to the largest pension funds. Between 1981 and 2001 the number of fund management firms serving the top fifty pension funds only rose from sixty-one to eighty. In 2006 the pace of change has quickened as this number has increased to one hundred and three. Similarly, the stability in the list of top ten fund management firms between 1981 and 2001 has between 2001 and 2006 been subject to some change. Although, the main actuarial consultancies of 1981 continue to dominate the advisory rankings twenty-five years later, there is significant change with respect to the provision of consulting advice. In 2006 a third of pension funds with size greater than two billion pounds discussed their investment strategy with investment banks and nearly a third did so with fund management firms¹⁵.

Conclusion

This article has provided an overview of the changes in occupational pension fund provision and investment over the past thirty years, arguing that this period reflects the implementation of a conception of governance that differs significantly from that which prevailed in the preceding thirty or so years. The establishment of Pension Funds and their Advisers in 1978 was, in conjunction with other changes, symbolic of this new era. It also served to record and contribute to subsequent changes. The thirtieth anniversary co-occurs with important new developments, proceeding from those that emerged thirty years ago.