Does the Railways Pension Scheme need to get back on track? The RMT has said it is preparing to ballot for the first national rail strike since privatisation, as a result of concerns over pensions. With rumours circulating that TPR believes there is a collective deficit of £7.5bn in the RPS, the RMT is concerned this will lead to reduced benefits or higher contributions for their members. So does the RPS have a huge deficit, meaning it needs to get back on track? Employers of non-TOC sections are not directly involved in TPR’s investigation. But the outcome could have a big impact on the funding and investment strategy of the whole RPS. There is a risk that it leads to large increases in liabilities in the 2019 valuation or beyond. Regulatory change in the world of pensions is also likely to have a big impact on the 2019 valuation, for all sections. In brief - TPR is challenging the Trustee of the RPS about the funding and investment strategies adopted for the TOC sections - TPR considers the covenant provided to the TOC sections through the franchising framework to be weaker than the Trustee assumes - If a more prudent view of covenant were adopted, liabilities could materially increase, with a figure of £7.5bn mentioned in the press - If a change to the funding methodology is made by the Trustee as a result of TPR’s investigation, it could also materially increase liabilities for non-TOC sections - The Trustee also needs to decide how to reflect the latest regulatory expectations on long-term funding targets as part of the 2019 valuation, which could have a big impact on closed sections of the RPS Next steps - Employers should consider the potential impact on their shared cost section, and their options for addressing any increase in deficit as part of the 2019 valuation xpsgroup.com Pensions briefing August 2019 Martin Hunter Partner – Head of Employer Risk This could be the most challenging triennial valuation in the RPS since privatisation. Employers should prepare by considering the actions they would consider taking if a big increase in deficit is revealed.
Transcript
Does the Railways Pension Scheme need to get back on track?The RMT has said it is preparing to ballot for the first national rail strike since privatisation, as a result of concerns over pensions. With rumours circulating that TPR believes there is a collective deficit of £7.5bn in the RPS, the RMT is concerned this will lead to reduced benefits or higher contributions for their members. So does the RPS have a huge deficit, meaning it needs to get back on track?
Employers of non-TOC sections are not directly involved in TPR’s investigation. But the outcome could have a big impact on the funding and investment strategy of the whole RPS. There is a risk that it leads to large increases in liabilities in the 2019 valuation or beyond.
Regulatory change in the world of pensions is also likely to have a big impact on the 2019 valuation, for all sections.
In brief- TPR is challenging
the Trustee of the RPS about the funding and investment strategies adopted for the TOC sections
- TPR considers the covenant provided to the TOC sections through the franchising framework to be weaker than the Trustee assumes
- If a more prudent view of covenant were adopted, liabilities could materially increase, with a figure of £7.5bn mentioned in the press
- If a change to the funding methodology is made by the Trustee as a result of TPR’s investigation, it could also materially increase liabilities for non-TOC sections
- The Trustee also needs to decide how to reflect the latest regulatory expectations on long-term funding targets as part of the 2019 valuation, which could have a big impact on closed sections of the RPS
Next steps- Employers should
consider the potential impact on their shared cost section, and their options for addressing any increase in deficit as part of the 2019 valuation
xpsgroup.com
Pensions briefingAugust 2019
Martin HunterPartner – Head of Employer Risk
This could be the most challenging triennial valuation in the RPS since privatisation. Employers should prepare by considering the actions they would consider taking if a big increase in deficit is revealed.
TPR’s investigationTPR’s investigation is focusing on the TOC sections, particularly their funding and investment strategies. Historically the Trustee has operated the TOC sections on the basis that they have very strong covenants, corresponding to a covenant category of 1 on the 6-point scale used by the RPMI in-house covenant team.
The Trustee assumes that the structure of the franchising model means that there is no realistic prospect of a TOC failing in a way which would lead to their pension scheme members falling into the PPF. The Trustee expects that pension liabilities will always be picked up by the new franchise holder, or the ‘operator of last resort’ set up by the Government, if there is not a new private sector franchise holder.
However, this is not the strict legal position: there is no explicit Government guarantee in place. If the employer covenant of the TOC sections is weaker than the Trustee currently assumes, a more prudent approach to investment strategies and funding assumptions would need to be taken.
Most of the TOC sections currently invest almost all their assets in return-seeking assets, such as equities. The Trustee believes that the covenant strength of the sections and their immaturity (most of them are still open to new entrants) means that they can take a very long-term view when setting investment strategy. This allows them to invest in the asset classes they expect to provide the highest return over the long term, as they can bear the associated price volatility. The Trustee takes some credit for these higher expected returns via the discount rate assumption. If a substantial proportion of assets were to be reallocated, say into bonds or other asset classes considered lower risk, this would reduce expected return.
Further, if a more pessimistic view of covenant strength were to be adopted, more prudence would be needed when adjusting best estimate asset returns to set discount rates for funding. A bigger reduction to best estimate returns would need to be used.
Who’s who in the Railways Pension Scheme?
TPR’s concerns centre on employer covenant. If this leads to an increase in liabilities, TOC cash costs would increase. This would need to be reflected in franchising models, which would ultimately probably be borne by the taxpayer or rail users, through higher fares. It would also be likely to increase member contribution rates, due to the cost-sharing mechanism in the RPS.
One way to address this could be for explicit support for TOC pension liabilities to be provided by the DfT or the Government. This should allow the Trustee to maintain the current approach to funding and investment, satisfying TOCs, unions and members. However, from a political perspective this may be unattractive, as there may be a view that this would not be in line with the principles of privatisation.
Another possible solution could be to put in place contingent support for the TOC sections, covering the gap between TPR’s and the Trustee’s views of the deficits. This would allow cash funding of the TOC sections to continue on the current basis, but providing contingent assets which could be available to the TOC sections if the security of members’ benefits were to be at risk in future, i.e. in the scenario where a TOC failed and their members were heading for the PPF.
The sponsoring employers supporting TOC sections typically have light balance sheets. They are operating entities set up to fulfil the obligations of the franchise holder for the period of the franchise only. The TOC usually has very little in the way of fixed assets, as the lines and stations are mostly owned by Network Rail and the trains are mostly owned by train-leasing companies. There are therefore limited assets available on TOC balance sheets which could be used to provide contingent assets.
A solution of this type would therefore need to be industry-wide. Assets held by Network Rail could possibly be used. Alternatively, perhaps an industry-wide contingency fund could be built up, to serve effectively as a buffer between TOCs and the PPF, providing cash to keep a TOC section out of the PPF in an insolvency scenario, if it were ever needed. This could be funded gradually over time, perhaps by adding a penny to rail fares as a pension subsidy.
TPR’s investigation has been taking place for several years now (it actually dates back to the 2013 triennial valuation). With so many stakeholders affected and the political questions around the structure and future of the rail industry, reaching a solution will not be easy, but finding the right answer is critical to the future of pensions in the rail industry.
Possible solution for TOC sections to address TPR’s concerns
The combination of an investment strategy with a lower expected return, and larger margins for prudence, would reduce discount rates. This could substantially increase deficits.
Impact on non-TOC sectionsWhile the investigation focuses on TOC sections, it could also have a big impact for non-TOCs. The Trustee currently operates a framework where decisions on funding and investment across all 106 shared cost sections of the RPS are driven by covenant category. A sliding scale is used, where investment risk reduces and prudence margins increase as covenant strength reduces from 1 to 6. If the approach is changed for the sections with the strongest covenant category (i.e. the TOCs) this may change the approach for the non-TOCs too, particularly the strongest non-TOCs in covenant category 2. While the impact on deficits would probably be smaller for non-TOCs, it could still lead to a big spike.
Stagecoach In mid-April Stagecoach said it had been disqualified from three rail franchise bidding processes (West Coast, East Midlands and South Eastern), on the basis that the DfT considered the pension aspects of the bids to be non-compliant. It has now launched legal challenges against the West Coast and East Midlands decisions, and provided a press release about its approach to pensions risk.
Currently rail franchise holders pay all of the employer’s contributions to their section of the RPS during the period of their franchise. At the end of the franchise the pension obligations transfer to the new franchise holder, including any surplus or deficit which exists in the section at that time.
Typically this has led to relatively stable pension costs for franchise operators, at least compared to most other DB schemes outside the rail industry. The funding approach adopted by the Trustee helps to provide some of this stability. In addition, the standard rules of the RPS mean that active members meet 40% of the total contributions, which includes deficit contributions. The employer pays the other 60%, so 1.5 times the member rate. Most of the TOC sections still apply the 60:40 rule. The need to consider the affordability of member contributions means that the employer’s contribution rate is more stable than for most other open DB schemes.
Stagecoach is concerned that TPR’s investigation could substantially increase contributions for employers. The DfT offered some protection in the bidding process, in relation to the employer’s deficit contributions payable as part of the 2019 valuation. Stagecoach feels that this still leaves substantial
unquantifiable risks, in relation to valuations from 2022 onwards, the risk of substantial increases in ongoing (rather than deficit) contribution rates, and the risk that the 2019 valuation leads to increases in member contribution rates which employees are unwilling to accept, potentially resulting in industrial action or the operator covering some of the increased cost.
To illustrate their point about the potential size of the risk, Stagecoach issued some figures in a press release, showing the potential increase in deficit across the three franchises in a ‘further downside risk’ scenario. The total figure was £1.3bn. To calculate this Stagecoach has assumed the discount rate is reduced by the Trustee from the current rate of 5.7% to 2.7% pa, broadly the average discount rate used by DB schemes across the UK for funding purposes. This has a huge impact on the liabilities - for an immature pension scheme like most TOC sections the liabilities might double. Stagecoach also modelled a fall in asset values of 20%, on top of the increase to liabilities.
This might be considered an extreme swing. Even if the discount rate is reduced to reflect a revised view of covenant strength, it is still likely that a higher-than-average discount rate could be used for the TOC sections, as the rail franchise model probably still leads to a stronger-than-average covenant and the investment strategies adopted by the TOC sections also have higher-than-average expected returns.
However, given that the outcome of TPR’s investigation is not yet known, the figures do demonstrate the point that a material change to the funding and investment strategy of the RPS could increase pension costs very substantially.
While the figures presented by Stagecoach might represent an extreme position, they do show that a change to the funding and investment strategy of the RPS could have a big impact on the rail franchising business model.
RPS – The Railways Pension Scheme - 7th largest pension scheme in the UK by asset
value (£27bn)*- 344,000 members - 106 shared cost sections sponsored by
112 employers- £1.1bn in benefits paid over 2018- £682m paid in contributions over 2018 (split
£371m by employers, £296m by members, £15m from government)
Trustee – The Railways Pension Trustee Company Limited. Has overall fiduciary responsibility for the effective operation of the RPS, including administration of benefits, collection of contributions, payment of pensions and the investment and safe custody of assets.
IFC – Integrated Funding Committee, a sub-committee of the full Trustee Board. Manages and agrees funding plans for the RPS and its sections, incorporating integrated risk management of employer covenant, investment strategy and funding issues. It determines the allocation of individual sections’ assets to the Trustee’s pooled funds and has to agree to changes to sections’ benefit structures.
RPMI – RPMI Limited, subsidiary of the Trustee. Carries out activities on behalf of the Trustee including administration and payment of pensions, advisory and support services for the Trustee Board, its committees and Pensions and Management Committees and commission and oversight of the work of external advisors such as actuaries and lawyers. RPMI employs around 400 staff in Coventry, Darlington and London.
RPMI Railpen – subsidiary of the Trustee. Carries out investment management and related activities on behalf of the Trustee.
Scheme Actuary – provides advice to the Trustee and carries out triennial actuarial valuations as instructed by the Trustee.
TPR – The Pensions Regulator, the public body that protects workplace pensions in the UK.
PPF – The Pension Protection Fund, a lifeboat fund which provides compensation to members of DB schemes, if their employer fails.
RMT – The National Union of Rail, Maritime and Transport Workers.
TOC – Train Operating Company.
DfT – Department for Transport.
DWP – Department for Work and Pensions.
Who’s who in the Railways Pension Scheme?
*Source: Pension Funds and their Advisers, November 2018
We are mindful to ensure the funding framework does not unduly increase the cost of future accruals and lead to unnecessary scheme closures. We will consult on a range of solutions for open schemes which take these factors into consideration while ensuring that members’ past service is protected to the same degree as in closed schemes.
David Fairs, Executive Director of Regulatory Policy, Analysis and Advice, TPR
TPR released its 2019 annual funding statement in March 2019, setting out what it expects from all trustees and employers of DB schemes with relation to pension scheme funding. TPR now expects trustees and sponsors to agree a long-term funding target that is consistent with how they expect to deliver the scheme’s ultimate objective. This expectation will be further enforced in a new DB Funding Code of Practice, upon which TPR intends to consult later in 2019, alongside a Pensions Bill when parliamentary time allows.
This could have a huge impact on how liabilities are calculated in the RPS.For closed schemes, the DWP’s White Paper envisaged that the long-term funding target would be one of:- Buy-out- Self-sufficiency / low-dependency- Transfer to a consolidator
The DWP’s White Paper did not provide much detail on long-term funding targets for schemes which are still open to accrual. However, David Fairs of TPR wrote a blog in May 2019 which provided some details of TPR’s views.
In our view TPR will therefore expect all schemes to have a long-term funding target, and take this into account when considering how to fund past service benefits. The Trustee of the RPS will need decide how to take these expectations into account as part of the 2019 valuation.
The Trustee will need to decide how to incorporate TPR’s expectations on long-term funding targets into the 2019 valuation for non-TOC sections. Most of these sections are considered to be ‘closed’ by the Trustee, as they have very few (if any) new entrants and a reducing number of active members. As part of the 2016 valuation the Trustee adopted a Flexible Discount Rate Model for these sections, where the allocation to return-seeking assets is assumed to reduce gradually over time as the section matures (typically over 15 to 20 years), with the ultimate allocation driven by covenant strength.
However, for most sections this ultimate allocation still represents substantially higher risk than any of the potential long-term funding targets outlined to date by TPR. The default ultimate allocation to return-seeking assets for a Covenant Category 2 section is 40%, reducing to 30% and 20% for Covenant Categories 3 and 4 respectively. Moving to an ultimate strategy more aligned with the examples provided by TPR has the potential to increase liabilities substantially.
We expect the Trustee to provide more detail on how they intend to reflect the latest expectations from TPR when they issue their consultation to employers ahead of the 2019 valuation, likely to be around autumn this year.
Changes to funding regulations for all DB schemes
Driving the train doesn’t set its course. The real job is laying the track.
Ed Catmull, former president of Pixar and Walt Disney Animation Studios
Timetable for the 2019 valuation We currently expect the Trustee to adopt a timetable for the 2019 valuation which is broadly in line with the 2016 valuation.
October - November 2019 Consultation with employers on assumptions and valuation process
31 December 2019 Effective date of the valuation
February 2020 Indicative valuation results might be available
End of May 2020 Full valuation results expected to be available
June 2020 onwards
Employers to consider how to address the valuation, including minimum 60 day consultation with employees if any changes to benefits or member contribution rates proposed, and agree proposals with Trustee’s IFC
31 March 2021 Statutory deadline for completion of valuation
What should employers do now? TPR’s investigation into the RPS and the changes to funding regulation both have the potential to have a big impact on deficits in the RPS.Employers should monitor the situation, with a view to playing an active role when the Trustee consults with employers regarding the 2019 valuation later in the year. Employers should also plan for the actions they might take if there is a substantial spike in the deficit, including considering:
- the potential to negotiate an improvement in covenant rating, perhaps by providing contingent support from a parent company or other source;
- appetite and potential for changing member benefits or contributions;
- the employer’s view of the long-term funding target for their RPS section; and
Important note: The content of this Briefing Note has been prepared based on our understanding of TPR’s investigation into the RPS, derived from information available in the public domain as at the date shown. While we advise many employers on various issues relating to their RPS sections, none of the content of this Briefing Note has been approved by the Trustee or Scheme Actuary of the RPS. It should also not be considered as advice for the employer of a particular section, although we would be happy to provide specific advice to an employer on any of the issues discussed in this Briefing Note based on their own circumstances.
All registered at: Phoenix House, 1 Station Hill, Reading RG1 1NB.
XPS Investment Limited is authorised and regulated by the Financial Conduct Authority for investment and general insurance business (FCA Register No. 528774).
This communication is based on our understanding of the position as at the date shown. It should not be relied upon for detailed advice or taken as an authoritative statement of the law.
RATED TOPfor fifth time in 6 years
XPS Railways Pension Scheme Seminar Tuesday 19 November 2019 | Central London
In previous valuation cycles we have run a series of seminars for employers in the RPS. We will do the same again as part of the 2019 valuation.
This complimentary seminar allows employers to understand their options to address the valuation, and see some of the approaches being adopted by other employers.
Book your place for this and other events by visiting: www.xpsgroup.com/events
Alternatively, for more information, get in touch with Jyothi Binu on 0117 202 0449 or email [email protected]
Martin Hunter, whose young family means that his current favourite railway line runs from Knapford Station to Vicarstown on the Island of Sodor.
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t 020 3994 4913
martin.hunter @xpsgroup.com
John Yarrow, a proud Yorkshireman, whose favourite railway line is the Stockton and Darlington Railway, the world’s first public railway to use steam locomotives.
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t 020 3994 4902
john.yarrow @xpsgroup.com
Dan Auton, who combines two of his great loves when selecting his favourite railway line as the Transpennine Real Ale Trail.
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t 01483 330 108
dan.auton @xpsgroup.com
The XPS railwaymen
The XPS railways team has been advising employers in the RPS since the 2004 triennial valuation. During this period we have advised on a wide range of projects, including valuation negotiations, changes to member benefits or contribution rates, the pensions implications of transactions and other corporate activity, and investment strategy. We currently advise the employers of 23 shared cost sections of the RPS.
