Michelle Ostermann and Morten Nilsson gave evidence.

We will now hear evidence from Michelle Ostermann, chief executive officer of the Pension Protection Fund, and Morten Nilsson, executive director and CEO of Brightwell. We have until 4.15 pm for this panel. Will the witnesses please briefly introduce themselves for the record?

Morten Nilsson:

I am the CEO of Brightwell. We administer 380,000 members and about £35 billion of assets. Our largest client is the BT pension scheme, which we manage end to end.

Michelle Ostermann:

I am the chief executive of the Pension Protection Fund. We were created by legislation in 2004; we have been in existence for 20 years. We manage a little less than Brightwell does, £30 billion. We are effectively a monitor of the entire DB system. We protect and backstop £1 trillion in it, pay compensation to almost half a million members, and enable the industry in general.

Q The Bill provides for surplus extraction from funds. Do you see that as a good or a bad thing?

Morten Nilsson:

I see it as a good thing. I think it will change the pension industry quite a bit as a positive innovation. Closed DB schemes, which we focus on, might be seen more as an asset for sponsors, rather than a liability that they would like to get rid of as quickly as possible. I think that it will create quite a lot of innovation, and a lot of good things will come out of that.

Q For defined-benefit pension funds?

Morten Nilsson:

Yes.

Q One of the questions around that is what drives a removal. We heard from previous witnesses that if a host employer puts in more money than is necessary, it seems perfectly reasonable for them to get some of that back. In some cases, that money could be used for investment in plant and machinery to expand the employer, but at the other end of the scale it could be used for share buy-backs to enhance the share price of the employer. Do you think it matters what happens to the money that is being withdrawn from these pension schemes, or should that be up to the host company?

Morten Nilsson:

I see it pretty much as you described. The main duty of the sponsors and the trustees is to ensure that there is enough money in the scheme to pay the benefits that were promised to members. If there are excess funds, it is reasonable that they can be invested back into the economy. In May, we surveyed 100 finance directors who are responsible for schemes with over £500 million of assets: 93% of them said that they would want to access the surplus, 49% said they would reinvest it in their local business, in the UK, to create jobs and do other good things, 44% said they would consider sharing it with members, 42% said they would invest it in their global operations, 40% said they would pay it back to shareholders, and 33% would invest it in DC. That is quite a wide range of uses. I think some of it will be paid back to shareholders, which may be local or abroad, but I expect a lot of it would be invested back into the UK economy in one way or another.

Q Michelle, you run the compensation scheme. Do you see any risk in surplus extraction? I know that by definition, it is surplus and therefore you should be able to take it out, but at the moment, a lot of funds are in surplus. We went through a period of low interest rates, where it was a bit tricky, but now interest rates have gone up, and suddenly those funds are in a lot of surplus. We are probably not going to see interest rates come down to super-low levels anytime soon—well, who knows? If the economy does particularly badly, they may well do. My first question is, do you see any increased risk as a result of this? You are presumably looking at the risk of having to pay out. Secondly, should the benchmark be slightly higher for surplus distribution?

Michelle Ostermann:

Obviously, just as you describe, because we backstop the entire industry, what we are watching most closely is the fundedness of schemes, combined with the credit quality or the covenant, and the financial stability of the organisation itself. Those two combined are what help us to assess industry-wide risk and determine how much reserve we need to set aside for future claims on the PPF.

There is a spectrum of schemes out there, clearly—some that are very well funded, which you have been speaking of, and several that are not as well funded. On that spectrum, our focus is on the left side tail—the ones that are most underfunded, or nearing the potential to be underfunded. Given the measures that are being discussed for the release of surplus, we at the PPF feel comfortable with it not imposing a material amount of risk to us, as it is currently defined. It seems to find a nice prudent balance between allowing some flexibility for sponsors to use that money in hopefully a productive way, combined with the test to make sure they do not fall below a certain level, which would bring risk upon the industry and the PPF. We have been a constant participant in that conversation, and we would like to suggest that we will continue to play that role as a surveyor of the net residual impact to the industry.

Q Do you stress test the pensions industry in the same way as the Bank of England stress tests the banking system?

Michelle Ostermann:

Yes—it is very similar.

And you war game it?

Michelle Ostermann:

Yes. The biggest variable that we have a hard time predicting in those scenarios is the likelihood of this being used and the manner in which it is used, but we test deep into the tail. We try several scenarios that give us a high probability of it being abused or overused, and the opposite, and we have come out with pretty strong confidence. As it is defined today, we feel comfortable.

Q I must ask a question that is perhaps a self beat-up, if you like. There was a disastrous mini-Budget a few years ago under a different Prime Minister—of course, at the time, we got rid of our bad leaders. Did you stress test a scenario such as that?

Michelle Ostermann:

Not here in the UK, but as you can tell by my accent, I am not a local. I worked in Canada for most of my career, at two of the largest Canadian “Maple Eight” pension plans, and those are things that we would assess quite regularly. In fact, the open DB schemes here in the UK function very similarly to those in Canada. I joined the PPF in large part because it is a mini-version of the Canadian model. It is exceptionally similar, to me. You will notice that during the liquidity crisis that occurred it was the liability-driven investment strategies, with the degree of leverage, that were most at risk, and it was interest rate-sensitive. Those open DB schemes that were using a more balanced degree of risk, including some equity risk, were unencumbered. It was Railpen, which I worked for when I was here previously. I was phoning back to my peers both there and at the universities superannuation scheme and PPF, and they all withstood that very well.

Q So while we were all running around like headless chickens trying to figure out what was going on, you were saying, “We told you so. We knew that was going to happen.”

Michelle Ostermann:

It is definitely something that was on our radar. When we build the investment strategy for an open DB scheme, such as those I described, it is quite different and less susceptible to that type of risk.

Q I seek some clarification from Michelle. At the moment, there is a fee extracted to support your organisation. What if that fee were ceased?

Michelle Ostermann:

I assume you are speaking of our levy?

Yes.

Michelle Ostermann:

We have several types of levies that support our organisation. If I may, I will just take a step back to help everyone to understand what role they play.

The PPF is not terribly well understood because we are a bit unique in this industry and there are only half a dozen bodies like us in the world. The UK is one of the few countries that have a protection fund such as this. In some ways we back as an insurer in that we collect premiums or levies from the industry from the 5,000 corporate DB schemes and backstop 9 million potential future members that still sit in those schemes. We collect the levies and hold them in reserve much like an insurance company. We are not an insurance company, but we do so much like they would mathematically and with similar models.

At the same time, if a corporation fails, we take its pension scheme, which is usually underfunded, and its orphan members and put them into a pension scheme. We are both a pension manager and an insurer of sorts. When there is a failure and a scheme comes to us with insufficient assets to make good on its pension liabilities, we take some of our reserves almost as a claim, and move them over to the pension fund so that it is fully funded at all times using a largely liability-driven investment-type strategy. The levies that we collect are twofold: first we collect a levy related to the risk of the industry. You may be familiar with our purple book and the industry-wide assessment we do. We monitor the risk of that entire complicated £1 trillion industry to decide how much to set aside as reserves.

Our reserves are often referred to as a surplus, but they are not a surplus; they are reserves sitting there for potential claims in 50, 80 or 100 years. We will be the last man standing in this industry. We are here as an enduring and perpetual solution. As long as there is DB in the industry, we will have to backstop it. We set aside those reserves for the 9 million members and current £1 trillion in case of future market environments that we cannot predict today. Those levies have been collected over 20 years from the constituents of that industry. We have collected just over £10 billion from that levy system and have paid out £9.5 billion of it as claims to the pension fund.

As those levies were coming in over that 20-year period we were investing them in an open DB growth-type strategy. As such, we have built up £14 billion of reserves and so now consider ourselves largely self-funding. We no longer need to collect that levy from the industry now that those reserves are sitting there—in so far as we can best tell with our models today. We prefer to reserve the right to turn it back on should we need it in the case of a market correction event, some unforeseen circumstance or an evolution in the industry. However, right now, those fees are no longer required by us; it is a risk assessment that is suggesting that.

Q Building on Steve’s question on the levy, some hon. Members have asked about surplus extraction feeding into the overall risk profile in the markets. Clearly, if that was to happen and there was perceived to be an increased risk, it could result in an increase in the levy. The Bill allows for the levy to be reduced to zero. What are your thoughts about that?

Michelle Ostermann:

We have thought a fair bit about that. We do not see very many scenarios in which we would need to turn it on, although it is always difficult to predict. As you know, the industry evolves in many ways and over the 20 years we have seen quite an evolution, including the creation of new alternative covenant schemes and commercial consolidators. We will backstop those as well, and we will need to charge a levy for them. There could be an unforeseen market event, similar to that just described, so we need the ability to turn the levy back on—simply to keep it as a lever. Today, the legislation reads that if we were to lower it to 0%, we can only increase it year on year by 25%. However, 25% of zero is zero, so we are a bit cornered. We have asked for a measure that would allow us to increase it by as much as a few hundred million a year. The most we have ever charged in one year was just over £500 million.

As I said, we have collected £10 billion gradually over many years. The new measure allows us to increase it by no more than 25% of the ceiling number every year, which is currently £1.4 billion. That means we could go up as much as £350 million in a single year, if needs be. However, we are a very patient long-term investor. Even though we are taking on closed corporate DB schemes, we run it as if we were an open scheme, because we are open to new members all the time. As such, our investment strategy does most of the heavy lifting for our organisation now.

On our £14 billion reserves, we make over £1 billion a year in gains from that investment strategy, which funds the £1 billion we pay out in the pension scheme to members. We are now a mature organisation that should be able to maintain a steady state. The most we would be able to increase the levy by in one year is £350 million, but we would expect to be patient, wait a few years, and try to ride out the situation not needing it, only turning it back on should we need it. We consult before we turn it on and we take a lot of feedback on this. We are quite thoughtful, as we have always been, and I hope people agree.

Q I am just interested in examples of recent shocks that have happened, where you had to pay out significant sums and what those sums were.

Michelle Ostermann:

The biggest example is a macroeconomic shock that would affect the solvency of corporations. The failure of the corporation itself is more likely to have an impact than just a change in interest rates or equity markets. The change in interest rates can affect the fundedness of a scheme, but many of those schemes, over 75% of them now, are actually really well funded. And they have pretty well locked down their interest rate risk because they have put a good chunk of assets against their liabilities in a fairly tight hedge. Although we saw, as a result of the liquidity crisis a few years ago now, that things can change. The degree of risk, specifically leverage risk inside some of those strategies, does make them fallible. I would say the biggest shocks would be massive interest rate movements that are unforeseen, a very significant macroeconomic environment causing failure in many corporations, and technically, even a significant move in equity markets, but we would usually just ride that out. Markets can go down 20% or 30%. We would only go down 10% or 15% and we would be able to recover that in under five years, historically speaking.

Q It has been a long-standing battle over pre-1997 compensation rights. Would you agree that this Bill is perhaps an opportunity to at last address that issue, perhaps by a judicious Amendment or two? Do you think that that is feasible, and what framework might that take?

Michelle Ostermann:

We have been progressing on this quite a bit lately. It is one of the most prevalent discussions, both with our board and with our members. We speak very often with the entirety of the industry. Several are very strong advocates for it as well, a few of which are here today, and we have taken quite a bit of humble feedback. We have worked as best we can with the Work and Pensions Committee to estimate a significantly complex set of potential scenarios for making good on historical indexation needs for pre-’97. They range in price, are quite expensive and would require us to incur or crystallise a liability. They are not cheap. It would be difficult for both us and the Government to be able to afford. The taxpayer would have an implication to some of these, depending on how they are formed, and it is beyond our prerogative to make that decision but we have been facilitating and encouraging it to be made. We would welcome progress on that. I understand, in fact, an Amendment was tabled earlier today in that regard, so I was warmed by that.

Q The DWP argues that the funds are on the public balance sheet and therefore they object to using them for this purpose. Do you think that is fair, given that the funds were not acquired by the taxpayer?

Michelle Ostermann:

To clarify the word “using”, as I think it is important, the PPF is an arm’s length body and those assets are ringfenced. Our board has independence over those. It was set up that way—arm’s length—20 years ago to make sure that it was a dedicated protection fund for that industry. It so happens that we do fall under some of the fiscal measures, so both our assets and liabilities do show. However, there is a bit of a conflict there in that we manage them in the prudent, almost in a trusteed fashion, on behalf of our members and all of our stakeholders. But the use of them would have to be prescribed by the board, legislated, and then approved by the board for its affordability, so as to not put at risk the rest of the industry that we are backstopping.

The ability for us to be able to afford that and the risk to the organisation is the primary, most sacrosanct thing that our board does. We have very complicated actuarial models to figure out the affordability of all the risks that we take on in the entire industry. That is why we have gone through quite a bit of work to build, just recently, a much more sophisticated model to estimate both the asset and liability implication to us and have even started to form a plan for how we might implement it. So we stand at the ready, but it is beyond our responsibility to be able to legislate the necessary change for it.

GivenQ the international experience that both of you have in this realm, I am interested to know whether there is either anything in the Bill that you think is a red flag or anything that you think is a missed opportunity and not in the legislation in front of us today.

Michelle Ostermann:

That is fascinating. I came to the UK, and back to the UK, because I have so much enthusiasm for the UK and the pension system. I am very fortunate to be the chair of the global pension industry association, so I study pension systems around the world and am quite familiar with many of them. The UK pension system is the second largest in the world by size if you include underfunded pensions. It is one of the most sophisticated, but it is the second most disaggregated. As I think a few of my peers mentioned before we got up here, it has fallen behind, frankly. I think the motives that are in this Bill are exceptionally important—they are foundational. I love that we are speaking on scale and sophistication. These are absolutely key, in both DB and DC. I want to underscore that; it is really key.

One thing that is not spoken of quite as much is the concept of an asset owner and the importance of governance. In relation to the successful countries that I have seen, which have mastered the art of pensions and the ability to translate pensions into growth, it is not a proven model, but there is a best practice such that countries are able to make growth by leveraging pension systems. I think that right now we are trying to solve a problem of two things: reshaping the pension system and trying to solve the need for a growth initiative. They are one thing in my mind; they really are one thing. It is not a surprise that as we have de-risked the pension system over two decades, it has, I suspect, quite directly, but at least indirectly, affected overall economic growth.

Making members wealthier pensioners in general and less dependent on social services is what many countries are trying to do and use their pension systems for. I see that out of the commission that is being started, so I am most excited about the next phase. I think there is a lot of potential, and we at the PPF are doing quite a bit of research and want to be able to feed some global ideas into that.

Morten Nilsson:

I come from Denmark originally and I think, to echo some of what Michelle said, scale just matters in pensions. The Danish pension industry has been fortunate to have few and relatively large schemes. One of the things I saw when I came over to the UK 15 years ago was that the industry here is very fragmented, and that fragmentation means also that there are so many conflicts of interest in the market. That in a way makes it quite hard to get the best outcomes, and that of course leads into the governance models that Michelle talks about. So this Bill is something we very much welcome across what it is covering. I think it is a really good initiative, but I think scale matters, and governance really matters. I would not underestimate how big a change it is, in the defined benefit sector, that we are moving from two decades of worrying about deficit into suddenly worrying about surpluses and having very mature schemes, which is the other thing that is important. Most of the DB schemes are closed.

If I talk about the BT pension scheme, the average age is 71, so they are pretty old members and that means there is a risk level, from an investment perspective, that really matters. We are paying out £2.8 billion a year in member benefits. That means liquidity is really important. It is really important that we have the money to pay the members and that we do not end up being a distressed seller of assets.

So there is quite a lot in that evolution we are on, and when we go into surplus management or excess funds—Michelle was talking about this at macro level; we would be managing at our micro level in each scheme— I think it becomes really critical that we have the right governance to manage what is a new era. I would really recommend that the Pensions Regulator issue guidance as soon as possible on all this, because it will be quite uncomfortable for a lot of trustees. It will be quite difficult also for the advisers in how we manage this new era.

Q I am really glad that you both mentioned governance, because that absolutely stands at the heart of this. You also mentioned conflicts. We have not talked much about the role of consultants and things like that, but it is clear that you think the framework laid out by the Bill will be helpful and a key part of mobilising those things.

Conversations that I have had also flag up the importance of culture among trustees. We can give people the tools, the powers and the permission to invest, and we can be clear in the framework we set up, but, culturally, they may still be very risk averse. Of course, some of that is appropriate because they have to safeguard member benefits, but there is a point about whether they are overly cautious and about how one creates the appropriate culture to go with the change. From your perspective, what is needed to create the right culture to go alongside the right governance?

Michelle Ostermann:

I have one small observation from when I first came to the UK. I recognise that there is a very strong savings culture, but not necessarily an investment culture, and there is a distinct difference there. I even notice the difference when we talk about productive finance targets. We speak in terms of private assets, but there is a difference between private equity and private debt, and between infrastructure equity and infrastructure lending. All those lending capabilities are here in this country. I feel that the debt sophistication is strong, but where it lacks is the equity.

I am a Canadian. With one of the largest Canadian schemes, we had no problem coming in and buying up assets here in the UK—you may have noticed. We own a lot of it, and with Australia, most of it. The supply was never an issue for us. We brought the scale and sophistication, but what we did not have was a local British anchor. We did not have an anchor investor. We did not have a home-grown Ontario Teachers, a Canada Pension Plan or even an ATP that we could use as the local one. I see that the PPF, NEST and Brightwell can be that. We are still not megafunds. I know that we are referred to as behemoths and megafunds at £30 billion and £60 billion, but the peers with £100 billion, £200 billion and £500 billion are those that are putting in £0.5 billion or £1 billion in one investment. They are not lending, but investing.

That is the biggest difference I notice: the definition of scale and the degree of sophistication. It is even about sophistication in the governance model, and having a board and a management team with that sophistication. It is about having a management team with some power that you are hiring out of investment, and being a not-for-profit and an arm of the Government that is allowed to put in that sophisticated capability, with a board that can properly oversee it so it is not done without proper consideration.

Morten Nilsson:

I think it is quite critical that you have trustee boards that are supported well by regulation and guidance, as we talked about before. It would also be helpful to start to focus on the management teams that are supporting the trustees. Cultural change is always very difficult. We must acknowledge that we are coming out of a situation that was really quite difficult for a lot of trustees and sponsors in terms of finding out how to fix the big deficits that schemes had. We must acknowledge that that is where we are coming from and that is the mentality we have had for decades. Regulation and guidance is still all over the place, and we must work through how we move that forward. I really recommend more guidance from TPR and, sooner rather than later, more guidance on surplus extraction. That would help a lot of trustees to take more risk and think in a more balanced way about risks.

Of course, if we are considering allowing excess funding to go back, we need to ensure that we are doing that on a prudent and well-considered basis. It is an educational challenge more than anything, but it is also about the advisers. The market really needs to get comfortable with investing for the longer term. Within that, it is critical that we move away from being obsessed with a mark-to-market, day-to-day obligation. We measure our liabilities on one day of the year and then we might panic if there is a little swing in the market, but we are actually working through quite a long horizon and therefore we can smooth that out in a different way. We need to think about how we look through some of these blips.

If there are no further questions from Members, I thank the witnesses for their evidence. We will move to the next panel. Thank you very much indeed.