Good intentions, poorer pensions?: The Goode report's minimum solvency test could ensnare those funds offering generous benefits, writes Paul Durman

RECENT proposals to bring in a minimum solvency requirement for pension funds could present problems for the pensions industry.

Funds run by the privatised utility companies, for instance, are usually regarded as good schemes providing generous benefits. In particular, many have kept one step ahead of legal requirements through the early introduction of limited price indexation to protect benefits against inflation.

At first sight, such schemes should have little difficulty in meeting the recommendations of the Goode Committee, the government-appointed working party led by Professor Roy Goode that recently delivered a lengthy report on pension law reform.

Yet there are fears that it is precisely such generous and well-regarded schemes that could face the most difficulty in satisfying the Goode report's key proposed minimum solvency requirement.

The worry is that the schemes will not be able to show they can cover all their liabilities on a winding-up, the test suggested by Goode.

'There's quite a substantial problem, particularly for those schemes which have quite a substantial commitment to pension increases, and particularly the more mature schemes,' observed Bob Masding, a partner with R Watson, the actuarial consultancy.

The large ex-public service schemes, which have been among the first to adopt indexation, may find it hardest to meet the solvency requirement, he says.

The nub of the problem is the Goode report's suggestion that pension funds must be able to demonstrate that they can provide a cash equivalent on a winding-up for the accrued rights of scheme members - that is, the pension rights they have built up to date.

Schemes falling below 100 per cent of this minimum solvency level would have to submit a business plan to a new and powerful pensions regulator, setting out a way of eliminating the deficiency within three years. In essence, the choice would probably boil down to boosting the company's contributions or trimming future pension entitlements.

Schemes falling below 90 per cent of the minimum face a harsher penalty: the company would have to inject funds within three months of notification of the deficiency.

Limited price indexation (LPI), is an expensive benefit to provide. Nevertheless, the Government sought to extend LPI protection through the 1990 Social Security Act.

The intention was to require pensions in payment to be raised in line with the retail price index up to a maximum of 5 per cent. However, implementation has been delayed because of the uncertainties caused by the Barber judgment - the European Court of Justice ruling that raised numerous issues about equal pension rights for men and women.

If the Government decides to back the Goode solvency proposals, Mr Masding believes it may have to reconsider its commitment to LPI. Other actuaries are less pessimistic about the impact of the minimum solvency requirement. Ross Russell, a partner in the firm of Hymans Robertson, said: 'Most pension funds in the UK won't be significantly affected by it because they have quite a margin over their minimum funding requirement.'

Chris Long, director, client services, for Sedgwick Noble Lowndes, does not think many schemes are below the minimum solvency level. But he said this could change if there was a stock market crash or lacklustre equities performance for two or three years. 'We could see billions of pounds wanted from companies at short notice,' he said.

There are also fears that the Chancellor could make further inroads into the tax benefits enjoyed by pension funds. This would erode pension surpluses and reduce the solvency of schemes.

Bacon & Woodrow, the UK's largest actuarial firm, has analysed fluctuations in the solvency of an average pension scheme over the past 20 years.

Assuming the scheme was fully funded to meet its projected final salary liabilities, Bacon & Woodrow found that the Goode winding-up test produced a solvency level of less than 100 per cent on only two occasions, 1974 and 1976. In both, the deficiency was quickly eradicated by stock market recovery.

But Penny Webster, a Bacon & Woodrow partner, pointed out that a reassuring result such as this is very sensitive to the assumptions made. A scheme with a higher proportion of pensions in payment, and with more money invested in equities, would face a much tougher task in meeting the Goode solvency test.

Moreover, the range of assumptions used by actuaries in calculating the cash equivalent value of accrued pension benefits obscures the rules. A survey by the Institute of Actuaries found a large variance in the transfer values quoted by firms for the same schemes. Different treatments of discretionary pension increases pose a particular problem.

Without a clearer consensus on projected investment returns and other assumptions, the Goode solvency test could be rendered largely meaningless. Pension funds could demonstrate satisfactory levels of solvency simply by employing actuaries prepared to use less prudent assumptions.

Some actuaries also perceive a problem with the proposed sanctions against inadequately funded schemes. Miss Webster said that in the aftermath of the Maxwell pensions scandal, actuaries were going to be wary of pronouncing on scheme solvency without the benefit of properly audited figures.

These might not be available until months after a market crash, or other event, pushed the scheme into insolvency. By this stage, market movements might have corrected the position.

Others believe it could be inappropriate to require under-funded schemes to seek immediate cash injections from their sponsoring employers.

If the scheme was suffering because of an economic recession, these would be just the circumstances in which a company would find it hardest to fund a one-off payment.

Mr Masding suggested a better approach would be to give the pension scheme a priority debt over the assets of the employer. This should safeguard the interests of pension fund members in the event of the employer's failure. But it would not impose an immediate financial strain that could only increase the likelihood of such a failure.

As the Goode report recognises, quantifying the cash value of accrued benefits for each scheme member changes the nature of earnings-related pension funds. Adjusting the valuation basis to reflect the assets held could take pension schemes further down the road towards money-purchase schemes. 'I don't think many scheme members are going to thank us for that sort of step,' Mr Russell said.

(Photograph omitted)