Any changes the Pension Protection Fund makes to its levy when it consults later this year are certain to produce both winners and losers. Kevin Burgess explains why

There's no doubt that the Pension Protection Fund (PPF) has taken a lot of flak from advisers, trustees and employers in the last few months following the publication of its scaling factor. But whether the criticism is justified or not, it's worth reminding ourselves why the PPF was set up in the first place.

Around 2002 there were a number of high profile cases where members of UK defined benefit pension schemes lost the majority of their benefits just before retirement. Allied Steel and Wire (ASW) was one such case. The employer became insolvent and there was not enough money in the pension fund to pay benefits to all members.The worst affected were those who had not yet retired.

The PPF was set up in April 2005 as a lifeboat for eligible UK occupational pension scheme members. The fund pays benefits to pension scheme members whose sponsor becomes insolvent with an underfunded pension fund. The benefits paid by the PPF are usually lower than those originally promised by the occupational scheme but higher than might otherwise have been received before the PPF existed.

Around 12,400 members of over 40 different pension schemes have transferred to the PPF, with more than 3,500 currently receiving a pension.

While the added security the PPF provides is welcome, it comes at a cost, with each eligible scheme having to pay a levy to the PPF. The levy consists of two parts: a risk-based levy which takes account of both the strength of the employer and the deficit in the scheme, and a scheme-based levy, which is a percentage of the scheme's liabilities. For schemes with a weak employer or large pension scheme deficit, the PPF levy can be a substantial expense.

Each year, the PPF determines how much money it needs to collect. Then, to achieve this target, it scales each scheme's risk-based levy up or down by applying what is known as a scaling factor.

In November 2007, the PPF confirmed that for 2008-09 it needed to collect £675m (€855m) and advised an indicative scaling factor of 1.6. Many scheme sponsors budgeted and took appropriate action to reduce their own levy based on the indicative 1.6, and so were shocked when the PPF confirmed at the end of May 2008 that the scaling factor would actually be 3.77. In fact many schemes took no action to reduce their levy as the expected levy was manageable based on the provisional scaling factor. Their decision might have been very different if they had known in advance how high the final scaling factor would be.

So why did the factor increase so dramatically? In the scaling factor, the PPF looked at the strength of each sponsoring employer at 31 March 2007 and 31 March 2008 and took the strongest position for each scheme. This underpin is intended to anticipate possible appeals of the assessed employer strength. However, this underpin was excluded from the provisional figure of 1.6.

There is no doubt that the exclusion of the underpin in the provisional scaling factor made the jump to the final scaling factor seem even more dramatic. The PPF acknowledges that with the benefit of hindsight the underpin should have been included in the provisional scaling factor. It is likely that the provisional scaling factor was understated by around 50% as a result of this exclusion and so the provisional factor which was described by the PPF as indicative was never really indicative in the first place.

Another reason for the increase is because there is a discrepancy between the way the total target levy and each individual scheme's levy are calculated.

The total target levy (£675m for 2008-09) is calculated by looking at the long-term risk faced by the PPF. On the other hand, the risk-based part of the levy for each individual scheme is calculated with reference to short-term risk by considering the assumed probability of insolvency of the employer over the next 12 months, as calculated by the risk and rating firm Dun & Bradstreet.

Many scheme sponsors took action to improve their probability of insolvency for the 2008-09 levy calculation. As a result, the PPF had to increase the scaling factor so that it could get close to the total levy target of £675m.

If the PPF had been able to give schemes a more realistic idea of what the final scaling factor would be, sponsors would have been better able to budget for the levy and make decisions on levy mitigating actions.

The PPF is aware of the discrepancy between the long-term total levy target and the way that this is distributed
between schemes using short-term measures. It is likely to consult on possible ways to address this later in the year.

So why would the long-term risk be any different to the short-term risk? Imagine Scheme A, which has a very strong employer, which might not be able to get any stronger. In this case, the long-term risk will not be any lower than the short-term risk but the long-term risk could increase. Scheme A is paying a levy that is potentially too low under the existing formula.

Scheme B, on the other hand, has a weak employer. In five years' time, Scheme B will either have fallen in to the PPF or the employer might still be operating. If the sponsoring employer has survived five years, then it may be financially stronger than it was previously. Scheme B is therefore potentially paying too much in PPF levies using the existing formula.

The PPF is also very concerned about catastrophe risk. This is where very large claims with a small probability of occurrence could put a strain on the funding of the PPF. This could be caused by a correlation of risks across an industry or across the economy as a whole. For example, if there were an equity market crash, the funding levels of pension schemes that invest heavily in equities would be affected, and the crash could also lead to a large number of insolvencies in a particular industry. The combined risk of reduced funding in schemes and increased insolvencies of scheme sponsors places a considerable amount of risk on the PPF. In fact the American equivalent of the PPF, the Pension Benefit Guaranty Corporation (PBGC), has seen some catastrophic claims move its fund from a surplus of $5.5bn (€3.6bn) in 1998 to a deficit of $14bn in 2007.

In another example, consider Scheme C, which has a very large and well funded pension scheme, with a strong employer. Scheme C is currently likely to be paying a levy that is considerably lower than that required under the PPF's long-term
model, especially if catastrophe risk was included.

The PPF previously consulted on the possibility of allowing for a scheme's investment strategy when determining the risk-based levy. At the time it was concluded that the extra layer of complexity was not worth the small redistribution of the levy. However, the impact of the investment strategy is much more significant over the longer term and so, given the planned move to a longer-term levy calculation method, the PPF is considering introducing an investment strategy element into the levy calculation. 

Taking the investment strategy into consideration could benefit schemes with low equity holdings and schemes that hold insurance contracts to cover some members' benefits. There is, however, also a danger that in order to reduce their own levy, schemes will sell equities to invest in less risky assets, which could potentially distort investment markets. This is not dissimilar to the impact on markets when the accounting standard FRS17 was introduced in the UK and many schemes moved some of their assets to corporate bonds to stabilise their FRS17 funding level.

If the PPF does change the levy calculation so that it considers a longer-term view of the risk of the sponsoring employer, this could lead to an increased levy for schemes with stronger employers, and a lower levy for schemes with weaker employers. Inclusion of a catastrophe risk element could increase the levy for larger schemes.

Whatever changes are made, they will result in winners and losers. The PPF faces a challenging road ahead when it consults later this year on the future development of the levy.

Kevin Burgess is a senior consultant with Punter Southall