NEW LEVY FRAMEWORK WEBINAR Supplementary Questions and Answers

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1 Investment Risk NEW LEVY FRAMEWORK WEBINAR Supplementary Questions and Answers Q: At the moment LDI comes under other but they are matching assets and using a stress test that assumes a 21% fall in this asset value seems illogical. Please can you confirm? A: We recognise that schemes use LDI strategies to reduce risk and produce matching to scheme liabilities. There are a number of instruments that could be used to implement these strategies, so it would not be appropriate to automatically place LDI investments as equivalent in risk to equity. One way to reflect the specific characteristics of their portfolio is for schemes to report the effect of risk factors on their investments. We will also consider, in the light of responses to the consultation, whether there is a case for asking for more information through Exchange for schemes to allow for this sort of situation. However, there is clearly a cost to requiring more detailed information from all schemes, which may not be justified. Q: Do you think that these requirements may encourage schemes to derisk their investment strategies and in turn lose out on the potential for higher growth from the riskier assets? A: We think there will be limited impact. We ve carried out an analysis shown in the consultation package to test how adding the investment risk factor into the levy calculation would affect asset allocations. The change in levy does mean that schemes with higher-risk investment strategies would pay more but, for most schemes, the impact on the levy is very small when assessed against expected benefits in terms of higher returns from risk-seeking assets. However, schemes with weaker employers would see a bit more of an impact and would see relatively more benefit in moving away from high-risk positions. Q: Why are those specific numbers applied re 6.6% interest rate and 6% inflation? What has it been based upon? A: These levels are based on the possible impact on funding levels of particular risk exposures the strength of the stress has been developed to capture 84 per cent of scenarios (which represents 1 standard deviation for this distribution). More details on the derivation of the stresses are available in the Redington report: t_risk.pdf Q: How will diversified growth funds be treated in relation to the stresses. Will you be looking for the investment manager to provide an appropriate adjustment factor? A: One solution might be that schemes that have investments with risk sensitivities different from t hose prescribed for particular asset classes could ask their investment manager for information to calculate the effect of the risk factors we ve identified on their portfolio and report this. We are also assessing

2 whether more granularity in Exchange information would be appropriate (see above), to cover instruments such as diversified growth funds. Q: In the investment stress testing you said that deficit reduction contributions would be treated as cash. Would you not expect that trustees would quickly invest their deficit reduction contributions in other types of assets, perhaps in line with their previous asset benchmark, in which case the stress test impact would be very different? A: We propose to treat DRCs as cash as we would not want to make assumptions about the investments made with deficit reduction contributions. We have not seen any analysis that suggests that this would significantly advantage or disadvantage schemes. Q: Asset information from the Scheme Return, based on the latest audited accounts, can be very dated by the start of the levy year. Will there be an opportunity to provide more recent asset split data (eg with deadline of 31 March 2012), given its crucial significance to the levy under the proposals? A: We propose that schemes report their stressed and unstressed values based on investments as at their most recent annual accounts date - as striking an appropriate balance between recognising changes in strategy quickly and using accurate data. We would welcome comments on whether we have achieved this balance in a workable manner. Q: It's not clear from annex F how the real yields will be adjusted to calculate the stressed liability. Could you please clarify? A: Annex F provided an illustrative example of smoothing and stressing and so presents a simplified scenario. The stress on inflation-linked liabilities would use interest rate and inflation stresses. As drawn from the table on p.28 of the consultation document, these would total a decrease of 126 basis points. We would also note that a stress of per cent would apply on the asset side. Insolvency Risk Q: My experience in a past role where I was a trustee and treasurer is that D&B is a very crude tool that can be mechanistic and formula driven. This can lead to misinterpretations of commercial realities and some odd results in terms of scored probability of failure. My experience is that it is difficult to have conversations with D&B about factors that are not fully reflected in the D&B outputs. Are you concerned about that and if so what can be done about it? A: We have gone through two competitive tendering exercises to select an insolvency risk provider. In each case D&B has provided the bid that best matches the PPF s need for insolvency risk measurement on our universe of 20,000+ employers. We, of course, do not rule out using an alternate provider

3 in future, following a further tendering exercise. In the meantime, we continue to work with D&B to ensure that their system as well as the way we use it continues to meet our needs, and responds to stakeholder feedback. Q: What s the PPF's view on the failures score issues raised about D&B's by the British Chambers of Commerce? A: The BCC were a member of the steering group, and so had the opportunity to feed into the proposals an element of which is to focus on broad bands rather than fine distinctions when measuring insolvency probability. We would also note that in terms of BCC concerns raised earlier, we have worked with D&B to seek to address them for example recognising from 2011/12 that employers whose business can be assessed as essentially national in scope can gain a reflection of that, rather than the location of their head-office, in their score. Q: Please can you tell us the plans for last man standing schemes which currently have a x0.9 adjustment factor? A: We would expect to still recognise scheme structure in the levy calculation. Modelling for the consultation used the adjustment factors for last man standing schemes, in calculating the weighted average probability, and then assigned the scheme to the most appropriate band. This will tend to result in last man standing schemes making up a larger proportion of the better bands, but does not provide a discount relative to other schemes in the same band. Alternative treatments could be considered, and we would be interested to hear stakeholders views. Contingent Assets Q: At present you base funding scores on individual sponsoring companies to a scheme. Where there is a parent company guarantee in place, would it be more valid to look at the failure score of the parent company only, especially where the parent is an overseas parent? A: We have developed type A contingent assets specifically for this purpose, and would be interested in any comments you may have on improvements to the contingent assets system. Q: Applying stress tests for Type B CAs - doesn't this ignore the fact that many assets supporting such a CA will have significant 'headroom' value over the amount pledged to the scheme, eg 5M charge on a property with a value of (say) 20M? So reducing the 5M value in the levy calculation would appear unfair? A: Based on our assessment of uses of contingent assets, we have not seen any evidence that suggests that stressing Type Bs in this way would disadvantage a significant number of schemes. We will consider this further but will need to weigh the increased complexity, and potential new requirements on schemes, against the scale of the issue.

4 General/Other Q: When will you publish the outcome of the consultation? Schemes and their sponsors will want to know soon whether information submitted in the run up to 31 st March will be used in their levy? A: We have said that we will publish our response by next spring. However, we are aware that stakeholders would value as early as possible an indication of whether the proposal is going ahead and we will look to provide an indication by the end of January if at all possible. It is unlikely that we can have the full detail on that timescale, but we would look to cover the issue of data deadlines, so that schemes are aware whether data submitted in the run-up to 31 March 2011 will be used in the 2012/13 levy or not. Q: Will the PPF levy change if the DB scheme is closed to new members and stops accruals for existing members? A: The PPF levy depends upon the cost of providing compensation to the members of the scheme estimated by the s179 valuation. To the extent that changes to a scheme reduce the value of s179 liabilities that will, other things equal, reduce their levy. Q: Uncertainty and therefore risk increases with time. How is this change in risk reflected in the levy? A: In setting the total amount it aims to collect, the Board has regard to the risks of pension scheme funding, of sponsor insolvency and the interactions between the two. Our modelling of long-term risk reflects the increased uncertainty of risks with time and we take account of that in setting the funding objective, and following from that, the total we will aim to collect. We do not seek to distinguish, at individual scheme level, any difference in how that individual scheme s risk may alter over time. Q: Impact analysis shows 39% of schemes pay at least double the levy on the new basis, how is this consistent with other information you provide? A: Regrettably there was an error in the table showing the proportion of schemes seeing large increases / decreases (Figure B13 in Annex B). We estimate just under 8% of schemes would have seen bills on the new basis that were double (or more) their 11/12 levy under the current formula had we used the proposed new approach for 11/12. These schemes will typically fall into one or both of the following categories: well-funded schemes with higher than average investment risk, or schemes whose weighted average insolvency probability puts them at the top of a band (e.g. a failure score 100). Not all schemes in these categories will see increases in levy a scheme with an insolvency probability that equates to a 100 failure score that is well-funded and with low investment risk may well pay no risk-based levy at all, and so could see a marked reduction in levy.

5 Schemes whose levy doubles are expected, as a group, to still pay relatively low levy around a quarter of the average levy. The corrected chart is shown below: 25% Figure B13: Distribution of Schemes by Change in Total Levy 20% Number of schemes 15% 10% 5% 13% 7% 8% 23% 16% 11% 14% 8% 0% Percentage change in levy

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