EQUITABLE LIFE MEMBERS
EQUITABLE LIFE: PENROSE AND BEYOND
- ANATOMY OF A FRAUD
A paper by Dr. Michael Nassim
Last Updated: Friday, February 11, 2005 09:59 AM
An
illegitimate child: secret birth and prolonged unofficial existence of
the DTBP.
In Chapter 2.51-104 of his
report, Lord Penrose examines the origins of the differential terminal
bonus policy. He differs from the earlier Corley report as to the date of
its origins, largely on account of Headdon’s written and oral evidence
from the autumn of 1998 onwards, which included depositions to the
Treasury Select Committee and his own Inquiry.
In 2.61 he writes:
“At a meeting of executives of the Society arranged to discuss
the annuity guarantee issue in the autumn of 1998, Headdon gave a
presentation on the background.
He gave further information about the origins of the practice.
He stated:
“that internally the current argument (i.e. linking of
guarantees) has been the consistent view for the last 15 years.”
Fifteen years would have
taken the discussion back to 1983 soon after the fall in interest rates in
the autumn of 1982.
The guaranteed annuity was briefly in the money at that time.
Headdon’s account has been consistent since, and is accepted as
reliable evidence.
It is consistent with the manuscript notes referred to (see P1.33):
specific provision for a situation that could not be dealt with by a
differential final bonus scheme would be more likely to reflect a belief
that the more usual contingency had been dealt with than it had been
overlooked. I
consider that it has been established that at a differential guaranteed
annuity terminal bonus policy was conceived at the latest in 1983, and in
a context in which discussion would have been appropriate.
It would follow that it was understood when the change to personal
pensions took place.
The evidence supports the view that the Society’s actuaries were
conscious of the implications of a long-term fall in interest rates from
1982, or, at latest, early 1983, and that there would be implications for
bonus, both reversionary and terminal.
The precise form that the differentiation would take in case of
need was not defined at that time, so far as the evidence has
disclosed.”
In P2.110-113 Lord Penrose
concludes:
“On the evidence available
to the inquiry, the differential terminal bonus policy was the established
policy of management from about 1982 or 83.
The inquiry has uncovered no evidence to indicate that the policy
was widely advertised to staff until about 1998.
Similarly, apart from the general comment in With Profits
Without Mystery, there has been no evidence that the board were
informed of the policy before December 1993.
The policy was first implemented in 1993-4.
It also seems clear that the
critical decision not to split the with-profits fund at the point that
personal pensions were introduced was taken (whether explicitly or not) on
the basis that the Society intended to market the new policies as a simple
development of the existing policies, relying on the investment record and
returns to policyholders of the existing fund, and minimising the
administrative burden for the Society.
Management at least had recognised the potential value of the
annuity guarantees within the existing policies, and are likely to have
relied, implicitly, on the differential terminal bonus policy in making
that recommendation.
But there is no record that the inquiry has found to suggest that
this was an explicit consideration so far as the Board was concerned.
It would be consistent with
the inquiry’s general findings on corporate governance that in the
contexts of valuation of liabilities, product design, and the computation
of policy benefits, executive management exercised a wide discretion
unconstrained by active board supervision.
It is this that enables the inquiry to conclude that the
differential final bonus policy was developed in 1982-3, and influenced
matters such as the treatment of personal pensions after 1 July 1988, the
amendment of group and AVC contract forms, leaving retirement annuity
contracts unaltered, the application of level premium bases to apparently
incompatible classes of business, for example, without the Board of the
Society being actively involved in the development of the policy and its
implications for business generally.
It appears unlikely that most members of the board knew of the
differential terminal bonus policy or its implications until the autumn of
1998, or that those who knew anything of the policy understood that it
could have serious implications for the Society.”
Given the Society’s
precarious position, deployment of the DTBP would have had less serious
public consequences had it been possible earlier than 1993.
Its deployment would, however, have led to a collapse in the
Society’s sales drive, and with it the chance of more widely diluting
– even of concealing - its liabilities.
However, the circumstances related in “Fat cats and poor mice
etc.” below made it impolitic if not impossible to deploy the DTBP
before the end of 1993, by which time the inequities and liabilities of
the new fund had been considerably increased.
So much for the date of
deployment; now to the manner of it, which could hardly have been a proud
affair. Such
formal record of the DTBP’s announcement as was made to the board is
related in P2.80:
“On 22 December 1993 the
board passed a resolution in these terms:
“The Board approved the
changes set out in the statements attached to the paper”
The paper on which the board
had proceeded had proposed a range of changes in bonus rates in the light
of experience to date, and stated:
“The attached amendment to
the formal statement of bonus agreed at the 10 February 1993 Special Board
makes that change…”
Among the detailed material
was a new paragraph to be included in the notes to retirement annuity
bonus notices relating to differential bonus policy: paragraph 7.
The narrative of the report made no reference to this, and there
was nothing in the record to suggest that particular attention was drawn
to it. The
note stated:
“Where benefits are taken
in annuity form and the contract guarantees minimum rates for annuity
purchase, the amount of final bonus payable is reduced by the amount, if
any, necessary such that the annuity secured by applying the appropriate
guaranteed annuity rate to the cash value of the benefits, after that
reduction, is equal to the annuity secured by applying the equivalent
annuity rate in force at the time of the benefits are taken to the cash
value of the benefits before such reduction”
As related in P2.96, this
statement was repeated in February 1994, but on this occasion prefaced by
a related note dealing with the cancelling out of the benefit of
guaranteed interest rates (GIRs) and other additions in certain
circumstances. It
reappeared in subsequent years, and stated:
“Where the contract terms
guarantee any increase in benefits by way of interest or other addition
for the period from 31 December 1993, or such later date of purchase of
benefit as applies, to the date of payment of benefits, the amount of
final bonus allotted… is reduced by the amount of any such increase.”
This passage is worth the diversion, because with hindsight we can
see that it is material to continuing debate about residual inequities in
the with-profits fund, and the disparities in bonus rates for GIR and non-GIR
policies which became evident for the first time in the 1996 bonus
declaration. This
has been covered previously in section 10 of EARW, to which those
interested may again refer.
At some point after 1993 the
actuaries must have become aware that, if the disparity between the
guaranteed annuity rate in possession and current annuity rates at
maturity was sufficiently large, the commensurate reduction in accrued
terminal bonus would exceed the amount available.
As previously explained (EARW Second Order Sophistry Item 5), any
further reductions in policy value would come from the guaranteed
fraction, which de facto would have indicated insolvency.
Hence when this point was reached it could not be indicated, and a
sum in excess of the policyholder’s discounted asset share had to be
paid out, which could only come from the with-profits fund’s other
pooled assets. And
so in the 1998 declaration the now standard GAR/DTBP text had an amended
ending: “…value
of the benefits before that reduction, subject to a minimum value for the
final bonus after such reduction of zero (P2.102)”
The GAR/DTBP was modified
again shortly after this, because the first complaints to the PIA
Ombudsman had been intimated in July 1998, and the Board had taken legal
advice from the Society’s solicitors.
The new text read:
“The non-guaranteed final
bonus is the sum which the Society would need to allocate to the policy by
way of addition to the guaranteed value to produce the total value of the
benefits available if taken in fund form and used to purchase an annuity
on current rates.
The actual amount of any final bonus will be the sum which the
Society would need to add to the guaranteed value at retirement in the
financial conditions prevailing at that time in order to produce the then
actual total value.
If the policyholder takes benefits in guaranteed annuity form, and
if guaranteed annuity rates are higher than current annuity rates, the
amount which would be needed to be added by way of non-guaranteed final
bonus in order to bring the value of the benefits of the policy up to the
stated total value will be less than that required if current rates were
applied, and could be nil (P2.103).”
It is hard enough for the
average person to divine the meaning and significance of these passages
with hindsight, let alone a director in the context and at the time they
surfaced. As
yet there are no minutes and no uncontested evidence that the actuaries
ever made verbal reference to them before 1998 or thereabouts, or that any
non-executive director questioned their import.
However, in P2.81-2 Lord Penrose relates that Peter Martin had
publicly stated that the “solution” devised by the actuaries was
presented to the board in December 1993, and approved.
He also told the Inquiry that non-executive director Alan Tritton
had queried it in 1994, and received Roy Ranson’s affirmation that the
DTBP was “OK on Contract” (having been assured that the Board had
article 65 vires). Tritton has no recollection of this exchange.
Another account of these differences has been given by Mr Justice
Langley in paragraphs 49-58 of his October Strike Out Judgement.
Though we may duly note it all, we should not speculate further at
present. But
it is abundantly and consistently clear that from its inception in 1982/3
the DTBP was never given the prominence that it deserved by those who
devised and implemented it, until external events both forced and allowed
them to do so. And
by 1993 the new with-profits fund structure and status was an established fait
accompli, such that the pivotal damage had already been done.
Again, therefore, let us pose the uncomfortable question as to why
these important matters were not minuted in 1993/4, let alone 1987/8, or
indeed what their relationship may have been to the conduct of the
Society’s institutional and corporate business in the light of
insistence on retaining GAR rights for a further five years.
The DTBP was not formally
disclosed to the regulators, but mentioned en passant by Ranson at
a meeting on November 30th 1993.
The circumstances are related in P16.114-123, from which it is here
sufficient to quote the following:
“116.
In the course of discussions about the resilience test, Ranson
remarked that the Society’s pensions business had a guaranteed annuity
rate at about 7%, and said:
“…but
this was not as onerous as it appeared since, because old policies had
been given the benefit of more modern features and options, it would be
reasonable (in his [Ranson’s] view for the allocation of final bonus to
be conditional on waiving this guarantee”.
Handwritten jottings by the
line supervisor on the face of some of the board papers provided19 suggest
that Ranson confirmed that the guarantees were not reserved for, and that
Rathbone* may have queried whether this was consistent with PRE.
117.
In this way, the existence of the annuity guarantees and Ranson’s
proposed solution were apparently disclosed to both GAD and DTI at this
meeting. However
it was not followed up and did not receive another mention in the
regulatory papers until after the issue had been exposed in 1998…”
19 “Guarantees-don’t reserve for
them”, “We have no guarantees that bite.
JR: PRE?”.
* GAD Principal Actuary John
Rathbone.
If the regulators had hardly
been vigilant or even diligent, the manner of this disclosure is
consistent with everything else noted above.
With this hurdle cleared by fair means or foul, the Society could
claim carte blanche to implement the WPWM paradigm fully.
How that paradigm might have been represented to the board can in
part be judged from an investment considerations report presented by
Ranson on March 28th 1990 (P4.38-50).
1990 had been a difficult year, and the paper reveals much about
contemporary policy and freedoms it allowed.
Here it suffices to note the following quotation from it in P4.47:
“9.
The most technically and financially efficient way of allotting the
return for the year would be to apply it wholly by way of an increase in
the “unconsolidated” or “final bonus” element of policy values.
This element is not guaranteed, requires no capital to finance it
and is only paid out on policies leaving the fund.
Hence it is very well suited to the situation where future earnings
are being anticipated.
If it eventually emerges that we have “got it wrong”, the
damage is limited and room for future manoeuvre is retained”.
With the DTBP finally out of
the closet over 3 years later, the position could be, and was, fully
implemented. It
neatly condenses and encapsulates many of the issues covered in this
paper.
Loss of the estate and the
events of 1982–7 had effectively transformed the “with-profits” fund
firstly into a “null” fund, and then into a “with-liabilities”
fund owing to continued over-bonusing and the covert DTBP. Yet even though
the Society was now over-allocated, the marketing pressure to stay at the
top of the payout league intensified.
Moreover
the Society now needed yet more members to help service its hidden
deficits. If
inflation and interest rates had stayed high, and markets continued to
register large gains, deficit-linked underperformance might have been
obscured. The taking on of too much underwriting risk attendant upon new
business before much premium had been received (i.e. “new business
strain”) would similarly have been eroded.
But this was not to be, and the Society’s position became
progressively more exposed.
In the event the position was
covered in at least three additional ways.
They were:
·
A modified or quasi-Zillmer adjustment which assumed
continuing future premium income, against which some of the liability
could be set.
·
A subordinated loan of indefinite duration serviceable
at the rate of 8% p.a., which if the Society were to be wound up would in
theory not be met until the liabilities to policyholders had been
discharged.
·
A treaty whereby some of the Society’s liabilities
were conditionally re-insured.
In fact, although a Zillmer
adjustment had been mentioned in the 1989 WPWM paper, it was not utilised
until 1990-91. Eventually,
however, £900 million pounds of liability was covered by it.
Among other options to maintain solvency a subordinated loan was
first mooted in 1993, and eventually a £350 million pound loan at 8%
interest was launched in 1997.
Like the quasi-Zillmer adjustment, servicing it depended upon
future earnings, such that only about half the value of such a loan could
be counted as an asset for solvency purposes.
1997 was a turning point in
other ways, because any good effect the new business loan might have had
was more than cancelled by the withdrawal of pension fund earning and tax
credits by Chancellor Gordon Brown in the same year, which according to
Roy Ranson was equivalent to wiping a further £500 million off the
Society’s statutory reserves and solvency margin.
Given the other pressures on solvency and how they had been dealt
with, this is likely to have been a relatively optimistic estimate.
1997/8 was also when GAR policyholders’ challenge to the DTBP
became public news with the onset of the Hyman case.
Assuming the Society won, the ultimate GAR liability with the DTBP
fully implemented was estimated at different times to be between £15-50
million, which the writer has previously conjectured in EARW to reflect
the absolute insolvency margin of the GAR segment of the with-profits
fund. But
if the Society lost, the cost of the liability would be very much higher.
Just how high depended on the percentage of GAR policyholders who
took up the option when their policies matured or were contractually
surrendered. A
middling estimate was 50%, which could publicly be justified as reflecting
the historical average GAR uptake. With this prospect looming Roy Ranson
retired. It
ultimately led to an estimated GAR liability cost of £1.6 billion in
Society’s annual report for the year 2000.
The tide of the Hyman
case ebbed and flowed, and ultimately the House of Lords ruled against the
Society. There
was an urgent need to restore confidence.
It was thus both irresponsible and inaccurate for Alan Nash to
maintain as late as February 2000 that the liability was of no consequence
to the Society, because it would be no more than £50 million.
The Society may have thought this was justified because, as
previously explained in EARW the official contingency figure for the
liability had been held on its books at £50 million.
The reality was thus incompetently or consciously deceitful. And it
transpired that the reinsurance treaty was negated by a side-letter
agreement signed by Christopher Headdon in April 1999 that had not been
declared to the regulators.
In effect the treaty had been for show only.
Given the complex realities
of the underlying situation, the House of Lords decision could not have
ended all controversy whichever way it went, or whatever form of words it
might have taken. Yet much of that controversy is informed by hindsight,
whereas their Lordships’ judgement may be viewed as just and reasonable
within the contemporary face value context of its likely financial
implications as intimated by the Society.
The measured and responsible tone in which the Society represented
the Hyman test case and its progress to its members and
policyholders suggested little cause for alarm.
But as we have seen, the underlying reality was starkly different.
Not only was the Society over-allocated, but as the premium stream
dried up any relief afforded by the quasi-Zillmer and subordinated loan
disappeared. And since the Society could no longer renege selectively on
GAR policyholders’ terminal bonus by means of the DTBP, that liability
had now also to come onto the books.
The Society opted to value it at 1.6 billion pounds, and cancelled
any bonus additions for the last 7 months of 2001, nominally in order in
order to cover it.
But even as they did so, GAR uptake rates were running at 90%,
which the 2000 annual report showed would cost twice as much.
However, despite all the
previous public reassurances, under the WPWM paradigm it was possible to
remove terminal bonus entirely, although now it had to be done
even-handedly. There was thus plenty of slack in hand for maintaining
statutory solvency.
And so the next move was to reduce all total policy values by 16%.
Almost unbelievably it also entailed pro rata cuts to
members’ guaranteed funds, and this the regulators allowed.
Since the total fund value then stood at over £30 billion, the
cuts represented a drop of some £4.8 billion, which agrees well enough
with the PR’s £4.5 billion shortfall estimate. That would cover 3
billion of GAR, 1.25 billion of quasi-Zillmer and subordinated loan, and
Chancellor Brown’s £500 million or so. Now the GAR policyholders could
in part be bought off with seven months of retained earnings and cancelled
bonuses in exchange for their GAR rights, in which case their total policy
values would be marginally more than restored by an 18% uplift. The non-GAR’s
had to accept a nominal 2% uplift, which in the event did not materialise.
In effect, therefore, GAR fund values were held as ransom for
surrender of the GAR right, and the non-GAR’s had to cover the statutory
solvency gap which now threatened.
The Society’s fundamental inequity was thereby more equitably
restored, and all were the worse for it.
From then on with-profits status was lost, and all w-p members
equally must cover solvency without the backing of any free reserve.
Meanwhile either all (GAR) or the residue (non-GAR) of
policyholders’ terminal bonuses is thereby placed in jeopardy.
As related elsewhere, private
members and ex-members received no external help or guidance in making
their decisions to vote for or against the Compromise. And despite
increasingly urgent representations about the irregularities underlying
more general mis-selling and misrepresentation the Treasury and regulators
turned a blind eye to them.
The record also shows that these included two direct allegations of
fraud by retired trust solicitor Nicolas Bellord and ex-banker Arthur
White at the S425 legal hearings, but that they were dismissed by Mr.
Justice Lloyd or not minuted.
Mr White has since taken his case to the European Union.
Corporate and institutional trustees and their consulting actuaries
went in to bat for their members, in which case they could extricate them
on favourable terms; history has not yet officially related whether any of
the New Board of Directors were in any way their nominees.
Four awkwardnesses remained.
The Compromise could not restore any kind of free assets or estate,
and the Society’s recent history had shown that investment freedom,
smoothing and any reasonable return net of overheads could not all be
funded from a fluctuating deficit.
With-profits fund status was thereby forfeit, and a defensive
investment strategy had to be adopted; a move into bonds followed (see
also Cazalet Consulting’s evaluation of the contemporary situation).
This was just as well, because the long bull market subsequently
turned and despite some recovery has remained relatively depressed.
A rectification procedure for imposing the DTBP on GAR
policyholders whose policies had matured between 1993 and 2001 had also to
be implemented, but progress has been slow. And lastly, annuities in
payment had to be cut to reflect fallen policy values.
As related previously in EARW, the Society bided its time until the
inconveniently timed government FSAVC review and compensations had been
decided before making these cuts in Nov. 2002.
Effectively, therefore, the Society complied with FSAVC (Free
Standing Additional Voluntary Contribution) annuity and fund value uplifts
after the Compromise that it had no intention of honouring. A final
awkwardness, namely residual inequity of guarantees which had come into
existence under the aegis of the WPWM paradigm, was simply ignored.
As also explained in EARW it notably includes convenient
ambiguities and discretions in the implementation of Guaranteed Interest
Rate (GIR) policies.