Strategy & Operations » Governance » Economics: Sour taste

Dennis Turner

In no other policy area have so many government initiatives turned sour. It
is probably fair to say that on pensions they have not got much right as far as
the public and companies are concerned. From the Chancellor’s abolition of
dividend tax credits in 1997, through to the delayed response to Lord Turner’s
proposals for reforming state pensions and the reluctance to bring the generous,
but unfunded public sector pensions more in line with the private sector, the
authorities have had to endure a sustained barrage of criticism.

But for corporate Britain, the legislation which matters is the Pensions Act
2004, the provisions of which are now starting to bite. Following the failure of
several high-profile occupational pension schemes, the government created a new
regulatory framework to protect members of employer-organised final salary
schemes. It believed that, since pension schemes were private agreements between
employer and employee, the taxpayer should not be expected to pick up the tab
when a fund fails.

In trying to protect both employee and taxpayer, a system has emerged which,
critics claim, is intrusive, expensive and onerous. It will be damaging for
companies, employees and shareholders and, in the long-term, is likely to speed
the demise of the very schemes the legislation is trying to protect.

The magnitude of the problem can be measured by the difference between the
pension promises and the value of the present pension assets. This deficit,
according to the official figures for March 2006, is at least £440bn using the
strictest test of solvency. Some FTSE companies have a deficit equivalent to 25%
or more of market capitalisation, clearly a drag on their activities.

This estimate covers 5,800 schemes that account for 85% of all UK pension
liabilities. Independent consultants put the total shortfall for all schemes at
£518bn. Some believe another £20bn should be added because life expectancy
figures have been underestimated.

Whatever the exact number, it is a big one and bigger than it was two or
three years ago. And the factors that contributed to the rise in the deficit are
unlikely to go into reverse. As the value of many defined benefits schemes fall
below their commitments, companies have understandably tried to switch to
defined contribution schemes, initially for new recruits, but now also for
existing pensionable staff. The Post Office has recently announced just such a
move. The costs are lower and more predictable, but the benefits to members much
less generous.

At the heart of the new legislation is a pensions regulator, who potentially
could become a significant presence in business life. Ensuring that funds
achieve solvency in five-to-ten years is one of the regulator’s key
responsibilities and if firms try to achieve the Statutory Funding Obligation
sooner rather than later it could well have an impact on dividend policy and
capital expenditure, as well as salaries and benefits. Some uncomfortable
choices will have to be made.

The Pension Protection Fund (PPF) is the safety net for protecting pensions
if the sponsoring employer becomes insolvent. The money will be raised by a levy
on companies operating a DB scheme, a sum proportionate to their fund
liabilities but adjusted for the financial strength of the business (a
‘risk-based levy’). Already, after just a couple of years, the annual levy has
soared from £138m in 2005/06 to £675bn in 2007/08. These charges, particularly
on weaker schemes, may push some companies over the edge.

Pre-clearance of merger/takeover deals is the other important area of the
regulator’s focus, as J Sainsbury is likely to find out. Fund deficits have
already proved a stumbling block in several major deals and the regulator now
has the right of veto over any proposal involving a final salary pension scheme.
The price of approval could well be an increase in scheme contributions, a
situation that will affect equity transactions and other debt-financed takeovers
in particular.

As if this were not enough, the government has to reconcile the increasing
fragility of private sector pension funding with the gold-plated schemes still
available in the public sector. The shortfall has been estimated at anything
between £600bn and £1 trillion, but it is not subject to the same solvency tests
as private DB schemes. It is funded out of general taxation, with contributions
coming from those whose pension expectations have been seriously diminished.
Some tentative steps have been made to limit taxpayers’ long-term liability, but
an enormous disparity between public and private pension provision remains.

The pensions issue, therefore, cuts across all aspects of economic and
business life and few households or businesses will be untouched. Given where we
are starting from, it is hard to see how the problem or the potential solutions
can be regarded as a plus. There are some questions for which there are no easy
answers. Pensions is one of them and the obvious message of work longer and save
more will not get many votes.