Pension deficits continue to run at historic highs

COLLECTIVELY the FSTE 350 companies recorded an IAS19 deficit estimated at £84bn at the end of 2011, with deficits continuing to run at historically high levels. These deficits have persisted for almost ten years. Despite continued contributions to repair these deficits, they have remained stubbornly high for a number or reasons including; poor equity returns, falling bond yields, rising inflation, and increased longevity.

Only a small number of schemes have actively looked to hedge their pension risks, and as gilt yields have fallen, so the attractiveness of hedging has declined. Therefore companies and pension scheme trustees are gradually looking at non traditional methods of managing their risks and funding deficits.

In this article we explore the environment that has given rise to the current position and, looking forward, explore what actions finance directors might take to manage future risks. These actions should, in our view, be seen as part of a change management project along a journey to remove pension scheme risk from the list of things that ‘keeps us awake at night’.

How did we get in this position?

There are two sides to a defined benefit pension schemes. On one side they are made up of the pension promises (the liabilities) which are long in duration and mainly inflation linked. On the other side assets are held to back these promises. Whilst the liabilities change in value broadly in line with long dated inflation linked bonds, most schemes will invest their assets in a combination of equities, alternative assets and short and long dated bonds. Historically these assets have increased in value more quickly than the liabilities. However, since 2000 this has not (generally) been the case with asset portfolios under performing the liabilities. Furthermore, the asset liability mis-match results in considerable short term funding volatility, and 2011 is no exception.

Mercer estimates the IAS19 deficit at the end of December for FTSE 350 companies was £84bn compared to IAS19 liabilities of £562bn. The corresponding deficit at the end of 2010 was £64bn, despite companies having paid in an estimated £25bn over the year to fund pension liabilities.

This year it has been the European Sovereign Debt crisis which has increased volatility in the equity markets, which saw them fall 15% in August, a position they only now appear to be recovering from. It has also resulted in a flight to quality in the bond markets, with prices of gilts and high quality corporate notes at all time highs, sending yields plummeting. In addition the Bank of England’s Quantitative Easing program which restarted in October has depressed yields further. Overall, 2011 was ‘another’ bad year for pension funds.

The combination of these two factors has resulted in the increase in pension scheme deficits now being reported.

Why don’t Scheme’s match their assets and liabilities?

Matching assets and liabilities make sense and increasingly companies and pension scheme trustees are looking to de-risk their scheme, but for many this is unaffordable. Under the current funding regime the liabilities are discounted on an interest rate which reflects a combination of factors including the strength of the company covenant and the assets held, so holding equities reduces the perceived value of the liabilities with a corresponding reduction on the short-term cash required to fund them.

Furthermore, under the accounting reporting standard IAS19 companies are rewarded for equity based investment strategies, as the expected investment income (not the actual investment performance) increases earnings. However for 2012/2013 year ends this practice is to change, so that irrespective of the asset strategy, the expected return on assets will effectively be the same as the discount rate, which is determined by the yield on AA corporate bonds. Therefore changing the asset strategy to a lower risk strategy will no longer impact company earnings.

Moving from the current (and historical position) to a position where liabilities are better matched is also influenced by timing. No one likes to lock in a loss. At current yields and with current deficits, making a material change to investment strategy to buy more gilts will do just this, fixing deficit repair contributions at what is seen as historically high levels. Most companies therefore have developed a strategy to move from the current position to a substantially matched position over a period of time, seeking deficit funding from a combination of higher contributions and market returns.

How are the FDs going to manage these risk and deficits?

There are now no FTSE 100 companies that offer defined benefit schemes to new employees; UK defined benefit schemes are in run-off so that the upside benefits of risk taking will significantly reduce over the coming years. In our opinion the asymmetric nature of future risks will result in substantial pension scheme de-risking as funding positions eventually improve so that neither companies nor trustees will be put in the position where deficits will open up again. This journey will star with 2012 and 2013 valuations, but will continue for many years to come. In addition to putting in place a ‘journey plan’ to move scheme’s investment strategy to a de-risked investment strategy, companies are adopting other strategies for managing and reducing the risk posed by their defined benefit pension schemes and also seeking alternative funding approaches to manage cash contributions more carefully. Some examples of strategies being adopted include:

• The use of contingent assets or special purpose vehicles as an alternative to cash contributions. These approaches rely on the company having some form of alternative asset available that is acceptable to the trustees. Key advantages to the company include lower pension scheme cash contributions, potential tax advantages and a more flexible asset that can be returned to the company if the funding level improves. We see “special purpose vehicles” potentially having an increasingly prominent role in funding discussions in 2012.

• Enhanced transfers remove risk – and often at a lower cost than the funding basis or the cost of buying out benefits with an insurance company. It also addresses risks associated with deferred pensioners, whose contribution to the overall level of risk can be substantial. Under an enhanced transfer value exercise the Company offers members an ‘enhancement’ to their statutory transfer value to move their benefits out of the scheme to another pension provider.

• Employers can also reduce the financial risk (inflation risk and longevity risk are reduced) and volatility of a defined benefit scheme by restructuring non-statutory pension increases (“pension increase exchange”). In addition, a pension increase exchange exercise can be structured so as to result in an improvement in the scheme’s funding position. The major advantage for companies is this exercise can be performed at minimal upfront costs.

• Implementing ‘insurance’ against future longevity improvements. These transactions, known as longevity swaps, largely remove the scheme’s exposure to future changes in life expectancy for the covered population, typically retired members. This increases certainty on the value of the liabilities and reduces deficit volatility.

Any liability management exercises or alternative funding method needs to be considered on its own merit, for example companies need to be aware of mis-selling risk with an enhanced transfer value exercise. However, well run exercises with clear communication and independent financial advice provided at the company’s expense are a legitimate means to manage risk and tackle funding deficits.

Adrian Hartshorn is a partner in Mercer’s financial strategy group. Robert Hart is a consultant in Mercer’s financial strategy group.