Pension deficits: An inescapable problem

ANOTHER SEPTEMBER has come and gone and, as far as FTSE 350 companies are concerned, it seems they are no nearer to solving their defined benefit pension scheme deficits than they were in 2011.

This was the dismal finding highlighted by PwC’s latest version of its pensions support index, which tracks the level of support companies are providing to their DB schemes. On average, support for schemes remained flat between December 2011 and June 2012 (the most recent figures available for PwC’s index). Figures from Mercer show that pension scheme accounting deficits for the FTSE 350 amounted to £98bn at 31 August 2013, up some £13bn through declining asset values and an increase in anticipated long-term inflation levels.

The PwC index is set up so that a score of 100 represents a fully funded scheme and scores above 90 reflect a position where scheme deficits are heading for a happy solution. The latest score, 74, shows that, on average, FTSE 350 DB schemes remain in a worrying position and the level of sponsor support for schemes is woefully behind that recorded back in 2007 before the onset of the global financial crash, when support ran at 88 on the index.

The reasons why FTSE 350 companies can’t seem to get on top of their DB problem range from continued mortality creep (pensioners’ life expectancy keeps creeping upwards, adding to funding costs), constantly increasing regulation and the associated compliance costs, and, of course, low levels of investment return since the 2008 global financial crash.

Returns remain well short of levels required for the equity markets to rescue schemes. Undoubtedly – if it could be done cheaply – just about every finance director in a company of any scale that still has a defined benefit scheme would dump the scheme into the lap of an insurer through a scheme buyout. However, as Mercer principal, Adrian Hartshorn notes, for many companies this is either not an option, because the cost would be crippling, or it has been ruled out because, while the company could do a buyout if pushed, it would rather spend the money elsewhere – on revenue-generating projects, for example.

“When push comes to shove, not many finance directors actually want to commit significant amounts of cash up-front to have their entire scheme bought out,” he says.

There are, of course, exceptions. Mercer was an adviser to the biggest buyout so far, when Citibank handed over the EMI pension fund to the Pensions Insurance Corporation for about £1.5bn.

Offloading incentives

However, Hartshorn points out that there are particularly sharp incentives for banks to offload DB pension schemes. The Basel capital adequacy rules require any risk-based liability in the bank to be backed with appropriate levels of capital reserves, so unfunded pension liabilities can tie up disproportionate amounts of a bank’s capital. This puts them in a rather different position to FTSE 350 companies, which can in effect muddle on for as long as their pension fund trustees and the Pensions Regular are prepared to tolerate.

What everyone seems to agree is that the best course of action for finance directors cursed with legacy DB schemes that they cannot “dump” is to seek to derisk as much of the scheme as they can.

“The right thing for the finance director to do is to work with the trustees to ensure that the scheme’s assets are invested efficiently, to commit to additional contributions to help solve or mitigate the deficit over time, and to work to bring the scheme into a sound financial position. What that is will vary from company to company,” Hartshorn notes.

“The end goal is a scheme that is 100% fully funded according to sensible funding assumptions and has an investment strategy that supports the level of risk that the scheme sponsor can tolerate and the trustees are prepared to endorse.”

It is always tempting for employers to seek to crank up the acceptable risk level for the fund, in the hope of getting stronger returns. But Hartshorn points out that the dilemma for trustees is that they have to assess very clearly whether or not the employee will be in a position to make good the investment losses if the higher-risk investment should fail.

“It will come down to how the trustees view the strength of the sponsor’s covenant. If the employer wants the scheme to run more risk, by extending the allocation to equities or adding riskier equities, for example, is the employer in a position to make good any losses so the scheme deficit is not exacerbated?” he asks.

Kate Smith, regulatory strategy manager at Aegon, set up one of the last DB schemes to go live in Scotland back in 2002, when she was with PwC. “Twenty years ago, the beauty of DB schemes was that no one had to think about them – neither the employers nor the employees. Then Maxwell happened and we got reams and reams of regulation, to the point where employers can no longer afford to maintain DB schemes and, unfortunately, most can’t afford to get out of them either,” she says.

The only time a new DB scheme is set up these days tends to be when staff in a public sector body are TUPE’d across to a private sector company, which means that the business is obliged by law to honour and continue that DB scheme.

DC schemes not taken seriously

The problem with defined contribution schemes, she notes, is that employees really do have to think about them and the tragedy of these schemes is that not many employees take them seriously – and those that do often lack the skills and experience to make sensible investment decisions, and end up losing money chasing investment “fads”.

“The only option for finance directors stuck with a DB scheme, which is not sensible or economically viable to move to a buyout, is to derisk parts of the scheme, so that they are not running unrewarded risks,” she says. This takes expert help and guidance and even the best strategies can turn out badly if the timing of their execution turns out to be off.

“Human beings are terrible at timing markets, and even the best can get it wrong – moving a scheme to low-yielding bonds, for example, just before equity markets surge upwards,” she adds.

One of the most nerve-wracking times for a finance director, she points out, is the triannual scheme review carried out by the scheme’s actuary. The review will highlight the scale of any shortfall and the finance director will then have to agree an improvement plan with the trustees and the company board.

“Part of the worry for the finance director is that this sets the deficit which then becomes a published figure in the accounts. Banks see it and it can affect how they view you as a borrowing risk, the level of interest they will charge and so on. In the worst cases, the scheme might well tip the company into administration and then itself fall into the Pension Protection Fund,” she concludes.