Pensions are one of the few critical concerns that all employees within an organisation share. Workers across the spectrum in some form pay into pension schemes under the presumption they’re effectively securing their futures after the world of work – which is why confusion and panic can often ensue when these schemes run into deficit. Unfortunately for UK workers, pension deficits are becoming increasingly common amongst large firms.
According to data compiled by consultancy JLT Employee Benefits at the end of 2018, the shortfall of all private defined benefit (DB) pension schemes in the UK jumped by a nail-biting £59bn in just one month, rising from £48bn in November to £107bn at the end of December.
Companies in the FTSE 100 saw scheme deficits rise by £1bn in December 2018, and FTSE 350 companies saw an increase of £6bn. The funding level of these schemes similarly dropped from 97% in November to just 93% in December. Believe it or not, last year was such a tough climate for pension schemes that this actually represented a tiny improvement over the previous December, when there’d been a pension shortfall of £119bn.
These damning figures come under the spotlight when problems occur at individual schemes, such as the downfall of outsourcing and construction giant Carillion. When it collapsed in January 2018, it left behind a pension deficit of £580m in its wake – creating turmoil for its 28,000 member defined benefit (DB) scheme, and subsequently final salary, members. The scheme was ultimately rescued by the Pension Protection Fund (PPF), but those below the retirement age will now face cuts of up to 20% because there’s a cap on pay outs for high earners.
Carillion’s unfortunate pension scheme members have since joined about 20,000 members of British Steel who’d needed their pensions rescued by the PPF, along with thousands of workers from the defunct high street retailer BHS. After the corporate failures and ultimate collapse of BHS, retail magnate Sir Philip Green and its subsequent owner of just one-year Dominic Chappell left workers facing a pensions deficit of £571m.
After the government stepped in to take action, Green later agreed to pay £363m of his own money to try and fill some of that black hole – but a specialist insurer still had to swoop in and take on £800m worth of scheme liabilities in order to secure member pensions.
Carillion and BHS are two of the best documented cases of pension deficit in recent months, but they’re hardly the only organisations to be hit by a shortfall. IAG (the parent of British Airways), BT, British Gas and BAE have all chalked up large deficits.
This and a number of other factors have prompted many firms across the UK to shut down their DB schemes to new employees and refuse future contributions from existing members. BA has closed its New Airways Pension Scheme covering 17,000 staff in response to the increasingly hostile pension environment, and Tesco has ditched its DB scheme in order to save cash after its deficit rose to more than £3bn.
These shortfalls are often blamed on a range of factors across the wider economic spectrum, from Brexit uncertainties and drops in equities to mounting pressure on Sterling. That being said, there are several shared causes that the vast majority of UK schemes that are in deficit appear to be facing in unison. Unfortunately, the solutions to those problems aren’t terribly straightforward.
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Why are UK pension schemes in deficit?
While booming stock markets over recent years have helped to narrow shortfalls across many schemes and erase the damage pension holidays incurred upon many schemes throughout the 1990s, one key reason deficits have continued to soar across the UK is because most companies calculate their future pension liabilities using safe assets like government bonds.
Around 62% of pension investments are now in bonds – a two-fold increase over the course of the last decade. Yet while government bonds are indeed considered a generally safe bet, they’ve also been drastically stunted in recent years by historically low interest rates.
Rock-bottom rates implemented by the Bank of England, US Federal Reserve and a negative interest rate policy in Europe have all significantly pushed up corporate liabilities, making it harder and harder for corporates to meet their pension scheme obligations.
Unfortunately for financial leaders, there’s little corporates can do in to influence external factors like interest rates. Likewise, increasing life expectancies have been wreaking havoc on pension schemes in recent years. Because defined benefit schemes are required to pay out a pension to members for the entirety of their lives – and a spouse’s pension subsequently payable to surviving spouses for the remainder of their lives – longer life spans have elongated payment promises to members and dramatically pushed up scheme liabilities.
“Broadly speaking, every one-year increase in life expectancy increases the scheme’s liabilities by 4%,” says Alistair Russell-Smith, Head of Corporate DB at Hymans Robertson.
That said, Russell-Smith points out that although people are living longer than ever before and creating a new burden on pension schemes, increasing life expectancies have admittedly slowed in recent years in order to create some welcome respite for schemes in deficit. “It is worth being aware that although life expectancy is still increasing, the rate of increase has slowed in recent years,” he says.
“As schemes budgeted for the increase rates seen five-to-ten years ago to carry on, schemes are actually now seeing a reduction in liabilities as these increase rates have slowed.”
Yet even more concerning has been the increasing trend of firms handing out unsustainable dividends at the expense of pension schemes. According to a 2017 report by consultancy LCP, FTSE 100 companies paid out four times more in dividends on average than they handed over in contributions to their DB pension schemes – and according to JLT, 41 of the FTSE 100 companies that are currently in deficit would be able to settle their pension deficits in full using cash from just one year’s worth of shareholder dividends. Eleven companies could clear their deficits by sacrificing two years’ worth of dividends.
Further research by Barnett Waddingham indicates that the Pensions Regulator should be concerned by at least 43 companies within the FTSE 350 that have boosted their dividend payments while simultaneously slashing contributions to reduce pension deficits.
This concerningly disproportionate relationship between high dividend payments and low pension scheme contributions was one of the most blatant reasons behind the pension crisis that happened at BHS, which has subsequently pushed UK lawmakers to explore regulatory changes that could punish boards for following suit.
How can companies push forward to bridge or avoid deficits?
It can’t be denied that some of the reasons behind pension scheme shortfalls simply cannot be controlled by finance leaders. Interest rates, lacklustre equities markets, increasing lifespans and regulatory shifts simply need to be mitigated in a calculated and proactive way.
Meanwhile, other root causes such as disproportionate and irresponsible dividend payments or a decrease in size of a scheme’s sponsoring company are easier to predict or prevent. Because several key factors behind the sorry state of UK pensions are within the control of financial decision-makers, there are indeed steps companies can take to minimise the damage.
According to Lynda Whitney, a partner at Aon, the first step organisations must take in order to avoid the fate of pension schemes such as that of Carillion is to be open and realistic about their obligations and commitments – and subsequently communicate that to various stakeholders across the corporate ladder. “It is important for sponsors to work with the trustees of their DB pension schemes,” she says.
“This can enable the management of deficits or removal of risk through using a range of techniques including providing members with more options such as pension increase exchange or more support for transfers at retirement, seeking return and diversification of risk of investments and hedging interest rate, inflation or longevity risk”
Whitney also points out that companies wanting to slash deficits would do well to reduce the effective size of their scheme using the purchase of annuities with an insurer through a buy-out or buy-in.
Likewise, Hymans Robertson’s Alistair Russell-Smith says that boards have got to set long-term funding objectives for their pension schemes. For example, a firm could choose a buy-out option to remove it from the balance sheet entirely, or they could opt to run-off the scheme on the balance sheet to avoid paying the additional cost of insuring liabilities.
From there, organisations can use the key levers of employer contributions, investment returns on the scheme’s assets and time in order to set out an efficient funding strategy for reaching the scheme’s predefined objectives.
“One interesting development for corporates to consider now is transferring your DB scheme to a ‘commercial consolidator’ like Clara-Pensions or The Pension SuperFund,” he adds.
“These funds aggregate DB assets and liabilities outside of the insurance regime, meaning some employers can now get a clean break from their scheme at a lower cost than insurance buy-out.”
While FDs absolutely must steer their organisation towards establishing a sustainable and responsible funding strategy for their pension schemes, it’s worth pointing out that regulators and lawmakers in the UK are simultaneously pursuing legal changes that could impact the ways in which corporates fund their schemes, too.
“After the 2008 financial crisis, there was a regulatory push to balance the sustainable growth of employers with the security of their pension scheme,” Russell-Smith says.
“So some schemes set longer recovery plans with lower cash contribution levels to enable the employer to invest in its business with the intention of improving the long term covenant support for the scheme. Since BHS and Carillion, the tables have turned, and there is now a regulatory push to fund deficits more quickly whilst the sponsoring employer is financially robust and has the cash, and ‘fix the roof whilst the sun is shining’.”
Earlier this year, Work and Pensions Secretary Amber Rudd announced plans to take the government’s increasingly active role in pensions relationship management a step further by proposing to jail company bosses for up to seven years as a result of “wilfully or recklessly” mismanaged pension schemes.
Rudd’s proposal had initially called for a maximum prison sentence of just two years for organisational leaders found to be guilty of mismanaging pension funds – but after a public consultation, it was deemed two years was simply too lenient.
The proposed law would also give UK courts the power to levy unlimited fines on companies or individuals for inadequate pension management. Although this legislation has yet to receive Parliamentary approval, the Pensions Regulator has welcomed Rudd’s plan.