Company pension fund deficits are still a big headache, with FTSE 100 companies currently facing cumulative pension fund deficits of £47bn, according to JLT Pension Capital Strategies. In a way, this is good news because the deficit was the same this time last year, but it can fluctuate wildly, so taking a snapshot reading doesn't really tell the whole story. But what is clear is that defined-benefit pension schemes in the private sector are disappearing very quickly because they are expensive to run. And existing pension rights cannot be touched. So the problem of matching the books for some companies will take a long time.
There are several reasons why pension fund assets have failed to keep up with liabilities, including greater longevity. But the real killers have been low interest rates, poor equity performance and a drive to make pension fund assets as risk-free as possible.
And pension fund trustees are not even starting with a level playing field because not only have they to match income with liabilities, they also have to generate funds over and above to reduce the deficit of assets over liabilities. And since funds are now more invested in low-yielding/low-risk fixed income, the only other way to top up the books is by taking more money away from the company itself. And this has created problems, especially since legislation giving trustees much greater power in deciding what a company does with its cash.
Is there a way out of the problem? Yes there is for some companies in specific circumstances, but for most companies there is no silver bullet.
Marks and Spencer
(MKS) had a pension fund deficit of £1.3bn in 2009, but by March this year that figure had fallen to £290m. Some of this is as a result of increased payments into the scheme, but M&S also benefited from a timely decision to invest nearly three-quarters of its portfolio in gilts and fixed-income compared with around half, which was then the norm. This was a timely move because the Bank of England's subsequent bulk purchase of gilts as part of its quantitative easing programme sent gilt prices sky high, enough in fact, to boost the value of the pension fund's fixed assets from £4bn to £6.2bn in three years. A new agreement struck with pension fund trustees will now see the company make cash contributions of £28m each year from 2013-14 to 2017-18, down from previously agreed annual contributions of £60m. And this is for a pension scheme that has been closed to new entrants for 10 years. There are problems, though, some potential and some real. The real problem is that much of the gain in the value of its gilt holdings was wiped out by the huge increase in liabilities as a result of the fall in interest rates (see below). And the potential problem is that gilt prices look overstretched at current levels, and at some point will start to fall.
A pension scheme promises to pay a 55-year-old man £100 in 10 years' time when he retires. Of course, if the pension fund invested £100 now to cover this liability it would in fact end up with a lot more when it came to be time to pay the pension. So, to calculate today's value of a £100 liability 10 years hence, a discount rate is used. This provides a figure that, if invested now for 10 years in a fixed-rate investment would equal £100 in 10 years' time. Using interest rates of 1, 2 and 4 per cent, the amount needed to be invested now would be £90.54, £82.03 and £67.56. So it can be seen that interest rates play a crucial part in calculating future liabilities.
(ISYS) found another way to tackle its £490m pension black hole, selling its rail division to Siemens for £1.7bn. Around £400m of the proceeds will go straight into the pension fund, and the engineering group has wisely decided to set aside a further £225m in a reserve trust to meet future pension fund liabilities. Removing the debt pile will also remove one of the stumbling blocks for potential bidders for what has become a perennial bid favourite. The asset sale approach is not new, however, and construction companies like
(IRV) have been selling private finance initiative assets into their pension funds. This performs two useful functions as the company gets paid for the assets, while the pension fund receives a regular income stream for the life of the contract.
For kitchen range manufacturer
(AGA), the options are fewer. It didn't switch into fixed-income securities in 2009 and it has no spare trading arm to sell off. In fact, its core business of making and selling cast-iron cookers has itself been a victim of the economic downturn, with sales down from 19,600 five years ago to 11,000 last year. The company employs around 2,500 people but there are 12,000 people in the pension scheme, and the latest deficit calculation was around £165m. This is a serious problem for a company which last year made just over £7m in pre-tax profits. In fact, the pension fund needs £40m a year in cash to pay pensions, cash which would otherwise be used to improve, modernise and expand its range of cookers still further. A temporary solution has been arrived at after the company agreed to hand over £16m, with no further contributions for three years. Between now and then, the company is keeping its fingers crossed that interest rates will rise sufficiently to reduce the perceived liability, while hoping that an improvement in the global economic climate will help to boost demand for Aga cookers.
With defined-benefit pension schemes being rapidly replaced with defined-contribution schemes, where a company's liability is confined to the amount of money it puts into the pension fund, the liabilities associated with defined-benefit pensions will eventually go away as members die. But this could be a long process. Meanwhile, for companies without the good fortune of having assets to sell, the outlook is pretty gloomy. And for these companies, the Aga plan is perhaps the only one open - fingers crossed, and hope for global recovery and higher interest rates.