Many UK companies are in a mess when it comes to sorting out their defined-benefit pension funds. Market volatility has certainly played a part in the growing pension fund deficit, but regulatory changes - most notably that which recognises pension liabilities as a form of corporate debt - are a constant source of worry. Furthermore, pension fund trustees now have much more power over what a company does with its money if there is a pension fund deficit.
How much of a worry are pensions? Well, in August last year, the defined-benefit pension schemes run by FTSE 100 companies sported an overall deficit of £38bn, according to JLT Pension Capital Strategies, but by August this year this had risen to £57bn. This may not seem a lot, but in 2011, the latest year for which statistics are available, 10 FTSE 100 companies, including BAE Systems, Barclays, BT, Lloyds Banking Group, Marks & Spencer and Royal Bank of Scotland, paid more into their pension schemes than they did in dividends to their shareholders. Just imagine, if they managed to sort out their pension problems they could double the dividend and still have some cash left over.
And with a number of companies the deficit represents a material risk to the business. In fact, eight FTSE 100 companies have pension liabilities that exceed their market capitalisation. And in the case of International Airlines the £3.32bn market valuation at the end of 2011 was dwarfed by a pension liability - not deficit - of £16.2bn.
Efforts to close the gap have simply not worked. Moreover, distortions in financial markets created by huge injections of capital have played havoc with investment strategies. Daily fluctuations in equity markets, for example, can alter the total deficit by as much as £10bn. And volatility in equity values has led to a shift into bonds, with allocations rising from 33 per cent in 2006 to 55 per cent. But this has happened over a period when government intervention has driven bond yields to disastrously low levels, and this is prompting some trustees to reverse the process, simply because nearly all FTSE 100 companies offer higher yields on their dividends than the paltry 1.5 per cent on 10-year gilts. Admittedly, it’s not as bad as this because coupon rates are as much as 4.5 per cent, which is the guaranteed return assuming that the gilts are held to maturity when they are redeemed at par.
The problems
At the heart of the problem is the method used to calculate the amount of future liabilities that a fund faces. This liability is calculated by applying a discount rate. Using an example provided by the Pensions Commission, a pension scheme promises to pay a 55-year-old £100 in 10 years' time on retirement. Putting that aside now would generate more than required at maturity, so discounting calculates the amount that should be invested now that will be worth £100 10 years hence. Using an annual interest rate of 4 per cent just £67.56 has to be invested, but this climbs to £82.03 on 2 per cent and £90.53 at 1 per cent.
But the fall in yields masks another potential headache, because even using AA-rated corporate bonds to calculate discount rates has seen costs increase as yields have fallen. And the idea of eliminating risk altogether by using gilt yields to calculate the discount rate would make most pension funds unaffordable. In fact, JLT calculated that if pension liabilities were measured on a 'risk-free' basis, the total deficit would balloon to £185bn.
Matching projected liabilities with income from 'risk-free' gilt investments would involve a higher cost because of the lower discount rate, and would also lock in any residual deficit because there would be no topping up, a state of affairs that pension fund trustees would not accept. So, while the cost of benefits in 2011 at Barclays' pension fund came to £371m, the bank put in a further £1.849bn to plug a deficit which at the time stood at £2.7bn.
And there are other problems, too, notably the position of the Pension Protection Fund (PPF). The PPF has now taken on around 500 pension schemes and is currently taking on about 15 defined-benefit pension schemes every month. At this rate it will have absorbed a quarter of all UK pension schemes in seven years, which apart from anything else would mean that an increasing PPF levy would be drawn from a shrinking pool of companies with defined-benefit schemes.
Inevitably, this has led to a steady decline in the number of defined-benefit schemes in operation. And after Royal Dutch Shell and BAE Systems close their DB schemes, there will no longer be any FTSE 100 company offering a final-salary pension to new employees. But some relief is at hand from the decision to index pensions using the consumer price index rather than retail prices. The thinking here is that the Retail Prices Index (RPI) contains an element of mortgage costs, something that a majority of pensioners don't have to worry about. Even so, the bottom line is that pension liabilities have been reduced by cutting pensions. The benefits are significant, though, with BT disclosing a saving of £3.5bn.
Surplus funds
| Company | Assets (£m) | Liabilities (£m) | Surplus (£m) | Funding level (%) |
|---|---|---|---|---|
| Prudential | 7,163 | 5,620 | 1,543 | 127 |
| Standard Life | 2,756 | 2,315 | 441 | 119 |
| Rolls-Royce | 10,016 | 8,765 | 1,251 | 114 |
| Aviva | 11,791 | 10,527 | 1,264 | 112 |
| British Land | 110 | 99 | 11 | 111 |
| Kingfisher | 2,149 | 1,962 | 187 | 110 |
| Old Mutual | 594 | 546 | 48 | 109 |
| Experian | 571 | 529 | 42 | 108 |
| Scroders | 764 | 708 | 56 | 108 |
| Centrica | 4,670 | 4,340 | 330 | 108 |
Deficit funds
| Company | Assets (£m) | Liabilities (£m) | Deficit (£m) | Funding level (%) |
|---|---|---|---|---|
| Wolseley | 889 | 1,249 | 360 | 71 |
| WPP | 654 | 935 | 281 | 70 |
| Whitbread | 1,341 | 1,940 | 599 | 69 |
| Meggitt | 585 | 850 | 265 | 69 |
| Hammerson | 52 | 82 | 31 | 63 |
| Sage Group | 18 | 30 | 12 | 60 |
| Glencore | 184 | 332 | 148 | 55 |
| Evraz | 305 | 640 | 335 | 48 |
| Vedanta Resources | 25 | 60 | 35 | 41 |
| Eurasian Natural Resources | 0 | 34 | 34 | 0 |
Source for both tables JLT Pension Capital Strategies
The solutions
Closing a scheme to new entrants doesn't solve the problem, though. Existing members' pension rights cannot be altered, so the scheme still has to be funded. And, apart from the difficulties generated by market volatility, companies also have to deal with the effects of longevity. A few companies have modified their mortality assumptions but life expectancy is still rising. Seven years ago, a male life expectancy at 65 was just under 20 years, but by last year this had risen to over 22 years.
There are ways to guard against this by using longevity swaps, with International Airlines, ITV and Rolls-Royce among those companies that have gone down this route. It is only a partial solution, though. Essentially, the pension fund pays a premium - usually to an investment bank - and if pensioners in the scheme live longer than expected then the investment bank pays the difference. But if pensioners die prematurely, thereby reducing the pension fund liability, the pension fund pays the investment bank an additional premium. Some companies have also elected to buy bulk annuities, whereby pension schemes pay a premium to a bulk annuity provider such as Prudential, and in return the insurer writes an annuity that pays the retirement income of a scheme's pensioners who have already retired.
In this way, trustees offload all investment, inflation and longevity risks, while the insurer gets all the assets and a premium. However, even this has a potential downside because recent data from the 2011 census indicates that the number of people aged 85-89 is about 2 per cent lower than forecast just two years ago. This is potentially good news for pension funds, if the news is a trend and not a discrepancy, but it is bad news if you have already offloaded your longevity risk. The jury remains out on whether the numbers indicate a trend.
But given the poor return on gilts and the drive for a 'risk free' discount rate, there has been pressure on the government to relax the rules a little. Most countries require pension funds to mark their liabilities to market by discounting them at current bond rates. But the paltry discount on offer as a result of falling yields has prompted some countries to change their approach.
In the US and Netherlands, pension funds can use a 'smoothing' calculation, whereby discounts are calculated by using an average rate over a period of time. In the case of the US, incoming legislation will allow corporate pension plans to discount long-term liabilities based on a rate averaged over 25 years instead of two years. Sweden has simply put a one-year floor on how low the discount rate can go, while Denmark has set a long-term discount rate of 4.2 per cent for liabilities that will fall due in 30 or more years.
Measures proposed for the UK by the Society of Pension Consultants include broadening the range of assets used to discount liabilities, possibly to include the average dividend yield on FTSE 100 companies. But the rate of return implied by the discount rate has to be achievable. And, of course, as the return increases so does the risk. And this is where pension funds face their next big hurdle – Solvency 11. If proposals come into law, pension funds may be required to hold reserve capital against their obligations, which could lead to deficits being crystallised.
