The defined benefit pension scheme is a dying breed. Manufacturing as a sector has traditionally looked after the retirement needs of its employees well, but even paternalistic companies cannot fight the reality of big pension fund shortfalls. In the first part of a two-part article, Will Stirling asks what happened and what employers should do about it.
Do you remember the final salary pension scheme? Many under-30s working today won’t have heard of this exotic concept, and by the time our children are working it will be consigned to the scrapheap of extinct financial vocabulary along with the gold standard and subprime mortgages.
With the majority of final salary schemes, a type of defined benefit (DB) pension schemes, now discontinued, it is widely acknowledged by accountancy firms and organisations including the Department for Work and Pensions and EEF, the manufacturers’ organisation, that any remaining schemes will be wound up. Employees, or more accurately members of existing schemes, are also becoming more aware that accruals on existing DB schemes are being frozen. This means that members who joined a DB scheme will have their covenants – benefits – protected up to date, but going forward the benefits will not match those offered at the time of joining.
Richard Farr, a pension partner at business advisors BDO, who has experience with mediating pension deficit issues during IPOs and restructuring for both companies and pension fund trustees, says freezing the future accrual is likely to be a bigger concern for employees than the demise of remaining DB schemes. He says: “Some defined benefit schemes, Sixtieth schemes, worked like this: you work for a company for 40 years – unlikely today – and your pension would be based on two thirds of your final salary. You work there for 20 years and it’s just one third; but work for 20 years and the pension fund freezes your accruals after 10 years, your future benefits will be worth no more than a promise. And you find that once one big company starts this, they all do it.”
Table 1 Survey respondents by company size
Actuaries struggle with C21st problem
David Yeandle, head of employment policy at EEF, says the implications of switching pension schemes and freezing DB scheme accruals are profound. “For many companies the problem is more significant than any other issue – it directly effects employees’ planned retirement dates, and in many cases whether they stay with or leave their employers,” he says.
BDO’s Richard Farr was involved in revealing the scale of the mismatch between DB and other pension scheme assets and liabilities and has worked with the Pensions Regulator. “There, I helped create the concept of employee covenants; how strong is the covenant to pay your pension promises. In previous work experiences, I was able to understand the employee covenant as a key feature of pension risk. If you look at the cash-flow and pension liability of a business, it is a 60-year projection until the last person’s widow or offspring dies”. Dissecting that cash-flow pipeline reveals four types of pension risk:
1 The scheme’s liabilities – what the scheme promises them
2 The employer covenant – what the employer can pay
3 The scheme’s assets – what has been paid into the fund so far
4 The governance – how it operates, how it can expand and move, based on the changes and the rules.
Farr devised a pension risk quadrant that illustrates where these four factors overlap and affect, in turn, the trustee, employer and employee (this will be discussed in the follow-up feature). This overview is the crystallisation of a complex subject – company pension liabilities – where the component parts have been developed more or less in isolation from each other for several decades, by actuaries, accountants and the Government, who never had the full picture. “Until recently CFOs would not have been exposed to these risk quadrants at all – the actuarial profession has its own skillsets, so you are either an actuary or an accountant,” says Farr. The point for employers, he says, is that they are stuck in the middle of a complex mess trying to make sense of the disparate components of their pension liabilities, with sometimes conflicting advice coming from the leftfield.
Table 2 Type of pension arrangements for different categories of employees
Chart 1 Defined benefit schemes in decline for executives … % of firms offering type of pension scheme
Chart 2 … and for management % of firms offering type of pension scheme
The picture today should be clearer but for many CFOs is by no means transparent. “The only instrument that overlaps the quadrants is the Accounting Standard FR17, introduced in 2003, which imposed for the first time an estimate of the true pension liability on balance sheets.” The lack of cohesion between the professions and parties involved has detached some people from the bigger problem, engendering a laissez-faire attitude that sees this as a long term problem to defer. “The long term view is fine, if you think the long term employer covenant is strong but as soon the company goes through a restructuring or a major transaction, the fundamental premise – the employer covenant that was there to underwrite the promises – is fundamentally altered.”
The HR issue and new options
A pension fund that has trouble honouring its obligations, where accruals are frozen, is bad for any company. From the employee’s and employer’s perspective, an important secondary effect of poorly managed pensions is that, with little direct recourse for employees to claim frozen benefits, the situation breeds employee dissatisfaction and lower morale.
“In the old days,” says Farr, “a company could say ‘no’ to a pay rise this year but we will increase your pension benefits. Now there are no pension benefits, people say they want more pay. Either way it is a big HR issue.” In March the Department for Work and Pensions published a useful report, Risk taking: information for employers considering making changes to defined benefit pension schemes. It outlines a range of options of DB pension scheme variants available to companies who discontinue final salary schemes under current legislation, which sit within the spectrum between final salary schemes (most employee-friendly) and defined contribution schemes (in simple terms, least employee-friendly). Case studies from companies including John Lewis, Barclays and Morrisons illustrate how companies are employing different schemes, including cash balance/hybrid, career average and longevity adjustment factor schemes (see the link below). “The practical case studies show the issues that employers need to consider when making changes to their DB scheme, including the very important role that comprehensive communications plays in gaining the positive engagement of members to new pension arrangements,” says EEF’s David Yeandle.
As a sign that the DWP is on top of the issues and potential solutions to what some people refer to as the pension crisis, the report has been endorsed by Brendan Barber, general secretary of the TUC.
“There are a range of options both for those who want to improve a standard DC without going to full DB, and for those trying to ensure the sustainability of defined benefits,” Barber says.
Take action now
For CFOs of manufacturers who are reviewing their DB pension scheme, who have not reviewed the risk quadrant thoroughly, BDO’s Farr has a key message: “Your accounting deficit already on your balance sheet is almost certainly wrong. That was calculated using overinflated discount rate spreads.
Under accounting standards as a rule you have to use double-A bond rates, which with the 2008 credit crisis have gone through the roof. This means the liabilities have been artificially understated.” The new Scheme Specific Funding rules, introduced in 2005, mean that the funding negotiation between the employer and trustees is invariably going to lead to a higher target funding level than accounting. The next article in this series will explore the accounting nuances of pension deficits in more detail.
Farr’s advice is to take advantage of the current distressed economy and the banking market.
Manufacturers are asset heavy, they also tend to be bank heavy and since 2008 banks have taken more security over the assets. “The banks have to understand the pension liability is an important partnership, they have to recognise the need to share the security – which they dislike,” says Farr. “But in the current market environment the Government is telling the banks to be more business-friendly, so now is the time for the banks to help you.” So, the message is, use the depressed banking market as leverage to get the trustees on a better footing with both the bank and the company. And companies should be able to get their banks to back off slightly and accommodate the trustees.
EEF’s Yeandle says: “Whatever you do you need a very clear communication exercise with your employees, and now. Take time over it and provide as much information to them as possible.” He says the time is right as the European Commission will soon weigh in to the compulsory retirement age arena. It is publishing a green paper on the sustainability of pensions in Europe in June where, like the UK, member nations may be required to extend the mandatory retirement age from 65 to 68. The EC may impose rules on the time horizon for extending the retirement age, and the Conservative Party has said it is keen to accelerate that process to a shorter time frame than the Labour Government has committed to.
“If you’re a manufacturer, sort it out this year, because the market should be more accommodating than usual,” says Farr. “The Government is supportive, the Regulator is supportive, banks are having to be supportive – so at least get a plan.”
Defined benefit pension: A traditional pension plan that defines a benefit for an employee upon that employee’s retirement is a defined benefit plan.
The DWP report is available at: www.dwp.gov.uk/docs/risk-sharing-db-pension-schemes.pdf
Advice on retirement and pension options is available from your regional EEF office: www.eef.org
BDO LLP: www.bdo.co.uk