Pension apprehension

Posted on 9 Sep 2010 by The Manufacturer

Large firms’ pension funds were heavily depleted before the downturn reared its ugly head; recession has left them ravaged. In part 2 of a double-feature on company pension schemes, Mark Young explores what some companies are doing to plug the gaps.

Midway through 2009, the collective pension deficit of FTSE-100 companies was reported at a record high, £96bn, in Lane Clark and Peacock (LCP)’s annual pensions report. The report says that over the last year FTSE-100 companies have collectively paid an unprecedented £17.5bn into their pension pots in an attempt to plug the gap.

Top tier industrials like BAE Systems, Rolls-Royce and Serco were among a group of eight FTSE-100 companies that paid more into their pension pots than they did to their shareholders. The efforts have worked: this year the deficit is just £51bn, comprising of £389bn of liabilities against £338bn of assets. However, LCP says the improvement is mostly because asset values have recovered from the almighty tumble they took at the back end of 2008.

Similar improvements in the pensions picture do not appear to have occurred among a wider pool of companies. Consultancy firm Aon Consulting estimates that at the end of June, the largest 200 defined benefit UK pension schemes had a combined deficit of £100bn, up from £88bn in May. And, as a large proportion of pension liabilities are made up of gilts – government issued bonds – the ‘age of austerity’ kick-started by the coalition Government’s public spending cuts could mean the deficit will widen, in the short term. Aon says that if the rate on gilts is down by 0.5% over the next year, the pension deficit of those 200 schemes will rise to £143bn.

Marcus Hurd, head of corporate solutions at Aon Consulting, said: “A consequence of the tough financial measures introduced in the Emergency Budget is that deficits could increase in the short-term.

This will be a bitter pill to swallow for companies who are already piling in billions of pounds to plug these deficits.”

Tough economic measures should eventually lead gilts to rise though, boding well for pension schemes in the long term. “For those companies that can afford to take a long term view of pensions, the Emergency Budget is short term pain followed by long term reward,” says Hurd. “The short term pain, however, may be too much to bear for some companies in difficult times.”

How are firms tackling the issue?
Since the 1960s, companies have been looking to replace defined benefit pension schemes – where the employee receives a defined return, like a final salary scheme – with defined contribution schemes, shifting the risk from the employer to employee. In addition, many companies have asked their employees to increase their contributions, pensionable salaries have been capped and in some cases schemes have ended altogether, usually for new employees but increasingly for existing scheme members too – what is called frozen accruals (see Don’t be shy in retiring, TM May 2010).

Clearly these are not measures that will endear a company to what many describe as their most important asset – their employees.

“It is unlikely that the benefits emerging from the defined contribution schemes that have been set up to replace defined benefit schemes in recent years will deliver adequate benefit,” says LCP partner Bob Scott. This will have severe repercussions for the economy and social mobility when large numbers of people reach retirement with low levels of pension income.

Hence, some companies have tried to come up with innovative ways through which they can keep a defined benefit scheme yet plug the gap and mitigate their risks.

Faced with an £862m pension deficit, in July alcoholic drinks giant Diageo, which makes Guinness, Smirnoff and Johnnie Walker brands among others, agreed a deal to place some of its scotch whisky under the ownership of its pensions trustee while the drink ages – and becomes more valuable. Under the 15-year agreement, the firm will place the whisky under the ownership of the Trust, buying it back when it reaches three years old and continually replacing what it takes. This model will generate £25m a year. An initial £197m has been put up by Diageo and the remainder will be covered by the sale of all of the stock that the Trust owns when the agreement expires. Sainsbury’s and Marks and Spencer have also used property, rather than stock, as pension collateral in this way.

British engineering group Smiths recently announced 10-year funding plans for the two pension funds it operates. In the latest three-year valuations, one was found to be £545m in deficit and the other £110m.

Within the last 18-months, the company has taken various measures to limit its post-retirement liabilities, including capping its healthcare cover.

Now the company is placing £25m into an escrow account which it will top-up with monthly instalments of £2m for nine years commencing in July 2011. The money will remain on Smith’s balance sheet and at every three-year review, the company will assess the deficit and decide whether it needs to transfer more money into the scheme. In 2020, any surplus will be paid back into the company accounts.

“This provides a contingent funding commitment to SIPS (Smiths Industries Pension Scheme) without locking the investment into the Scheme should its funding position improve,” said a Smiths spokesperson.

A matter of life or death
The biggest problem with pensions is that people are living longer. Therefore, their pensions must last longer and it costs the company or pensions trustee more money. LCP says FTSE-100 companies have added a further £9bn to their liabilities by redefining life expectancy.

Defence company Babcock Marine has circumvented this problem by hedging the risk of its pension members living longer than planned for. In 2009, the company agreed a deal with a high street bank which will see the bank pay the pensions of employees who live longer than the scheme’s terms allowed for. If the member dies before he is expected to, the bank receives the balance that the employee was expected to receive.

Telecoms corporation BT and technology firm Invensys are among companies that have promised to pay more money into their scheme if they perform well financially. For Invensys, this amounts to a contribution of 8% of any transactions over £1 million.

“These are a few examples of interesting, innovative approaches which show how desperately keen some employers are to hang on to defined benefit schemes, despite all of the problems they present,” says David Yeandle, head of employment policy at EEF, the manufacturers’ organisation. “Companies are desperately scrabbling around for ways and means of mitigating their risk profile and trying to ensure they can maintain the financial viability of their scheme.” While Diageo’s asset collateral scheme would only be a practical solution for a very small number of companies, Yeandle says he is surprised that more firms have not followed Babcock Marine’s lead. “I thought that might set a model,” he says. “It seems to have a lot going for it as a longer term solution.” He concedes that this might prove difficult for firms outside the FTSE350. For this group, defined benefit schemes could very quickly become consigned to the history books. “Inexorably, in the immediate future we are going to find that defined benefit schemes will be pretty thin on the ground in our industry,” he says.

The contention surrounding pensions is far from over, but there is bold evidence that companies are looking for innovative ways to plug their deficits while offering certain features of the coveted defined benefit schemes.