Company Pension Deficits – The Problem

Today’s post is about company pension deficits, which have been in the news a lot over recent weeks, following the collapse of the Tata (British) Steel and BHS schemes along with their parent companies.

The problem

We’ve written about the problems with company pension schemes before, but the recent collapses of BHS and Tata Steel – and the potential transfers of their schemes into the UK’s pension protection scheme – have brought the subject back into the newspaper headlines.

What’s going on?

As most readers will know, there are two kinds of pension scheme – defined benefits (DB) and defined contribution (DC).

The former is the old-fashioned “gold-plated” pension, where the employer tells you how much they will pay you in retirement, and they (theoretically) take the risk of putting aside assets and growing them to provide the income you will need.

• In the private sector these have been mostly closed to new entrants, though they still survive in the public sector.
• They only closed recently, though (over the last 20 years), so there are still plenty of active (drawing a pension now) and deferred (eligible for a pension in the future) members in them.

The latter is the normal pension today.

• The employer and the employee both put money into the pot each year and whatever’s there when you retire can be converted into an income (via drawdown, or less efficiently, through an annuity).

A further complication is that most of the DB schemes are “final salary”.

• This means that the income paid out in retirement is linked to the last salary you had at the company (which is usually the highest salary you were paid).
• The amount you are due would usually be a 60th of your salary for each year you worked at the firm (this was originally chosen so that 40 years of work earned you two-thirds of your salary).
• Thus as your salary rises each year, the amount of money you are entitled to (from previous years, not just the current year) also increases.

This means that companies have to make additional contributions for previous years, to keep the pot big enough.

• This doesn’t happen with DC schemes – once the contributions are made for a particular year, they will never be revisited.

Changing times

The problem with DB pensions is that they were mostly funded in different times.

• Interest rates were much higher.
• So were returns on investment assets (in particular bonds).¹
• Life expectancy was much lower.

These factors combine to make the assets in the pension pot less able to provide the promised income.

• The difference between the assets in the pot and the assets that would be needed to provide the required income – under today’s conditions – is the pension deficit.

Pension liabilities are calculated in two different ways:

1. using corporate bond yields (matched to liabilities by duration) for reporting on balance sheets in company accounts
2. using gilt yields for calculating the cash contributions required each year
3. liabilities are also affected by the BoE’s inflation projections (derived from gilt spot rates)

So you might see two figures for the same company’s pension deficit.

You can see the effect of changing conditions in annuity rates:

• 25 years ago, in 1990, annuity rates were around 16% – a £100K pension pot would produce £16K of income each year
• today £100K will produce only £4,800 (4.8%) – less than a third of the old rate

Turn this around and the size of pension pot needed to produce a certain level of income has tripled:

• in 1990, to receive £25K pa you needed to save £156K
• today you need to save £521K

The same is true for companies managing a shared pension pot on behalf of their employees.

Pension protection scheme

As the deficit in a scheme grows, the risk of default increases.

• Eventually a deficit may cause a company to go bust.
• Or the company may go bust for other reasons.

In either event, the scheme would transfer to the UK’s Pension Protection Fund (PPF), which is overseen by The Pensions Regulator (TPR):

• this fund pays 100% of the pension due to those already retired, and those who retired early through ill health
• it also guarantees a 90% payout for those who have not yet retired, with an annual cap based on age (the cap at age 65 is around £33K pa)
• there is also a dependent’s pension of 50% of the members entitlement (100% / 90% as appropriate)
• pensions are indexed to the lower of 5% and CPI

The PPF is funded from a levy on underwritten schemes, and if it runs out of money then it can reduce payments or lower the indexation.

Members who are worried that their scheme might collapse can transfer their pension out into a SIPP.
This is generally a bad idea, but is an option when the scheme is at risk.

• Note also that with historically low interest rates and bond yields, transfer values are very high at the time of writing.

What should be done about deficits?

There are two answers to this question.

The first approach is to look at what companies are actually doing.

• This is essentially to put together a plan to contribute more each than is absolutely required by the changes in the number of scheme members and their changes in salary.
• Over a period of time, the deficit should clear.

If it doesn’t clear, TPR offers employers and trustees three options:

1. increase contributions (after assessing their impact on the sustainable growth of the firm)
2. take longer to repair the deficit (assuming that the company has good long-term prospects)
3. change their assumptions about future returns (take on more investment risk for higher returns)

Alternatively, companies can pay an insurance company to underwrite their scheme, or even to take it of their hands entirely.

• this commonly takes the form of a longevity swap, where the insurance company takes the risk of pensioners living longer than expected, in return for regular payments from the scheme
• sometimes the insurer takes on all risks – this is known as a buy-out
• a buy-in is similar but the insurer makes the necessary payments back into the existing scheme

There are also solutions that are not being used by employers, such as changing asset class mixes and valuation benchmarks.

• companies can also pledge their assets to the scheme (say property or aircraft) rather than making cash payments

The recent pension freedoms should also help, as some DB pensioners will transfer out early to DC pensions to access the freedoms.

• There could also be savings if schemes switched from RPI to RPIJ (which averages 0.7% pa lower).

And there have been proposals (as in the Tata Steel collapse) that companies should be able to reduce their obligations to pensioners in order to reduce their deficits.

• Of course, if this happens once it will set a precedent and other companies will have an incentive not to make up the deficit in their own pension schemes

We’ll look at all these options in a future post.

From an investor’s perspective, diverting extra assets in to the pension scheme will affect cash flow and investment in the business itself.

• Dividends might also be affected.

The state of play

The figures reported by the various pension analysts tend to be different, so we have plenty to choose from.

• But few of them are good.

In 2015 the PPF itself reported that pension deficits were at a record high:

• 5,175 schemes were in deficit and only 882 in surplus
• the total deficit was £367.5 bn (up from £46.4 bn in 2014)
• six FTSE-100 companies had liabilities larger than – in most cases, close to double -their market cap (including Sainsbury’s, British Airways, IAG, BAE, RSA and RBS)

PWC’s 2015 survey found that pension schemes were taking longer to clear their deficits.

• 71% of the 213 companies they surveyed – with combined pension scheme assets of £180 bn – had lengthened their recovery plans by three years of more.
• The average target date for recover was 8 years, though some plans ran for 25 years.
• They also found that 30% of firms were targeting a buy-out from an insurance firm, and 16% were planning to match cash ouflows by holding “high-quality” bonds.

LCP’s 2015 report “Accounting for Pensions” (AFP) on FTSE-100 companies found record liabilities but a fall in contributions.

• the 10 largest schemes had total liabilities of £350 bn
• the 10 largest deficits totalled £40 bn
• average deficits were 4% of market cap, but some companies owed their scheme up to 25% of market cap
• contributions to pensions are lower than dividend payouts – 28 FTSE-100 companies paid out more than double their pension deficit

Hymans Robertson reported that the total shortfall for the private sector (including unlisted companies) had more tripled over 15 years to £900 bn.

• the shortfall was £250 bn in 2000
• the increase was despite payments of £500 bn over the 15 years
• total liabilities were over £2 trn (at a time when the UK’s GDP was only £1.8 trn)
• the report also found that 50% of FTSE-350 schemes are or will soon be cashflow negative, as pensions paid out exceed the new contributions each year
• careful management will be required to avoid losses through forced disinvestment (selling low)

JLT Employee Benefits reported in May 2016 that total liabilities for private sector pension schemes were £1.57 trn, with defcits at £310 bn.

• the deficit was up 20% from £255 bn in 2015
• on average schemes were 80% funded, with FTSE-350 companies 85% funded

JLT have also reported that FTSE-100 pension schemes now have an average 60% bond exposure, as they try to match investments to liabilities – the so-called liability-driven investment (LDI) strategy

• in theory this reduces risk, but we’ll see in a later post that in fact it just introduces another form of risk
• it has also resulted in out-performance over the recent past, encouraging further moves towards bonds

In a rare bright spot, Mercer’s Pension Risk Survey from February 2016 – which looked at FTSE-350 schemes, about 50% of all UK pension scheme liabilities – shows a slight decline in deficits, though liabilities continued to increase.

• liabilities were £696 bn and total deficits were £49 bn

Barnett Waddingham found that in 2015 FTSE-100 deficits fell by £15 bn, as employers reduced estimates of future salary increases and used higher discount rates (3.8% vs 3.6% in 2014, from higher corporate bond yields).

• salaries were expected to shrink by 0.2% pa in real terms
• inflation was 3.1% for RPI and 2.1% for CPI
• life expectancy for a 65-year-old male increased by 0.1 years to 23.4 years
• both assets and liabilities fell over the year
• they added that the reduction drivers were unsustainable in the future

Conclusions

We’ve about run out of space for today.

With so many industry reports covering different sectors of the pension universe, it’s a complicated picture.

• But it’s safe to say that pension deficits are a real problem in the UK.

In future posts we’ll look at what they mean to investors and to pension scheme members, and we’ll analyse in more detail what could be done to fix them.

• This will include an analysis of return and liability assumptions, and what could be done to make them more realistic.

We’ll also provide case studies on some of the more interesting recent pension scheme events, such as BHS, Tata Steel, Aga, RSA and Thames Water.

Until next time.

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1. Massive growth was expected from equities back at the turn of the millenium, since returns over the previous 15 years had been so high [↩]