Strategy for survival
29 Jun 09
The struggle to fund defined benefit schemes while balancing commercial needs in the current economic climate is becoming an increasingly risky burden for employers
by Stephanie Hawthorne
Businesses are contributing vast sums to their defined benefit pension schemes. Increased longevity, volatility of funds, and the recession have all taken their toll. Employers have also been burdened with increased compliance and regulatory costs, including age discrimination changes, tax simplification and Pensions Regulator codes of practice. There are also questions around the impact that personal accounts and auto-enrolment will have in 2012.
Lower investment returns have compounded the problem – the Pension Protection Fund states that 87 per cent of UK pension funds are in deficit with a total shortfall of £204.8bn at end April, while Donald Fleming, head of pensions at KPMG in Scotland, says that the collective value of Scotland’s schemes has dropped by around £12bn since the start of 2008.
With this burden, it is not surprising that the typical DB pension costs probably three or four times as a percentage of salary than what it did 20 years ago. Employers are under huge pressure to look at their final salary pension schemes and minimise the financial risks they present to the business. Yet in the private sector today, 2.75m people are still accruing money in these pensions and almost 5.5m scheme members have preserved pensions from former employment. Four hundred final salary schemes have closed in the past year and 80 per cent of DB schemes have already closed to new members, with 20 per cent also now closed to accrual for existing members. This proportion could rise to above 50 per cent within three years.
Many finance directors are struggling just to pay contributions to the final salary pension scheme, let alone the Pension Protection Fund levy. Around 60 per cent of schemes are facing funding reviews this year.
Terry Simmons, lead pensions advisory partner from Ernst & Young said: “For some companies, increased deficits can hit their distributable reserve so hard they are legally unable to pay dividends. Problems are also being stored up too for the future – when the unusually high discount rate on AA bonds inevitably unwinds, it will increase significantly the value of the liabilities.”
Donald Fleming, head of pensions, Scotland, KPMG, summarises the employers’ difficulty: “While there is a legal obligation for employers to fund their defined benefit pension plans, there is also a moral duty to maintain the commercial viability of a company to sustain employment. Many employers are experiencing a daily balancing act.”
Louisa Knox, pensions partner, Shepherd and Wedderburn, gives the example of ITN: “Its recently reported £39m deficit is just one example of a pension shortfall rising dramatically and casting doubt on the future of the company.”
The CBI is calling for urgent action. John Cridland, CBI deputy director general, has said: “We need much clearer signs of support from the Government, who hit these pensions again in the last Budget and from the Pensions Regulator. Longer recovery periods will help firms keep their commitment to pensions without forcing them to divert critical cash flow.”
Paul McGlone, director of propositions at Aon Consulting, comments: “With three quarters of UK pension fund assets held in DB schemes, UK companies who have DB pension schemes are at a severe competitive disadvantage to their European peers. Recession is increasing the pressure on these companies, and those which have already scrapped their DB schemes now hold a competitive advantage over those who haven’t.”
But Colin Browning, senior associate solicitor, pensions at Dundas & Wilson, urges employers to avoid such drastic measures. “Closing a scheme to all future accrual only eliminates part of the ongoing cost and might make you more likely to lose existing experienced staff. It can also lead to a need to fund any deficit in the scheme on an accelerated basis.”
Sarah Smart of Smart Cats Consulting warns: “Knee-jerk reactions to reduce benefits do not always deliver the cost reductions that employers expect.”
Iain McClay of Paull & Williamsons explains: “A decision now to seriously reduce pensions provisions could have a long-term impact on the employer’s recruitment.”
Some employers have no option but to reduce costs. The box (left) shows most of the options available to employers. Terry Simmons tells employers to: “be ahead of the trustee. Get expert advice that is totally independent of any adviser to the trustee”.
But trustees have to be realistic to allow businesses to remain commercially feasible. Jim Boyle, divisional director with pensions specialists Bluefin and a member of the ICAS Pensions Working Party, recommends examining the trust deed and rules to see where the balance of power lies and to determine what options are permissible: “Have an open dialogue with trustees to try to achieve consistency of objective or to identify problem areas”.
If the scheme is in deficit, review the investment policy with trustees and look at opportunities to reduce liabilities. A long-term strategy with a “roadmap” for managing and reducing the DB impact, with an exit strategy in place to have all benefits bought out within 15 years for example, is vital.
Gary Cullen, partner and head of pensions with Maclay Murray & Spens, suggests reducing the Pension Protection Fund levy, by having a parent company guarantee to the trustees of the occupational pension scheme; or for employers to offer security to trustees such as charges over company property, rather than paying huge additional amounts of contributions if the employer believes the stock market will rise. Jim Boyle says: “Changes to future accrual are, in most cases, relatively straightforward for employers to achieve and, in the current economic climate, trustees and members tend to be more sympathetic of the business case.”
Fully buying out benefits with an insurance company and winding up the scheme is the only foolproof way for employers to completely discharge their pensions liability and even that is open to question. Jim Boyle says: “The buy-out/buy-in option may have residual risk – the insurer could fail.”
However, in today’s difficult market, Louisa Knox points out: “the cost of purchasing annuities is prohibitive for most employers, as scheme funding is generally well below buy-out level, meaning employers would have to inject significant amounts of cash into the scheme”.
As well as buy-out, many employers are throwing in the towel and switching to defined contribution (DC). Some employers, such as Aon Consulting, are further cutting back even on their existing DC contributions. There is a moral duty for the employer to be open and honest with the employee, and to make clear the impact on them of any switch to DC. If a lower contribution is made to DC than was paid for DB accrual, then this should be explained. But a move to a DC scheme does not end liability, for an employer as it still has to pay contributions in accordance with the contract of employment. Employers will also stay on the hook for past service benefits. With DC, it is the employee who bears all the investment risk, no longer the employer. As a result, the employer may become more financially secure so that there may be fewer redundancies in the future. DC may bring other problems. Iain McClay warns that: “If questions continue to be raised around employer liability for the choice of default funds, then some liability for DC schemes may shift back to employers.”
Although times are difficult, in the current climate it makes no sense to panic. Employers should get involved through the CBI or the NAPF and respond to the many consultation documents.
If necessary, there are many creative ways to reduce pension liabilities. Employers should close their DB schemes only with extreme reluctance. Employees and unions now put great value on such schemes and, when the economy starts to recover, there will once again be a premium on recruitment and retention of staff. Generous pensions provision is the most sought-after employee benefit, so cut it at your peril. n
STEPHANIE HAWTHORNE is editor of Pensions World magazine.