As the costs of final salary pension schemes rise due to new regulations and increasing life expectancy, many organisations are taking steps to reduce their exposure, Ceri Jones reports
The government’s decision to protect members of final salary pension schemes by introducing the Pension Protection Fund (PPF) and tough scheme specific funding requirements has had the perverse effect of hastening the demise of defined benefit provision.
Almost half of existing final salary schemes are expected to disappear over the next five years, according to a research report by Alexander Forbes, Accounting for Pensions UK & Europe 2006.
The cost of meeting the latest legal requirements is primarily to blame, with some sponsoring employers facing a 30% increase in costs just to comply with the terms of the Pensions Act 2004.
Under the new rules, defined benefit (DB) schemes have to meet a statutory funding objective whereby assets cover their liabilities.
Employers have also been alarmed by the reduction in corporate activity arising from visible deficits and by the impact of increasing life expectancy on scheme liabilities.
Meanwhile, the EU Directive on Institutions for Occupational Retirement Provision 2003/41, governing cross-border activity, requires DB schemes to be “fully funded at all times” - a more stringent funding regime than the UK’s scheme-specific requirement, as there is no provision for a “recovery plan” to bring a scheme back to a satisfactory funding level over a period of time.
Roger Mattingly, a director at HSBC Consultants, says some employers’ contributions are significant: “A lot of schemes are becoming very mature and so the percentages can be mind-boggling, commonly 40%, 50%, even 60% of payroll.”
Many employers have closed their final salary schemes to new joiners and some are moving existing scheme members into defined contribution schemes. The Pensions Regulator has even issued a consultation, Abandonment of defined benefit pension schemes, from which guidance will be issued imminently to alert trustees to any strategies that might be viewed as abandonment.
When the Royal Bank of Scotland (RBS) closed its final salary scheme to new members it offered existing employees a 15% increase in salary if they left the scheme, some or all of which could be invested in an alternative money purchase arrangement.
Peter Hurcombe, head of pensions at RBS, says the new deal is only slightly less expensive than the old scheme, and that a key reason for the decision was to give employees choice on the basis that at certain stages in their careers the money might be put to better use, for example, by helping young employees onto the housing ladder. However, he admits that another reason was to avoid the variability of costs dependent on fluctuations in the deficit.
“It wasn’t really a high-priority issue, but we were concerned about volatility and once a decision was taken that we should take a view, and we then looked at the additional costs in 10-15 years, we fairly readily came to the conclusion that the thing to do was to close the scheme. It wasn’t just about how recent legislation has piled on the costs, but legislation over the years,” adds Hurcombe.
Such concerns have caused employers to consider many strategies to reduce their future exposure. One option is to curtail benefits by switching staff to schemes based on career-average salary, with the final benefit calculated on an average of the employee’s best 20 years. Standard Life is one firm that has been wrangling with the unions about replacing its final salary scheme with a less generous model along these lines.
Many more organisations have raised employee contribution rates. According to the results of Watson Wyatt’s Pension plan design survey, published last June, nearly half of all final salary plans now require members to pay more than 5% of their salary towards their pension, while two years ago only a quarter paid more than 5%. The average contribution figure is expected to increase to 6% or more over the next two years.
When Unilever closed its final salary scheme to new joiners in March this year, members were told to boost their contributions from 5% to 7% from the start of 2008. It is offering a hybrid scheme to new joiners, in which their pension will be related to their average salary for earnings up to £35,000 a year. Above that level, they will have a money purchase personal pension pot.
Unilever also adopted the popular measure of reducing inflation protection to further cut costs. From 2008, inflation-proofing will be limited to just 2.5% a year, in line with the minimum legal requirement that employers have to meet to protect individuals’ pensions against inflation.
Such changes to benefits are rarely implemented without a fundamental shift in investment strategies. Normally, there is a change in asset allocation, shifting a greater portion of the fund out of equities and into less volatile bonds. The subject of liability-driven investment has enjoyed many column inches in the press and involves matching some liabilities against long-dated gilts. Such strategies are slowly evolving to become more common practice, as asset managers launch collective long-duration funds with low minimum entry levels from around £10,000.
But allocating more of a fund to fixed interest does little or nothing to help close a funding deficit, particularly as long-dated bonds do not offer high returns. Many scheme managers are therefore devoting the balance of funds to search for high growth and so prevent the widening of funding gaps. This may include investments in hedge funds, commodities and currency management.
The Kingfisher Group, for instance, has reduced the proportion of the fund allocated to equities from 60% in 2003 to 35%, as part of a plan to cut non-bond exposure to 20% in the next eight years. A derivatives overlay, such as a swap, has been added to cut interest rate risk. A small percentage gain or loss on a large and mature portfolio can make a great deal of difference, and may dwarf the rise in employer contribution levels.
The difficulties caused to final salary schemes by regulatory demands have been compounded by the fact that life expectancy has been increasing faster than expected. According to the Office of National Statistics, with every day that passes, life expectancy for a 65-year-old man increases by five hours. And actuaries believe that, somewhere in the UK, a woman retiring next year aged 60 will go on to live another 60 years.
The assumptions of many schemes have not kept up with the reality of life expectancy trends. The Financial Reporting Council, the watchdog overseeing company reporting rules, has told companies offering pensions related to final salary to reveal their assumptions in their accounts. Although compliance with the request is not mandatory, firms are expected to follow it. Employers are, however, obliged under accounting standard FRS17 introduced in 2003, to show any funding deficit in their final salary plan on their balance sheet.
One complete and very final solution is to ship the liabilities off to a buyout firm such as Paternoster, Goldman Sachs or Prudential. A year ago there were only two insurance companies offering this option, but half a dozen entrants have now entered the market.
The difficulty is that buyouts are not a cheap option, although the new players are developing all kinds of partial, tiered and deferred arrangements that are making it more affordable. As a rough guide, a full buyout costs around 120% of full scheme funding, plus another 35-50%.
Mark Wood, chief executive of Paternoster, says the company has taken about £250bn onto its books from 20 schemes representing 10,000 members. “The key driver right now for trustees is that assets have been increasing at a faster rate than liabilities and some deficit may be about to disappear. They are keen to establish the price of a buyout and see this as an opportunity to crystallise their risk,” he explains. But it offers no way out for the very largest schemes. Wood says the cut-off level is funds of around £1bn, since schemes above that magnitude already have access to investment bank expertise and economies of scale and can be efficiently managed in-house.
Whichever options a company and its pension trustees take to manage DB liabilities, they know others will be in the same boat.
CASE STUDY: ITN
In November last year ITN proposed changes to its defined benefit scheme to reduce its own payments by £10 million a year.
The scheme has about 800 members and a deficit of £205 million despite cash injections.
Unions were told that the company wanted to reduce its contribution, which averages 28% of payroll, to 18%, and that without some modification the costs would rise to 34% of payroll.
The proposals, rejected by unions, included an increase in employee contributions to 7%, retirement at 60 and the pension to be based on members’ career average rather than final salary. It also proposed a reduction in the accrual rate, from 50ths to 60ths.
The changes were due to take place in January, but the Broadcasting Entertainment Cinematograph and Theatre Union and the National Union of Journalists balloted their members for industrial action after ITN refused to compromise.
ITN responded with new proposals, which include reducing the retirement age from 65 to 63, rather than 60. In return, it has proposed that staff contributions should rise by 2%.
Louise Evans, director of comunications at ITN, says: “Our intention the whole way through was to reach a satisfactory position for both employer and employees. We learned that staff would rather pay an extra 2% into the scheme than have the retirement age moved from 60 to 65 and so it was settled at 63.”
STRATEGIC OPTIONS
A Watson Wyatt survey of 100 senior representatives of companies with final salary schemes conducted in March 2007 found that:
- Three out of four companies with final salary schemes are considering or plan to limit their liabilities using measures such as breaking the link of benefits with salary or offering inducements to scheme members to transfer out.
- Cost permitting, one in four companies will transfer pension liabilities to insurance companies within the next five years. Only 4% of the companies polled said they would be prepared to strike a deal at more than 130% of the value of IAS19 liabilities, the traditional yardstick for buyout premiums.
- Two-thirds said that risk-managed run off, using insurance-based techniques to reduce liabilities, or return-seeking run off, using aggressive investment strategies to boost funding, were their planned approaches.
- Two-thirds of senior managers described managing pension liabilities as a “big issue” at board level for their companies.