The mere mention of pensions is enough to make some treasurers run for cover. With the financial crisis eroding asset values and scheme members living longer, we look at how companies are coping with the pensions crisis. We also examine how the role of the treasurer is expanding in response to these growing challenges.
The majority of pensions provided by companies throughout the world are ‘funded’ schemes. These operate as funds established by, but independent of, a company (known as the sponsoring company). Such funds are usually structured as a trust whose assets are separate from those of the sponsoring company. The fund is built up by regular contributions from both the company and its employees (fund members) and is managed by a board of trustees. When a fund member retires, they will either receive a regular payment directly from the fund (a pension), or be able to secure a pension by purchasing an annuity with their ‘share’ of the money in the fund.
Pensions in crisis
Within the past few years, and with increasing talk of a ‘pensions crisis’, there has been a steep decline in private occupational pension schemes, ie those pensions provided by companies on behalf of their employees (as opposed to state pensions). But what exactly is a pensions crisis? Essentially pension schemes are subject to a number of pressures which may mean that a scheme has insufficient resources to fund its forthcoming liabilities – leaving the scheme in deficit. These pressures, which we will look at in more detail later, are becoming increasingly great for pension trustees and finance professionals alike.
Types of pension fund
There are two main types of pension provided by companies for employees:
Defined benefit pension schemes pay members a pre-defined pension on retirement. The precise level of the pension received is generally proportional to either the average or final salary of a member. The most common scheme is the ‘final salary’ scheme, where the annual pension received by a member is proportional to their final annual salary.
Defined benefit schemes expose the sponsoring employer to the risk that the scheme’s liabilities may exceed its assets, as the level of future liabilities cannot be precisely determined. Defined benefit schemes are also fairly restrictive – when a member leaves the company, they cannot easily take the pension benefits they have accrued with them.
Defined contribution pension schemes offer members a lump sum on retirement, which can be used to purchase an annuity which will provide the member with a pension. The exact sum received by each member is determined by two factors:
The amount of money the member has contributed to the scheme. This amount includes both the personal contributions of the member and the contributions the employer has paid on behalf of the member.
The performance of the pension fund as a whole.
Defined contribution pension schemes are sometimes referred to as ‘money purchase’ schemes as members are, in effect, using their share of the fund to form their pension. These schemes are far more flexible than defined benefit schemes and can generally be transferred if a member leaves the company.
Traditionally, a pension offering used to be an expected part of an employee’s remuneration package – this is no longer the case. In instances where employees do have access to company funded pension schemes, there has also been a shift from defined benefit to defined contribution schemes as companies attempt to manage their future obligations to employees and ex-hires. Recent research from Xafinity Consulting suggests that those companies in the UK still providing defined benefit (DB) pensions could face a total deficit of £689 billion by the end of 2009, making the shift away from DB highly desirable.
In fact, many DB schemes have already been closed to new hires for several years, if not decades. The Association of Consulting Actuaries’ 2007 UK pension trends survey report identified that 81% of DB schemes were already closed to new entrants. This figure showed a 68% increase from the 2005 survey and the trend continues – oil giant BP has recently announced that it will close its UK DB scheme to new recruits from April 2010.
Another significant move made by companies to address the crisis has been to close DB schemes to existing members, meaning that no more benefits can be accrued.
High profile closures
The countries hardest hit by the pensions crisis are those where the state pension levels backing employers are less generous and corporate DB schemes have traditionally been popular – such as the UK, Ireland and The Netherlands. Notable examples of scheme closures include:
Plans have recently been announced to close the UK bank’s final salary to 18,000 staff, including existing employees.
The computer service company closed its final salary scheme to new entrants in 2000 but has recently announced plans to close the scheme to existing members in order to manage the company’s pension risk.
In August 2006, Rentokil became the UK’s largest employer to close all doors – including benefits for existing staff – to its final salary pension scheme. Employees were offered the opportunity to enter into a defined contribution scheme instead.
What is the impact of DB scheme closures?
Inevitably, the impact will vary from company to company. For the pension scheme itself, it will mean more manageable levels of risk, although schemes must be fully funded (ie not in deficit) before they can be closed entirely. Rentokil, for example, injected £200m into its DB scheme in 2005 to reduce the £325m deficit – the remainder will be paid off in cash instalments up to 2012.
For employees who are quite late in a long career, the impact of closure is relatively limited as they should already have a substantial benefit built up. The hardest hit will be those earlier on in their career, particularly with prospects of salary progression, because they potentially lose years of good quality accrual.
Growing pension pressures
The single most pressing threat to defined benefit pension schemes is that of a rapidly ageing population. In many developed countries people are living longer than ever before – this is known as mortality risk. This poses a serious threat to defined benefit pension schemes, as more members are drawing pensions for longer than ever before.
Mortality risk can be extremely difficult to manage and there is a lack of options in the market for mitigating this risk, aside from a full pension buy-out. Other actions taken by trustees have included raising retirement ages in an attempt to reduce the period of time over which benefits are paid.
However, there has been a recent market development in this area: longevity swaps. These products, marketed by banks and/or insurers, will allow pension schemes to swap fixed payments, defined at the outset based on mortality assumptions, for longevity-related payments, ie payments based on actual mortality rates. If the company’s mortality assumptions are too high compared with the actual mortality rate, cash will be generated within the pension scheme.
“Most organisations would not describe themselves as specialists in life expectancy, but there is a good opportunity here to offload what is really the greatest non-core risk that you would see in a pension scheme,” comments Simon Banks, Principal, Punter Southall Transaction Services. Longevity swaps are however relatively new to the market – the first UK swap was agreed between Babcock International and Credit Suisse in May 2009. Caution is therefore urged around the use of such products and the pricing levels at which they are being offered.
Poor stock market performances in the early 2000s and decreases in equity prices led to the assets of many pension schemes being worth less than was originally predicted. As pension schemes have traditionally chiefly invested in equities in order to pursue higher returns, the fall in the equity prices at the turn of the millennium had a severe impact on pension fund assets. This has, of course, been made worse by the recent financial crisis.
It is estimated that a further 25% has been wiped off the value of assets backing global pensions since the Lehman Brothers collapse and 91% of UK DB schemes are now said to be in deficit, whereas in June 2008 the majority were in surplus. The major threat with such deficits is that companies will be urged to make large cash contributions into the schemes to fund the deficits at a time when they have very little cash spare. Communication with trustees is therefore key, together with ensuring a long-term focus is maintained.
Tackling the crisis
Aside from the obvious moves to close defined benefit schemes, companies are also rethinking their pension strategies to deal with both the pensions and the financial crisis. Indeed, part of the problem seems to be more a crisis of faith in pensions than anything else, with trustees not satisfied that companies will be able to meet their obligations. As such, companies will need to ensure that their pension strategies have sufficient ‘safety nets’ built in to satisfy the trustees.
In the short-term, companies should aim to get a true picture of their current pension position. From there they will be better equipped to deal with any potential problems. It is also important to keep on top of financial reporting and pensions accounting, as well as to manage the balance sheet impact of the crisis.
Companies should obtain specialist advice where necessary and as Punter Southall has noted, “companies are increasingly seeking separate actuarial advice so they can form their own perspective on what they think the pension strategy should be. The company can then use whatever influence they have to steer the trustees toward their preferred approach.”
Taking a longer term view, in conjunction with the pension trustees, many companies will want to rethink their asset allocation, with a continuing emphasis on liability driven investment. Seeking to diversify counterparty risk is also expected to be high on the agenda of pension scheme managers going forward.
Company pensions and the treasurer
Companies offering access to an occupational pension scheme need to ensure that these schemes are solvent and comply with all the relevant regulations. In the case of funded pension schemes, these responsibilities will fall to the trustees of the scheme. However, weaknesses in a pension fund can have a disastrous impact on the financial health of the sponsoring company, meaning that responsibility will fall on the shoulders of the treasurer – particularly where balance sheets and credit ratings are involved. With an additional emphasis on risk mitigation, treasurers should keep an eye on financial pressures, such as inflation, which may affect the valuation of the scheme’s liabilities in the future. We consider the management of inflation risk in this month’s Risk Management article.
Dave Robertson, Worldwide Partner, Mercer Consulting concludes, “I see a direct connection between the lessons learned – the greater attention to risk and the attractions of hedging – and the skills of treasurers coming more to the fore. We are seeing treasurers become active, where they weren’t active already, when trustees or companies are looking to use derivatives to manage pension risk – be it in relation to interest or inflation. They often do this by being part of a joint committee of trustees and company representatives, bringing their specialist knowledge and experience to the table in order to reassure those involved about the quality of advice that is being received.”
The financial crisis and pensions
How has the financial crisis affected pensions from the point of view of treasurers and trustees?
The impact of the financial crisis on benefits has been to hasten the path that was already set – it has advanced the process of closing schemes to new hires and, for a small but growing number of companies, prevented more benefit accrual for existing staff.
Pension deficits are now commonplace with many of the large corporate schemes. As a consequence, trustees are duly concerned and looking to improve security. The economic woes have also brought sponsor risk into the spotlight – with trustees recognising in many cases that the sponsoring company cannot withstand financial shocks as well as it could before. Answers are needed.
The solution set seems to range from companies being able to provide reassurance to the trustees about their long-term plans and abilities to manage the economic pressure, to the cases where the trustees have actually concluded they need to advance valuations. Advancing the valuation brings the regulatory process into play, and although this only happens in the extremes, it is happening occasionally.
There is also a range of responses in the middle ground here. It might be possible to identify a contingent asset that the trustees could benefit from if the company runs into trouble, for example – thereby giving security to the trustees by a different means. Alternatively, the solution might be to keep a balance between the trustees and dividend payments out of the company – either not increasing or reducing them. In other words, “We can’t pay you, the trustees, anymore, but, so that we’re being proportionate in our actions, neither will we be paying dividends this year.” Inevitably, the right response for each company and scheme depends on circumstance.
Elsewhere, the crisis is certainly impacting on companies’ ability to get credit, but again, circumstances vary from company to company. Where refinancing is on the agenda, some certainty around pension contributions can be essential, such that the banks the treasurer approaches will be able to offer more favourable lending terms.
How have pension investment strategies changed with the financial crisis?
There are really two observations from the last 18 months or so: one is a sense of regret that more companies and trustees didn’t take a greater proportion of risk out of their portfolios when the opportunity was there. I think the lesson to learn from that, and one that is starting to gather momentum, is to have the structures in place and the principles agreed so that when favourable times come along again, some risk will be taken out of the pension scheme.
The other observation is around alternative assets, which fell with all the other equities when things got really tough. There’s a clear question now over their effectiveness in terms of diversification when times are difficult. Then again, opportunities come out of the difficult times as well. We have also seen the emergence of more straightforward risk management as opposed to the more complex solutions.
Naturally companies are more risk averse than they were, but I think there are good solutions out there and the important element is education around risk. Some trustees are being quite smart and looking at the opportunities thrown up from the turmoil. A number of trustees have been looking to increase their corporate bond portfolios and the interest levels around property are picking up again.