Since the turn of the millennium, more and more companies have switched from offering their employees defined benefit (DB) pension schemes to less onerous defined contribution (DC) ones. The funding gaps of the former are bigger now than in any time since the DB scheme was conceived. Why has this happened and what can be done?
A defined benefit pension scheme is one that provides a superannuated employee with the means to provide for their retirement. These benefits – typically a pension and a cash lump sum – are usually based on the length of time the ex-employee served and their final salary. Compared with their defined contribution counterparts, DB schemes are generally more costly to maintain and their cash flows more difficult to predict – which partly explains why they are being put out to pasture.
Since the turn of the millennium, the switch from defined benefit to defined contribution has gathered pace. The increased life-expectancy of scheme participants along with an investment environment in which interest rates and yields on equities have flat-lined has served to leave most company schemes with large deficits. In the United States, pension plans have been left with assets worth just 77% of their liabilities post credit crunch. On the other side of the Atlantic, the collective deficit of the UK’s 6,500 private sector DB schemes rose to £255.2 billion at the end of last year.
A few legacy DB schemes remain, but these tend to be in heavy, unionised industries and sectors in which staff recruitment and retention are top priorities. Change is in the offing in these last bastions of DB too, however. Shell, for example, recently announced it is closing its final salary DB scheme to new entrants, whilst at Unilever, one of the few non-oil companies to retain a final salary scheme, the trustees on the pension board last week gave their go-ahead to make the switch to a DC scheme.
As for the DB schemes themselves, their investment portfolios have seen considerable change over the past ten years. Before the turn of the millennium, a DB scheme typically held up to 80% of its assets in equities and other so-called growth assets, that figure is now closer to 50%. The rest is held in high-quality, low- yielding government and corporate debt.
“Changes in the accounting and regulatory environment have made volatility in funding valuations more difficult to manage. Accounting standards, for instance, introduced stricter methods of valuing liabilities, based on corporate bond prices, and those values flow through to the company’s balance sheet year on year. One way to reduce the volatility this creates is to invest in bonds and this, in part, explains the changing asset proportions. However, where equity holdings are sold, the expected return on the assets will fall and companies will then being expected to make up the difference. There is a general reluctance therefore from companies to switching out of equities too quickly,” says Dave Robertson, a partner at KPMG.
Another difficulty has arisen in Europe on the back of the financial crisis. Interest rate and inflation swaps – previously traded OTC – will have to be cleared centrally under European Market Infrastructure Regulation (EMIR), which might also oblige clients to post cash collateral of £25 billion against their derivative positions, instead of the high quality debt in their portfolios. Pension fund managers have managed to postpone the application of the new rules to their derivatives until 2015.
“The funding gap can only really be filled in two ways – by investment returns and employer contributions,” explains Dave. “The challenge for the company is to decide how much volatility it can withstand as this will dictate the balance between equities and bonds. Some companies have approached this question directly and so have a balance that is right for their circumstances. Others are perhaps still relying on their trustees and so could be carrying too much risk or, indeed, too little.”
Where does the treasurer stand in all this? In the eye of the storm, of course! He or she is in a unique position to advise the pension trustees, especially on derivatives and financial instruments the trustees might find a little too exotic for their tastes at first sight, but which can mitigate risk and boost returns when they are used correctly.
“In all cases, it is important that sensible risk management is undertaken. It can, in fact, be possible to reduce risks without increasing costs. For example, it may be possible to reshape the bond investments such that more closely match the characteristics of the liabilities,” says Dave.
Again, on the equities front, the use of derivatives – namely, stock options – and stock portfolio diversification can maintain returns whilst mitigating risk. “Diversification is a natural first means of reducing risk without necessarily reducing returns. Equally, equity collars can provide a very effectively means of gaining some downside protection without reducing the potential for the assets to achieve the required investment return.”
For a further update on corporate pension schemes – and the challenges facing them – don’t miss the February edition of Treasury Today.