Roger Daltrey of the rock band, The Who, sang the legendary words “hope I die before I get old” back in 1965. He is now well into pensionable age (69 at the time of writing) but few would say he’s old per se; life expectancy (from birth) in developed countries with state-funded healthcare systems (such as Japan, Canada and the UK) is now more than 80, with lifespan (the figure calculated for individuals making it into early adulthood) increasingly seeing people live into their 90s.
With such a proportion of life spent in retirement, making financial provision for the later years of life becomes an increasingly important part of working life for many – rock stars included. One of the most common ways of approaching this is through a pension scheme.
Most pensions provided by companies throughout the world are funded schemes. These operate as funds established by the company and will be built up by regular contributions from both the company and its employees. A fund is normally structured as a trust (and thus managed by a trustee), so the assets are kept separate from those of the sponsor company.
Defined benefit or defined contribution
The majority of funded pensions provided by companies for employees are either defined benefit (DB) or defined contribution (DC) schemes.
DB schemes pay members a pre-defined pension on retirement. The amount is worked out as a proportion either of the average or the final salary of a member, the latter being the most common model. A member leaving a company will often find it administratively difficult to take the pension benefits they have accrued with them; but DB schemes remove the risk related to investment performance. Employers operating a DB scheme can, in lean times, find themselves with a serious funding shortfall: the deficit in UK pension schemes hit a record high of £312.1 billion in mid-2012.
In the last decade, many DB schemes have closed to new members: latest figures in the UK from the National Association of Pension Funds (NAPF) show just 13% of private sector DB schemes are open to new members (in 2005 it was 46%). DB obligations must still be met and NAPF figures show that more than two million workers are still members and the schemes pay out to over four million pensioners.
Most companies started offering DC schemes as a way of mitigating the risk of future pension scheme insolvency. The aim of the DC pension scheme is to give a lump sum on retirement. This is used to purchase an annuity which pays out on a regular basis for the rest of the member’s life. The value of the lump sum is worked out according to the employee’s contributions (personally and those made by the employer on their behalf) and by the performance of the pension fund as a whole, passing the risk of poor performance onto the members. But employers must commit to a defined level of contribution which must be paid irrespective of the financial health of the company.
Accrued assets for each member are easier to transfer should the member leave the company, but DC schemes typically require more effort (and more expense) on the part of the company in terms of administration than DB because each member has a tailored pension according to their individual circumstances.
Trustees
All schemes must remain solvent and must comply with the relevant regulations. This is one of the main tasks of the trustees of the scheme. According to the Association of Corporate Treasurers (ACT), citing IAS19 accounting regulations, “the overriding duty of the trustee is to act in the best interests of scheme members and to be seen to do so”. In remaining at arms length from business decisions, trustees can influence the outcome of major commercial activities.
In July 2004, the trustees of the pension funds attached to UK-based retailer, WHSmith, forced private equity firm, Permira, to drop its plans to acquire the firm after failing to come to an agreement about how to fill the £250m gap in its pension fund. Trustees have been notably vocal in other M&A deals, including Kraft’s takeover of Cadbury (Cadbury’s scheme had a deficit of £500m), the failed takeover of Marks & Spencer by Philip Green (rumours of another attempt abound) and British Airways’ merger with Iberia (the BA pension scheme bearing an estimated £3.7 billion deficit at the time of the merger). In 2007, UK-based high street chemist Boots was acquired by private equity firm KKR, it was reported that there were ‘protracted and heated negotiations’ with the trustees to protect the pension fund.
Let it grow
The investment strategy of the fund is directed by the trustees. In their duty to maintain solvency and comply with regulations, trustees are required to mitigate risk by creating a broad investment portfolio. In taking the safe route, they often achieve relatively poor yield. Some firms took action against such low returns. In October 2001, the aforementioned Boots switched its £2.3 billion fund from equities to AAA/Aaa long dated sterling bonds, including 25% index-linked. In 2002 it increased its 25% index-linked content to 50%, executed through a series of interest rate swaps. That same year, the Financial Times ran the headline: “Bonds switch yields £700m gain for Boots”.
On the rocks
Liabilities have outstripped assets in DB schemes for a number of reasons, not least measures to aid the economy, such as quantitative easing (QE).
QE rounds, first applied in 2009, were intended to kick-start the economy. In the UK, more than £325 billion worth of gilts were bought, forcing down gilt yields and long-term interest rates. Whilst this was intended to drive investors seeking higher yield into riskier securities, it had the unintended consequence of hitting naturally conservative pension funds right where it hurts. “Businesses running final salary pensions are being clouted by QE,” said Joanne Segars, CEO of NAPF, in a statement. “Deficits that were already big now look even bigger because of its artificial distortions.” In the UK alone, NAPF estimates it has cost schemes more than £90 billion.
Even in better times, measures were taken that may not have been as generally helpful as intended. In 1997 the UK’s Advance Corporation Tax relief was scrapped. This meant pension funds were no longer able to reclaim tax on their dividend income, effectively lowering pension returns and reducing the incentive for corporates to put large contributions into their schemes.
The finger of accusation has also been pointed at actuarial miscalculations dating back to the 1980s and 1990s. Acting in tandem with existing regulations on producing valuations, actuaries seemingly took an overly optimistic view on the likely growth of pension investments – spurred on by buoyant stock markets – creating the impression amongst sponsoring companies that their liabilities were all taken care of. Many took ‘contribution holidays’ thinking they would simply catch up later. Boots, for example, had resumed contributions in 1999 after a long holiday, having adopted a market-based actuarial valuation of its fund.
In the UK, the government decided to tax pension fund surpluses in the late 1980s. According to Dr. Ros Altmann, Director General of the over-50s holidays and insurance specialist, Saga Group, these surpluses had built up not just because equities were fruitful, but also because there were more people contributing than retiring. The surplus, she wrote, should have been left to accumulate in order to take care of leaner times and to counter the point when the number of people retiring started rising.
Indeed, there is now a demographic shift to contend with. Where once people may have been expected to live another 15 to 20 years after retirement, now it is more like 25 to 30 years. Pension funds will struggle to cope.
The age of receipt of state pension can be raised to match changes of longevity, as it has in many countries including the UK and France, and the US is currently debating the issue. Plans are also afoot to bring private sector pensions in line by adjusting the benefit structure and UK retailer, Tesco, is noted for linking its scheme for new members to longevity.
Pension fund legislation update
In recent years there has been a general tightening of regulations governing pensions, with several new pieces of legislation being introduced covering areas such as mandatory indexation, re-valuation and spouse benefits, which together have increased sponsor liabilities (some NAPF members report increases of up to 30%).
IAS 19
In the preparation of accounts, International Accounting Standards (IAS) 19 covers employee benefits such as wages and salaries as well as pensions. It requires the assets and liabilities of a scheme to be noted on the balance sheet. DC accounting is relatively simple in that contributions and pay outs are recorded as they take place. DB accounting is more demanding as the value of the fund’s future liabilities are, at best, an estimate. IAS specifies the use of actuarial calculation methods to arrive at an appropriate figure.
As such, IAS 19 asks for DB assets and liabilities to be recorded at ‘fair value’. In terms of assets, market-based assumptions are most commonly used. Liabilities are more complex as they are calculated by discounting anticipated future outgoings of the scheme by the current return on high quality (normally AA-rated) corporate bonds.
Solvency II
Solvency II, due to go live in January 2014, is intended to standardise EU insurance regulation. It covers the level of capital that insurance companies need to hold to reduce the risk of insolvency. Imposing insurance standards onto DB schemes could have a negative effect on the liquidity and credit profiles of those still running these schemes.
Another component of Solvency II for pension funds is the deployment of the ‘holistic balance sheet’ (HBS). HBS is intended to iron out the differences across schemes in Europe and offer easier insight into, and comparison of, a fund’s long-term financial position. The goal is to itemise and account for all the fund’s assets and its liabilities.
Reasons not to be cheerful
According to the NAPF, the EU’s assessment of Solvency II-type rules for pension funds (under the auspices of the European Insurance and Occupational Pensions Authority and its Quantitative Impact Study), is “seriously flawed”. NAPF’s Seggars has commented that HBS is not a sound analytical framework for assessing the strength of pension schemes because it does not take adequate account of the “complex structures of many large, multinational companies and their pension schemes”.
Whilst it might be appropriate for insurance firms, Mel Duffield, Head of Research and Strategic Policy for NAPF, argues that most occupational pension schemes are already backed by an employer covenant indicating an ability to fund the scheme and underwrite investment risk. There is, she adds, also a compulsory insurance system (the Pension Protection Fund) which is funded by risk-based levies on all UK-based DB schemes. Adding strict requirements around what discount rates have to be used and what assets have to be held could see DB schemes facing an extra £300-£400 billion hit, she comments. As Solvency II rolls out over the next ten to 15 years, she feels it will “go against the government’s growth agenda”, as corporates needing to hold the extra funding will do so in safe but low yield assets such as fixed income and gilts, in order to be seen to be sufficiently de-risked. “When there’s a drop in gilt yields an employer can be looking at millions of pounds being added to their deficit overnight. If you’re forcing the corporate to put more cash into the pension scheme in the short term that is obviously cash not being invested elsewhere.”
Not only that, notes Duffield, but the legacy of DB may take another 60 years before all the benefits accrued in those schemes are paid out. In the meantime, corporates will probably be looking at managing “a whole series of pension offerings”. When auto-enrolment was introduced by the UK government in October 2012 (to ensure most people have access to a pension plan), some firms will have to create additional schemes on top of their existing DB and DC schemes to cater for the new influx of members. This could create “significant levels of administration” for companies.
An observed effect of this is that DC schemes can often become “a bit of an afterthought”, simply because they do not carry the same risk for the employer as DB, in which trustee time tends to be absorbed by the funding issues and the required level of interaction with the regulators.
One of the main challenges, therefore, is to reduce time taken in dealing with those issues. Tom Wood, Head of Professional Services Industry at Barclays, believes that it is essential for a trustee to grasp as soon as possible what is going on in the markets in terms of regulation and key risks, and to consider the resources needed to manage these changes. “Because of the extra challenges trustees have to deal with, our aim is to provide them with slicker systems and processes to carry out their day-to-day tasks, to give them time back,” he says. The bank’s insight puts trustees in a position to stop fire-fighting and start taking “a more considered approach”.
Creating a high level awareness of impending issues and pointing the way to the appropriate specialist advisors is a vital part of the role for Wood’s team of directors. Discussion may, for example, concern how regulations will impact upon the way in which funds are reported at the P&L level, or provide commentary on how volatility in the Eurozone will pan out. However, he says, there is “a real challenge in predicting what the potential shortfall would look like in any DB scheme”, and so direct bank-led finance solutions are an option, such as a letter of credit (LC).
Dealing with investment strategy is difficult because much of the regulatory pressure centres on fund de-risking, but at the same time the fund needs to get the best return. NAPF’s Duffield notes that in the past few years there has been “a big shift away from equities into fixed income”, and where speculation that the bond bubble “might be about to burst”, some funds have been looking for other growth assets (stopping short of a shift back to equities).
In terms of the shift from DB to DC schemes, the trend will continue, says Wood. As the general level of awareness of the important issues necessarily increases, so some trustees are becoming “a little more sophisticated” in the management of their funds. By putting in place “early warning” trigger points which reflect market changes, he believes they are better able to foresee the risk of those changes and to take appropriate action.
