Treasury Practice

Corporate pensions

Published: May 2014

Portrait of Raj Mody
Raj Mody, Head of Pensions, PwC:

Deficits remain stubbornly on companies’ balance sheets. This is due to a combination of artificially low interest rates, scheme members living longer than anticipated and pension schemes de-risking – which means schemes have a lower proportion of assets in equities than ever before and so do not really benefit from equity market increases. All of this creates an impression of a hole so deep and dark that there is no escape. But there are actions that treasurers can take to help their employers survive and thrive, notwithstanding their defined benefit deficits:

  1. Use available flexibility.

    The UK Pensions Regulator has a new statutory objective to take account of the financial well-being of the sponsoring employer when considering plans submitted to reduce the pension deficit. The regulator has said publicly that employers can use the full extent of that flexibility and in particular can take account of the need to retain cash in the business for investment or to protect corporate solvency. This means that treasurers should assess the annual amount that the company can afford to pay to the pension scheme without damaging future company prospects. This should then set an upper limit to any negotiations between the company and the pension trustees.

  2. Ensure input of relevant expertise.

    Treasurers could also participate in discussions on the shape of any proposed deficit recovery plan. It may be that the recovery plan could be lengthened or rear-ended, so bringing down the cost in the early years – particularly appropriate if the company is embarking on a growth phase. There is also scope to check whether trustees’ proposed actions around hedging risks and using financial instruments such as derivatives take advantage of the skillsets and market relationships which a treasury function can likely supply. Treasurers should be actively represented in any trustee discussions on these matters, and should not hesitate to appoint their own strategic advisers to challenge the perspectives of the trustees’ statutory compliance advisers.

  3. Examine non-cash funding.

    There may be assets that can be allocated to the pension scheme instead of paying cash either directly, via an intermediate special purpose vehicle, or to back a company guarantee. This is a trend that has grown in recent years. It requires the identification of suitable assets but can help to preserve cash in the company while simultaneously reducing the pension deficit.

  4. Look for market opportunities.

    Insurers’ appetite for taking on pension schemes’ longevity risks varies – there are times when longevity can be insured at a lower cost than it appears in the liability values. These opportunities tend to be temporary and often fleeting, so it is necessary to actively monitor the market if you want to have the chance to spot them and to act in time. In practice this requires real-time analysis tools that can help you remain alive to when these opportunities appear. It is only in very recent times that such tools have begun to emerge and the leading example by far is Skyval. Using such a tool enables the treasurer to identify the key variables, see and stress-test cash flows, and plan and execute in good time.

    Finally, it remains the objective of many companies that still have defined benefit liabilities to remove them entirely from the corporate balance sheet. In doing this, volatility can be the friend of the treasurer. Undoubtedly there will be short windows of time when opportunities arise and the difference between success and failure may well hinge on the ability to act quickly. Success will look like pension rights secured and protected externally. Failure will look like internal post mortems over why opportunities were not seized. Real-time analysis may make the difference.

Portrait of Paul Lee
Paul Lee, Head of Investment Affairs, National Association of Pension Funds (UK):

When looking at how to reduce their deficits, pension funds face two core challenges, both of which increase their liabilities. The first is a familiar problem – longevity continues to extend. The second is one that is relatively new – quantitative easing, or QE, which has created a bond market where yields are unnaturally low.

Increased longevity is good news for us all but does bring with it a number of issues, not least for pension scheme funding. And while QE makes debt financing relatively cheap, and so may bring positive benefits for treasurers in other aspects of their day job, the flip side of this is that liabilities look far more substantial when assessed on standard yields. There is, however, nothing that a company can do to alter either of these two challenges, so let us consider what other options are available to them.

When looking at how to reduce pension deficits, broadly speaking, there are four possible courses of action: consider the level of benefits; increase funding to the scheme; make an asset-backed contribution (ABC); and, develop a closer working relationship with the pension fund trustees.

Evaluating the level of benefits offered to scheme members is an important option. Some moderation of benefits can be done relatively easily and is often completed early in the course of reducing deficits. The remaining choices are more complicated and often involve difficult discussions with employee representatives. Perhaps the most obvious solution is to provide more funding to the scheme. While bolstering the asset position in response to the calculated liabilities is simple and straightforward it is unlikely to be a financially attractive solution.

ABCs effectively lock up a property, or other asset, often in a Scottish Limited Partnership, for the benefit of the pension scheme – giving the pension scheme greater security while reducing the size of the scheme’s deficit. When structured correctly, they can be reversed should the unwinding of QE lead to bond yields rising and resulting in a fall in the liabilities of the pension scheme.

The statutory role of pension fund trustees is to act as an independent solely in the interest of their beneficiaries. That said, trustees will naturally want to ensure the sponsoring employer remains financially robust as this is clearly an essential element in securing a pension scheme’s future. This sensibility may help trustees and sponsoring employers to develop a measured contributions schedule. In the UK, the Pensions Regulator (TPR) has a new objective to encourage it to be more understanding of sponsoring employees’ needs which should support productive and practical working relationships between trustees and sponsors.

Each one of these may not present a solution in themselves, particularly where a deficit is large, but increasingly we see trustees and sponsors working together to use some, or all, of these options to provide secure long-term futures for their pension scheme beneficiaries.

Portrait of Sean Gilfeather
Sean Gilfeather, Head of Corporate Pensions, Actuarial, Lorica Employee Benefits:

Apart from the usual headline reasons, such as lack of available cash flow, employer lethargy, opportunity cost and so forth, there are many fundamental underlying issues that mean employers are either frightened to tackle deficits or are ill-equipped to tackle them. These include:

  • Ineffective trustee boards.

    Trustees are empowered to manage significant risks on behalf of the members, but if they get it wrong, the employer pays the price. Despite advances in recent years in the standard of trustee knowledge and understanding, we’re still seeing trustee boards where the constituents lack the experience and skills to have the confidence to manage the underlying risks and deficits effectively.

  • The role of the Scheme Actuary.

    Many trustees, and indeed employers, still rely too heavily on their Scheme Actuary to provide them with the help and advice they need to reduce deficits. The role of the Scheme Actuary is clearly defined in regulation and employers must realise that a Scheme Actuary’s main driver on a day-to-day basis is compliance with a raft of regulations – it’s not their day job to help the employer to reduce the deficit.

  • Ineffective advisers.

    The way in which advice and management of risks is delivered on behalf of trustees and employers must change. Time and time again, we come across advisers that are ill-equipped to provide clients with the most effective and cost efficient advice available. Many advisers’ primary concern is achieving their chargeable hours or new business targets, rather than providing clients with the right advice.

How to remedy these issues

Treasurers must have more visibility over how defined benefit schemes are managed by trustees, and this can be achieved by:

  • Maintaining an open and transparent relationship with the trustees and their advisers – this can be facilitated by sharing objectives and agreeing a long-term business plan for the scheme.
  • Ensuring that the treasurer takes their own independent actuarial advice. Even though this will come at an additional cost, it should reduce the overall costs of servicing the scheme and help to improve their overall understanding of the underlying risks.
  • Appointing an independent trustee, perhaps on a sole basis, as this will dispense with the need for other trustees.
  • Improving awareness of the powers available to you as the sponsoring employer.
  • Ensuring that there is a robust and transparent operational and governance framework in place.

The next question:

“I’ve heard a lot about making sure treasury is a strategic partner to the business. Can you clarify what steps treasurers can take to achieve this and what the benefits of such an approach are?”

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