A bleak future

The deepening crisis in company pension schemes is prompting companies not just to close their defined contribution schemes to new members, but to scrap the schemes altogether

The more realistic of us have realised that the days of final salary pension provision are swiftly drawing to a close. What was once regarded as a basic employee’s perk now seems fanciful, and the idea that someone could retire and receive a substantial chunk of the salary that they retired on for the rest of their days is fast approaching becoming laughably naïve. Such employee rewards were illustrative of an era where people stayed with the same organisation from 16 years of age to 60, rather than move on every few years. Now, companies are keen to close the schemes to new members on the grounds of cost and “unrealistic expectations”, or close them altogether. Most final-salary pension pots have a massive shortage of funds — the result of stock market volatility, increasing longevity and tighter regulations. The world’s third largest arms manufacturer, BAE Systems, has seen its pension deficit triple in the past year from just over £1bn in the first six months of 2008 to more than £3bn in the same period this year. The pension deficit is due to the bonds the company has bought collapsing in value and inflation. On paper, the company made a loss of £70m compared with £599m profit the same time last year.

More widely, of the UK’s 7,400 remaining final-salary schemes, 87 percent were in deficit in July, with total losses of more than £200bn, up from £179bn in May, says the Pension Protection Fund. A survey released by PricewaterhouseCoopers, the accountant, this summer shows that only a quarter of employers offering final-salary pensions intend to keep the schemes open to existing members. Instead, employees are increasingly being offered one of three alternatives: a money-purchase plan, a career average revalued earnings (CARE) scheme or a cash balance plan. A study by Big Four professional services firm KPMG in August found that FTSE 100 companies were set to spend as much plugging pension deficits this year as they set aside to meet future benefits for current staff. The research said that a tipping point would come during the coming 12 months in which the cost of trying to close the funding shortfalls of the companies’ defined benefit schemes would be equal to the money they set aside to cover new pension benefits earned by workers. Tens of thousands of people now face lower than expected retirement incomes as more final-salary schemes close. BP, Barratt Homes, Barclays Bank and Morrisons are the latest employers to shut their final-salary schemes to existing members, leaving employees with inferior deals. In July, American Express, the financial services company, stopped making payments into employees’ stakeholder pensions, a type of money-purchase scheme. The freeze is expected to last 18 months. Staff had three percent of their salary paid into the stakeholder scheme and their own contributions matched by up to six percent. American Express closed its final-salary scheme to new members in 2006. Experts fear that other employers will now follow suit. Marc Hommel, of PricewaterhouseCoopers, says: “Sadly it is not only final-salary schemes that are affected by the current economic environment — employers will be looking to cut costs on all types of pensions.” The figures cited as evidence of the company pensions’ black hole makes for grim reading. According to the latest research by leading actuaries Lane Clark & Peacock (LCP), the current financial crisis has plunged FTSE 100 companies’ pension schemes into a £96bn deficit, more than double the £41bn estimated a year ago. In its 16th annual Accounting for Pensions report, LCP says that the deficit, which is calculated using data from mid-July 2009, is the largest recorded shortfall recorded under the IAS19 accounting standard currently used for pension schemes and illustrates the devastating impact that the financial crisis has had on pension scheme finances.

The cracks identified by LCP’s 2008 report in the IAS19 accounting standard – which requires companies to value liabilities using corporate bond yields – have widened considerably, says the firm. Not only have the IAS19 numbers continued to diverge from trustee funding numbers, but the wide range of corporate bond yields means that pension accounting numbers may no longer give a consistent comparison for two companies reporting at the same time.

LCP – like other actuaries – says that the fallout from the collapse of Lehman Brothers hit pension scheme assets particularly hard. It estimates that those FTSE 100 companies which reported in December 2008 revealed losses on pension assets of £42bn from the beginning to the end of 2008. However, the report also estimates that had new International Accounting Standards Board proposals to include pension-related losses and gains on company income statements been in force for 2008, aggregate reported profits for the FTSE 100 companies reporting in December 2008 would have been slashed by 70 percent (from £46bn to £13bn), due almost entirely to falling equity markets. Still, some FTSE 100 schemes benefited from earlier action taken to reduce their pension risks. Standard Life and Rolls-Royce Group, for example, both bucked the trend and disclosed gains on pension assets from the beginning to the end of 2008 of 14 percent and eith percent respectively. But the report found that some companies may be paying insufficient attention to their pension risks. According to LCP, while 46 FTSE 100 companies identify pensions as a key risk to their business, only 17 set out a policy in their report and accounts for dealing with pension risk. This is very different to the comprehensive approach taken by all FTSE 100 companies to their other financial risks (such as changing fuel prices or foreign currency exchange rates) where there is full disclosure on risk management.

Unsurprisingly, given the plummeting fortunes of the world’s stockmarkets and the resulting gaps in company pension schemes, companies are cutting back further on their defined benefit schemes. Only three FTSE 100 companies – Cadbury, Diageo and Tesco – now disclose that they offer defined benefits to new employees. Others have announced measures to reduce or freeze benefits completely for existing members. Furthermore, companies have again upped their assumptions of how long pension scheme members will live, adding another £8bn to balance sheet liabilities. This year saw the first longevity hedge deal by a UK pension scheme, as Babcock International transferred longevity risk for pensioners to the capital markets. LCP expects a number of deals of this type from FTSE 100 companies in the coming months. Falling schemata Bob Scott, partner at LCP, said: “The collapse of Lehman Brothers in September 2008 had a significant impact on the UK pension schemes of FTSE 100 companies. Asset values fell sharply yet, paradoxically, the effect did not show up immediately in company accounts as corporate bond yields rose and inflation expectations fell. However, since March this year, deficits have ballooned as aggressive cuts in interest rates and quantitative easing have caused these factors to reverse.”“Looking ahead, the outlook for the economy and financial markets remains unclear, creating further uncertainty for pension scheme finances. Those companies which work with their pension scheme trustees to identify and reduce pensions risk will be better placed to weather any future financial storms than those which fail to act.” However, some experts have pointed out that there has been too much focus on the pensions gap in FTSE100 companies, and hardly much discussion of the pensions black-holes of FTSE250 firms. According to a recent study, many midcap stocks appear even more vulnerable than blue chips. DS Smith, the packaging group and a member of the FTSE 250, was revealed as the most vulnerable to adverse pension movements, by one measure — the size of its pension deficit as a percentage of its total market value. Interserve, the construction services group, WS Atkins, the project consultants, and Go-Ahead Group, the transport operator, also appeared exposed on this measure. All four had larger proportionate deficits than either BT or British Airways, two FTSE 100 companies regarded as particularly vulnerable because of their past pension promises. Barclays Capital, which produced the study, warned that pension funding levels were often far worse than published numbers and that sponsoring employers would have to make higher contributions for years. One unfortunate side effect of quantitative easing, the Bank of England’s attempt to loosen monetary policy further, was that it was pushing down bond yields — which had the effect of boosting pension fund liabilities. Yields spiked higher in December, enabling companies with December year ends to report relatively healthy pension positions, BarCap said. However, companies with a March year-end have been hit by plunging bond yields and the fall of global equity markets and those with a March strike date for their triennial funding reviews could be especially hard hit as future funding requirements will be based on the health of their schemes at that time. BarCap also conducted the same analysis on large European companies: Bank of Ireland, Swiss Life, Allied Irish Banks and Lufthansa, the German airline, were revealed as having the largest deficits relative to their market values. BarCap emphasised that its analyses were no more than a static indicator of whether pension deficits could be material, adding that pension risk could not be judged solely on the reported deficit. Scores of companies are now planning to close their schemes for existing members, having already closed them to new recruits. A recent Watson Wyatt poll of large private-sector employers suggested that a million people currently accruing benefits will be disadvantaged over the next three years. But even this may not really help sponsoring employers, BarCap says. The high cost of closure, governance complexity and long-term nature of pensions meant that the short-term benefit would be minimal. The future may never have seemed so grim. Types of company pension scheme With the demise and potential closure of defined benefit pension schemes for new employees and even those are already scheme members, companies are looking to alternative models to reward their employees.

The main options are listed below:

1: Money purchase (defined contribution) These are the most common schemes, with employees and employers contributing to a pension fund that is usually invested in the stock market. When the employee retires, he or she uses the fund to buy an annuity that provides a set income for life. How much that is depends on how well the investments have performed, as well as annuity rates at retirement. There are no “guarantees” and the employee, not the employer, takes all the risks. Workers at companies such as Barratt, who are among those recently to transfer to a money-purchase scheme, could face a retirement income of about a third less than they had expected. Prudential, the pensions provider, says that a 25-year-old worker who begins paying into a money-purchase pension this year with his or her employer can expect to retire at 65 with a pension worth £16,023 a year in 2049 terms. If the same worker is offered a final-salary scheme, he or she can expect to retire on £57,714 a year.

2: Career average revalued earnings (CARE) Supermarket chain Morrisons’ is the latest employer to transfer its workers into a CARE scheme. These offer a percentage of a member’s average salary, rather than final salary, as a pension. This is better than money purchase as the pension is still “guaranteed”, albeit for a lower amount than it would be under a final-salary scheme. To calculate the pension, the average earning of each year of employment is uprated in line with current inflation. The totals are then added together and divided by the number of years of employment. So, as an example, a 25-year-old currently earning £26,000 could expect about £35,930 from a final-salary scheme after 40 years of employment. However, the same 25-year-old could expect £25,270 from a CARE scheme.

3: Cash balance schemes Under these schemes, employers will continue to provide some guarantees on the size of the employee’s pension fund. However, the fund is still used to buy an annuity, so there is no guarantee on income after retirement. Barclays now offers a “hybrid cash balance” scheme in which workers contribute three percent of their salary into their pension. In return the bank will provide them with a “credit” of 20 percent of their annual salary. The money that Barclays invests for the pension all goes into one pot, as with a final-salary scheme, but employees get a lump sum when they retire (the accumulation of their 20 percent credits) which they must use to buy an annuity.