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’ UK 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.
