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The demise of company pensions

31 October 2016 by John Stittle

The demise of company pensions - read more

Deficits, cultural shifts and regulatory complications have contributed to the dwindling health of pension schemes

The recent political turmoil concerning two well-known British companies has highlighted a financial time bomb ticking away in many companies’ balance sheets. Earlier this year, both Tata Steel and retailer BHS found that their pension scheme deficits had become the centre of business and media attention. But it is not just these two troubled companies that have problematic pension scheme deficits.

At the end of last year, a leading pension report suggested that around 1,000 private sector company schemes are unlikely to be able to meet their members’ entitlement. So, why in the space of less than two decades has the widely respected UK company pension sector now fallen into such a pitiful state? And, have accounting standards and greater pension regulation contributed to this demise? Or, more simply, have shareholders become just too greedy?

Until the 1990s, the vast majority of large companies, and even many smaller-sized companies, offered their employees a defined benefit (final salary) pension scheme. 20 years ago, many companies regarded the provision of a sound pension scheme as being essential to recruit, retain and motivate staff. Employee commitment and loyalty to a company would be rewarded by a good pension that ensured a reasonable standard of living in retirement.

The 1980s witnessed soaring global stock markets. As a result, most pension funds benefited considerably with their heavy portfolio weighting in equities. However, politicians and accounting regulators would soon intervene and muddy the pension waters.

Equity investment growth meant that a significant number of schemes became generously funded. So in 1988, this over-funding led to Nigel Lawson, the Chancellor in the Thatcher Government, imposing a tax on pension funds if they became in excess of 105% funded.

This taxation constraint on pension schemes building up their reserves led to many companies taking full or partial pension holidays. As a result, companies ceased or reduced their pension fund contributions, which resulted in their investment fund reserves weakening.

Reporting changes

Around the same time of the Lawson tax reforms, significant changes were also introduced to the accounting rules. In the UK, FRS17, Retirement Benefits, required companies to recognise their defined benefit pension deficits in their own balance sheet. The introduction of FRS17 coincided with a fall in UK equity markets, led by the collapse of the dot com mania, which made for a gloomy investment climate.

IAS19, Employee Benefits, shortly followed in a similar fashion to FRS17. It resulted in a further hammering of shareholder funds of many listed companies. By now, some companies were recognising unmanageably burdensome pension scheme deficits. As a result, many defined benefit schemes were withdrawn for new employees and, in some cases, even for existing employees.

In 2015, a firm of leading consulting actuaries, Lane Clarke & Peacock, highlighted a desperate picture in its annual survey of UK pension funds. Last year, these actuaries reported that only three FTSE 100 companies (Diageo, Johnson Matthey and Morrisons) provided any form of defined benefit pensions schemes to new employees.

The reasons for this removal of defined benefits schemes are both political and regulatory. Some analysts blame the former Blair Government’s taxation charges introduced in 1997, which prohibited pension schemes from reclaiming dividend tax credits. Some regard this change as lighting the fuse that destroyed the provision of defined benefit schemes.

This major taxation change alone deprived pension schemes of around £120 billion since it was implemented. Other analysts have blamed on-going sluggish equity markets and poor investment returns – combined with increasing life expectancy – which has made the plight of pension schemes even worse.

The regulatory and accounting changes in both FRS17 and IAS19 have also publicly highlighted the enormous funding gap in pension schemes. In fact, the accounting rules for determining these deficits is a direct consequence of FRS17/IAS19 that require pension scheme liabilities – essentially its pension commitments for future years – to be discounted and reported at their present value.

This discounting normally uses a rate similar to that of a high quality corporate bond. But with the collapse of interest rates and low bond yields in particular, the present value of pension scheme liabilities remains high.

Pension regulation

To complicate matters even further, as well as the IAS19 reporting burdens, the UK introduced new statutory pension scheme regulation under the Pensions Act 2004 that has wide and intrusive powers. Under the Act’s provisions, sponsoring companies that operate defined benefit schemes can be subject to the considerable proactive and interventionist powers of the Pension Regulator.

These powers can include directly intervening in the funding of financially ailing pension schemes and even require sponsoring companies to reduce the scheme’s deficit by injecting additional funding.

Although these regulatory powers can certainly benefit employees, they can, in practice, be yet another disincentintive for companies to continue having a defined benefit scheme.

A leading research group, the Pensions Institute, has recently issued an alarming report about the general financial health of UK pension schemes within the private sector. The Institute claims that around 1,000 corporate pension schemes, including 25 of the largest FTSE 100 companies, are unlikely to meet their full contractual pension commitments to pensioners.

Once again, it is claimed that the low gilt yields which hit the calculation of the pension deficit, together with increasing life expectancy, are to blame. The report suggests that the combined deficit of these 1,000 schemes is £45 billion and is an ‘unmanageable’ financial risk.

As a result, the report estimates that 60% of these companies will not be able to pay the full pension entitlement to members. Even more alarming, it is estimated that the remaining 40% may even see their sponsoring company collapse under the financial pressures of their pension
scheme burdens.

Tata Steel and BHS

Recently, two UK-based companies have highlighted the problems that defined benefit schemes can cause in corporate restructuring, seeking a purchaser or even just surviving. For BHS, using the UK reporting standard, FRS17, the retailer recognised a £271 million deficit in its defined benefit scheme before it recently went into administration. However, in practice, this accounting deficit even understates the size of the funding problem.

On a ‘buy-out’ basis, an external pension or investment company would be required to be paid an estimated £571 million to take on the ailing BHS pension scheme. But, as in the case of BHS, a failed sponsoring company can currently dump its defined benefit pension deficit into the hands of the Pension Protection Fund – that itself is largely funded by a levy on other pension schemes.

Likewise, Tata Steel – whose steel production costs are higher than heavily subsidised and low cost global competitors – is experiencing financial difficulty. Restructuring and arranging an asset sell-off or a management buy-out has been hampered by a £485 million deficit in its own pension scheme. However, recent estimates now believe the deficit may now be over £700 million. As a result, the Government is even considering legislative changes to reduce already contractually accrued pension benefits to alleviate the burden on the company.

OECD

The future is equally bleak when companies close their defined benefit schemes and offer defined contribution (money purchase) schemes instead. A recent OECD report sounded the alarm for not just defined contribution schemes in the UK but also for many countries around the world. It warns that, overall, on a like-for-like basis, employees retiring now will only receive about a half the level of pension income than similar pensioners who retired at start of the millennium.

The OECD places the blame particularly on the global fall in interest rates. It points out that most pension funds invest approximately 40% of assets for their pension funds in fixed interest securities and government bonds – with both categories now suffering from very low or nominal interest rates.

As well as giving low yields to the pension funds, globally low interest rates are hammering those pensioners who decide to convert their pension funds into an annuity on retirement. When these low interest rates are combined with little or no growth in many global equity markets, the future for these defined contribution schemes appears bleak too.

Preferential treatment

However, AJ Bell, the investment and stock broking services company, suggests that many companies are perhaps unduly prioritising the interests of their shareholders ahead of their employees’ pension provision. Its recent report highlighted that for the last two years there were 54 FTSE 100 companies that had an aggregate pension scheme deficit of £52 billion.

Nevertheless, these companies still chose to distribute dividends of an annual total of over £48 billion. Critics suggest that the level of these dividend distributions could be significantly reduced in order to offer greater support to their pension schemes – if companies choose to give priority to employee pensions.

However, responsibility for the demise of defined benefit schemes lies more on the interference by politicians and removal of pension scheme tax advantages, rather than on the impact of accounting regulation. In addition, poor investment growth and increasing life expectancy has also added to the burden of schemes. In an attempt to protect shareholders yields, companies are increasingly choosing to prioritise dividend payments rather then diverting cash to increase or protect pension benefits.

Even more worrying in the coming decades is the plight of current employees when they retire with inadequate or even no company pension provision. Many future retirees may be driven to seek state welfare support.

One aspect is clear: the era when UK companies were some of the world leaders in the provision of defined benefit pension schemes is clearly over.

John Stittle is a Senior Lecturer at the University of Essex

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