28 August 2019 by John Stittle
There is good news at last for the FTSE pension funds-but is it too late?
It has been another miserable year for many company employees expecting a secure pension in retirement. The trend leading to the extinction of traditional final salary defined benefit schemes shows no signs of abating. Companies are still continuing to close, de-risk and off-load their defined benefit pension fund liabilities. But do recent reports indicate that FTSE100 companies are acting too hastily in closing their pension funds? And are employee members of defined benefit schemes now suffering unnecessarily?
The bleak picture for defined benefit (DB) pension funds continued this spring. John Lewis, the UK retailer, announced the closure of its £6bn DB pension scheme. Rolls Royce then followed and ditched over £4bn of pension liabilities in a complex deal with the insurer Legal and General. Indeed, over the past year, other companies including Marks and Spencer, British Airways, Vodafone and ITV reported that they had also implemented various forms of pension fund ‘buy-ins’ and transferred pension liabilities to external insurers and finance groups.
There are many factors that have led to the demise of DB schemes over the past two decades – such as political influences, changes in pension fund taxation and the size of pension fund deficits. All these pressures have combined to place financial pressure on both company balance sheets and cash flows. In practice, IAS19, Employee Benefits, has been criticised for requiring sponsoring companies to recognise DB pension fund deficits in their own balance sheets. The Pension Regulator is now also becoming more vigilant in ensuring companies fill financial black holes in their pension schemes with large cash payments over shorter time scales.
However, a report issued this spring by international actuaries, LCP has highlighted that the tide of financial fortune may be changing in favour of DB schemes. The actuaries announced that for the first time in 20 years, 2018 ‘saw the aggregate FTSE 100 pensions accounting surplus [existing] throughout the whole year’. And significantly, this good news for employees continues so far this year too. LCP further point out that since companies have been making ‘large contributions and reducing levels of pension risk’, the pension benefits of employees are ‘now more safer and more likely to be paid than ever before’. These comments are highly significant; they undermine many of the arguments of companies that continue to seek closure of their own DB schemes – or at least those that still remain.
Even more reassuring for these remaining DB pension schemes, IAS19 determines pension fund surpluses on ‘a relatively low-risk basis’ – with the investment returns of these funds largely expected to be around 1% pa above gilt yields. But, as LCP points out, in practice, modern investment strategies are frequently expected ‘to deliver returns significantly more’ than the returns usually assumed under the IAS19 rules. The level of these interest rates is important in order to determine the discount rate to be applied in valuing future pension fund liabilities.
Indeed, in practice, there is often considerable variation in these interest rates. Some company pension funds have used discount factors ranging between 2.7%pa and 2.9%pa to determine the present value of pension liabilities.
However, there is another important factor that directly impacts on pension fund deficits. For several decades, companies have warned that the lengthening of the life expectancy of pensioners was imposing ever- increasing and unsustainable burdens on pension schemes. Some companies have previously referred to increasing life expectancy as a major justification for their abolition of their final salary DB schemes. But in March this year, the Institute and Faculty of Actuaries announced that its latest Mortality Projections showed that the rate of improvement in life expectancy over the coming decade was expected to be slower than the first decade at the start of this century.
Further evidence from LCP also showed that the number of deaths in England and Wales ‘in 2018 was the highest since 1999’. Indeed, these actuaries reported that more companies are now working on the updated assumption that average life expectancies at age 65 for both men and women are now five months lower than those reported in 2017. But LCP sounds a note of cation. The actuaries warn that ‘no-one knows whether life expectancies will continue their downward trend’ but, if they do, then the potential accounting consequences may be significant.
LCP also highlighted that individual companies also reported considerable differences in assumed life expectancies for their own employees. The median life expectancy in 2018 was 87.5 years but some companies chose to assume expectancies ranging from 85 to around 89 years – a marked variation. This degree of variation implies companies, together with their actuaries and auditors are making their own ‘significant judgements’ of life expectancy of employees. Indeed, differences of just three years in life expectancy are equivalent to around 10% of gross defined benefit funds reported under IAS19. These differences in assumed life expectancies equate to around £50bn of gross liabilities for FTSE100 companies. As such, in effect, around £50bn is being based on ‘subjectivity’ and ‘decided by company directors for company accounts’.
Although the assumptions made about reduced life expectancies and increased discount factors combine to improve the net surplus of pension funds there are ‘tensions’ that may potentially counter the impact of these positive changes. As a result, LCP state that companies may find themselves ‘being pulled in opposite directions’. The report identifies increased pressure from The Pension Regulator to ensure companies improve the financial health of their pension funds at a faster rate and to ‘mend the roof while the sun is shining’. Other pressures have come from the FRC which has already found that improvements are required in the audit of IAS19 issues.
However, there still lurks a potential change in accounting regulation that may potentially increase pension deficits in the coming years. For the Iast five years, the IASB’s International Financial Reporting Interpretation Committee (IFRIC) has been considering changes to tighten the deficit reporting rules. Although earlier plans were ditched – revised proposals in IFRIC14 are now under formulation. These revised proposals may mean some FTSE100 companies will have to recognise additional liabilities in excess of the IAS19 requirements, based on potentially extra pension fund contributions that a sponsoring company may have to contractually pay in the future. But this extra contribution is often based on how a pension scheme trust deed has been legally constructed.
Although LCP only reviewed FTSE100 companies, another report from PwC/Skyval examined the overall financial health of all of the UK 5,450 company defined benefit pension funds. Nationally, the financial health of these DB schemes showed an improvement, but, overall, there still existed a substantial aggregate deficit. PwC found that the total DB deficits were £230bn in November 2018, but significantly falling to £180bn in April 2019. Steven Dicker, PwC’s chief actuary, admitted that these pension funds were recently benefiting from an upward trend in both equities and in bond yields and from the slowing down of life expectancy improvements. Nevertheless, there is a clear distinction between the improving state of FTSE100 company pension funds and the on-going deficits of the majority of smaller and medium sized companies.
It is important to place into context the dramatic reduction in providing final salary DB schemes that has already taken place. Currently, only two FTSE100 companies, Croda and Johnson Matthey, offer DB schemes to new employees. Increasingly, even existing staff are being affected – with only 41% of these FTSE companies now offering DB to existing employees. Other remaining FTSE100 companies are also increasingly taking steps to de-risk their DB pension schemes – if they are still operating this type of provision for employees. Many pension schemes have reduced their holdings in more risker equity investments in favour of less volatile investments.
In the past two decades, it appears that many FTSE100 companies may have taken an unnecessarily over-pessimistic and too short term-ist view about the future of DB schemes – and have rashly closed them. The tide may now be turning and DB schemes may actually prove to be a financially viable form of compensation benefits for all levels of employees. Even so, smaller companies are still facing problems. But for most employees, the more favourable recent data for pension funds has probably come too late. Since the corporate fashion has been to de-risk and abolish DB pensions, it is unlikely that these schemes will be re-introduced.