Another nail in the coffin for final salary schemes – deficits mean more closures or buyouts inevitable. Bad for annuity markets, public sector schemes next?

by Dr. Ros Altmann

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Pension schemes back in deficit – surpluses were an illusion…
The latest research from Lane Clark and Peacock makes pretty worrying reading. UK final salary scheme members, employers and their shareholders breathed a sigh of relief last year when accounting figures suggested FTSE 100 companies had a combined IAS19 (accounting measure) pension surplus of £12bn in July 2007, however the latest estimates for July 2008 show this has turned into a net deficit of £41bn. Last year’s ‘surplus’ lulled people into a false sense of security but was probably an illusion. In reality, being in ‘surplus’ on IAS19 is a weak test and does not mean the scheme has enough money to pay all members’ pensions over the longer-term. There is scope to massage the numbers, because of the lack of standardisation of discount and mortality rates used. This creates a misleading picture of pension scheme health.

Employer contributions have fallen – member security too weak…
The research shows pension contributions fell from £13.4bn to £13.1bn over the year and suggests that most companies have not done much to reduce their pension risks. This is a real worry for scheme members, who are still – in most cases – just unsecured creditors of their employer. Trustees urgently need to try and negotiate improved security over company assets.

Tussle between shareholders and pension scheme members…
Obviously, as the economy worsens, there will be competition between the interests of shareholders, who want to delay putting money into a pension scheme and members, who need more money in the schemes to make up the deficit. Pension scheme liabilities are real and shareholders must recognise that either more assets or more money must be assigned to meet past pension promises.

More scheme closures inevitable, only public sector immune…
It is inevitable that employers will keep on closing schemes to both new and existing members, especially in the face of so much uncertainty around the funding and costs. This is the final chapter. Employers will also continue to look for ways to get rid of the huge risks they are facing. So far, of course, public sector workers are immune from such problems, but taxpayers will face mounting funding pressure in future, just as private employers are struggling with pension costs now. At least the private schemes have some money invested to help pay the pensions, in the public sector most schemes are completely unfunded!

Attraction of buy-outs enhanced…
The bottom line is that companies will become increasingly desperate to find ways to get rid of their pension scheme risks. There is £1trillion invested in pension funds and many large schemes are looking to the new buy-out vehicles to help share the risks. In fact, shareholders have not yet appreciated the very significant benefits to a company if they do manage to buy out some or all their liabilities. The costs of buying out will rise as there may well be capacity pressure in this new market. This will be a particular problem for smaller or very large schemes. Also, as more final salary scheme liabilities are converted to annuity-style contracts, there is bound to be pressure on conventional annuity markets with rates worsening overall. This is a worry for future pensioners who will need to rely on annuity markets to provide their pensions. The Government has not yet recognised this looming risk but it is there nonetheless.

Bottom line…
Final salary pensions promise will soon be a thing of the past for private sector workers. Public employees will become the pension elite for a while, but cost pressures will burden future taxpayers too much and, in years to come, we as a nation will face even greater problems with funding public sector pensions than the private sector is struggling with to fund its historic pension promises now. The sooner the Government gets to grips with this, the better, for all our futures.

Dr. Ros Altmann
5 August 2008

NOTES:

1. There are significant differences between accounting and actuarial methods of pension scheme valuation. On an actuarial measure, the value of liabilities is much higher than the value shown in the accounting measure, for example because international accounting standards use the AA corporate bond yield which is a higher discount rate than gilts and there is scope to ‘fiddle’ mortality assumptions too.
2. Being in ‘surplus’ on IAS19 does not guarantee there is enough money to pay all members’ pensions over the long-term and the funding position can vary sharply from one month to the next. For example, some companies who report to the year ending March 2008, when corporate bond yields reached a high, will show a much better picture, but bond yields have fallen since then. In addition, equity markets have declined, while inflation has increased – all of which lead to worsening scheme funding.
3. Trustees have not embraced the use of modern methods of money management to improve risk controls and hedging techniques that are second nature to corporate finance departments. This makes schemes and members more vulnerable to markets than they otherwise would be.
4. Perhaps it would be very helpful if there could be more encouragement for smaller schemes to consolidate, in order to improve economies of scale and also improve speed of investment decisions. Most trustee boards would benefit from pooling investment and hedging strategies and better protection against both falling assets and rising liabilities.