5 November 2012
The high levels of defined benefit (DB) pension scheme deficits are hampering the ability of UK companies to invest in their businesses, according to a new report published by the ICAEW and Mercer, the global consulting leader in talent, health, retirement and investments.
The report, ‘Living with Defined Benefit Pension Risk’, investigates attitudes to DB pension risk amongst the finance directors (FDs) and other senior leaders of some of the UK’s largest companies. The report also highlights the impact of the current depression of long-term gilt yields on the UK’s DB pension schemes is amongst FD’s greatest concerns, with Quantitative Easing (QE) often blamed for contributing to inflated scheme deficits.
According to those interviewed for the report, more than half (57%) said that their DB pension scheme will have a negative impact on the financial performance of their business over the next three years.
Respondents also highlighted that QE in particular has been perceived to have inflated scheme liability values, pushing their companies to increase their contributions to fill expanded pension scheme deficits. In parallel, the effects of QE have also made it prohibitively expensive for UK plc to implement DB risk mitigation strategies to help them manage the volatility behind their pension schemes.
Robin Fieth, Executive Director, ICAEW said: “DB pension schemes are under unprecedented pressure, the result of increasing longevity, difficult market conditions and a tough regulatory environment.
“Although recent years have seen many schemes close to new members and future accrual, DB is still an important part of the UK pensions landscape with around £1 trillion still invested in DB schemes. This research has provided valuable insights into the ways in which companies approach the management of DB risk.
“The difficult market combination of low gilt yields and euro zone uncertainty is hitting pension schemes hard. Many companies face the stark pressure of ploughing considerably more cash into their pension schemes, being unable in practical terms to agree longer recovery periods with their trustees. It is vital that employers take a proactive approach to balancing the need to meet their DB pension obligations whilst conserving cash, and investing in the future growth of their businesses.”
He concluded: “That’s why we believe that the Pensions Regulator may in future need to allow companies with schemes like these to take more account of wider economic factors when considering the duration of recovery plans, so that businesses are able to invest in growth and job creation.”
According to the report, the method of calculating pension scheme liabilities is typically linked to long-term interest rates so that as long-term gilt yields reduce the calculation of liabilities increases. Therefore scheme liabilities and deficits are perceived to have been inflated by the effect which QE has had on reducing gilt yields. For many sponsors, that position is prohibitively expensive to lock into, so they are biding their time until gilt yields recover.
“Our research reveals a paradox,” explains Mr Ali Tayyebi, Senior Partner at Mercer. “While the negative impact of DB pension scheme deficits is clear, companies face a quandary. The current environment which emphasises the need for a clear risk management strategy, is also the one in which it is most difficult to implement de-risking strategies. Companies are concerned about being locked into low interest rates, and the scope to increase cash contributions to their pension schemes in the current environment is limited.”
“Despite these challenges”, continued Mr Tayyebi, “our survey confirms a strong recognition of the need to take action and progressively mitigate or reduce pension risk. Almost 80% of respondents either already have or expect to have a glide-path or journey plan of de-risking triggers in place over the next three years.”
The report highlighted that management of DB pension scheme risk is recognised as a priority in almost all companies. As expected, attitudes depend on the size of the scheme relative to company turnover and the scale of the deficit. Nearly 40% of the reports participants said that DB pension risk is the most, or one of the most, important risk management priorities for their organisation. Of most concern to FDs are: the impact of low gilt or bond yields increasing liabilities which is often attributed to the Bank of England’s QE programme; the level of funding required or reducing the deficit in the DB pension scheme; volatility in the size of the deficit and investment performance.
While the high costs of current discount rates have made the total transfer of risk prohibitively expensive, there are a number of ways that FDs are managing their DB pension scheme risk. Most organisations in the report (93%) said that they have closed their schemes to new members and many (51%) have closed them to future accrual (although a third of companies have no plans to follow suit). As well as 38% saying they plan to develop a ‘glide-path’ or journey plan of de-risking triggers, more specifically over the next three years, 34% plan to invest in assets that more closely match liabilities. 22% plan to offer enhanced transfer values (ETVs) to existing members while 20% plan to employ alternative funding or contingent assets.