Pressure increasing on DB pension trustees to fully fund schemes

In the 1970s and 80s, if a company was to put a pension scheme in place for their staff, it would likely be a final salary, or defined benefit pension scheme. This was done regardless of size, and was offered to employees as a promised benefit based on the number of years they worked for the company, and the salary they earned.

Recently, we have seen a vastly different economy with low interest rates and little incentive for loyalty. Legislation has meant that employees have more protection when leaving a company’s service and are far more likely to change companies every few years. This has become the norm. In fact, research done by LV= found that employees on average will change employer every five years.

These ‘old school’ pension schemes were seen as a long-service reward, and therefore not in an employer’s best interest to implement if employees leave quickly. Employers began winding these schemes down, no longer offering such schemes to new employees.

However, an estimated five and a half thousand schemes remain in the UK private sector, with over two thirds recording a deficit, meaning the scheme does not have enough assets to fully fund and cover its existing membership.

Speaking to Accountancy Age, Robin Hames, institutional director at wealth management firm LGT Vestra, said: “Through successive legislation and through changes in the nature of our economy and behaviour, the costs kept going up for this promise that the employer was underwriting.

“It got to the stage where employers started to close their schemes, and then perhaps wound them up. But many didn’t. Because interest rates have been so low, and they ultimately influence how you calculate the cost of meeting those promises, the costs have gone through the roof.

“Over the last 10 years, an awful lot of companies have been faced with a position where the assets they held within the scheme were deemed to be insufficient.”

Recovery periods

In this scenario, trustees and firms must calculate recovery periods – the length of time it will take them to fully fund their pension schemes. Firms are required to account for this cost in their financial reporting, which is where accountants come in.

Hames said: “Auditors now need to include an estimate of the deficit within the company’s reporting accounts.

“Companies are having to continue to contribute to schemes where they may have no current employees still in the scheme, but they’re having to make ongoing contributions to try and fill this gap, this shortfall.

“If a company that has one of these schemes, it’s really high on the board agenda, because it impacts profitability year on year, and it impacts their report and accounts year on year. It’s a very immediate challenge for businesses.”

Trustees of pension schemes are under a great deal of pressure to resolve them, and to get them to a stage where they are fully funded. It is in their best interest to get as much money out of businesses as possible to do so. They are also very aware that there is a need to balance this with ensuring a business is still viable in the long-term. It is a difficult balancing act.

Larger companies, more often than not, have enough capital to manage such schemes, says Hames. In the majority of cases, he argues, if FTSE100 companies were to stop paying dividends for a single year, they could return their pension schemes to a fully funded position. Whether that is realistic or not is a different question, but it shows these firms have the capability.

The greater problem lies further down the market, with small and medium businesses (SMEs). Long-running family owned businesses, for example, can have very large pension deficit in comparison to the capital value of the company.

“A lot of these companies are in relative terms quite small. They have these pension schemes because of their longevity,” said Hames. “The size of the deficit in comparison to the capital value of the company can sometimes be quite a frightening ratio.

“While the numbers may not be the giant numbers you see with British Airways, for example, we come across plenty of companies that have deficit of five, ten, fifteen million pounds, which is a very significant amount of money compared to their market capital.”

Given that this deficit is included in a company’s valuation, it can have a big impact on what could be achieved if the company was to be sold. Not only are these schemes impacting businesses by diverting profits into a legacy pension, but they are also impacting the value of the company in the open market, and its ability to raise capital.

Pension regulator seeking greater powers

The 2019 pensions bill is currently in limbo owing to the country going through a general election, but industry experts predict that this bill will go through regardless of who finds themselves in power following the vote.

Part of this bill includes greater powers for the Pensions Regulator, and it is expected the regulator will look to clarify its position on defined benefit schemes and look to decrease pension scheme recovery periods.

Currently, the average recovery period is around seven years, meaning many of the 3000 smaller schemes that are currently in deficit won’t be fully funded until the end of the next decade, and even into the 2030s.

“What we’re likely to see is the pensions regulator will set out a much clearer framework on what it sees as acceptable,” said Hames. “There’s talk of them creating a ‘fast-track’ – meaning, if you meet certain criteria, you will see light regulation. If you don’t, then you will have to explain why not, and explain why the recovery period is as long as it is.”

This could also lead to scrutiny of investment portfolios and plans for getting members back to being fully funded. This will likely lead to negotiations between trustees and employers to become more complicated, as trustees are under more pressure to fully fund the schemes and will put pressure on businesses to contribute more.

Smaller businesses that are at risk of collapse are more likely to be targeted by trustees. Hames said: “We’ll see more pressure from the regulator on trustees to sharpen their pencil on what’s called covenant assessment. Their assessment of the financial strength of the supporting employer.

“Ironically, the weaker the employers seem to be, the greater the pressure on the trustees to extract more cash to secure the members outcomes, which I know seems counterintuitive. But if you think trustee has a fiduciary duty to the membership, then if there’s any question mark over the financial strength of the employer, that should spur them into trying to secure more money now, with a lot of recovery plans.”

For accountants, particularly those taking up an advisory role for businesses, it is important to have a good understanding of how much a business is expected to contribute by a scheme’s trustees, and ensure that this figure is taken into consideration by financial decision makers when taking on risk.