Until recently, companies that wished to move the liability for a final
salary pension scheme off balance sheet had few options. They could secure
immediate and deferred annuities from an insurance company or they could arrange
to transfer the scheme to another company as part of a corporate transaction.
These routes have become increasingly expensive, leading most companies to
continue to run closed schemes.
In recent months, new choices have emerged. First there is a new breed of
pension fund consolidators who are expected to compete with long-established
insurance companies. More controversially, news is emerging of companies
offering incentives to encourage members to transfer out of a scheme to reduce
the liabilities before the company pursues a more conventional solution.
Most final salary pension schemes are now closed to new entrants. A smaller,
but growing proportion have also closed to future accrual but are still run as
closed funds, paying pensions as they fall due. Over much of the past few years,
deficits in these have remained stubbornly large despite rising equity markets
because long bond yields have fallen.
Although FRS17 deficits have declined in the last three months, the cost of
securing benefits with an insurance company (‘the buyout liability’) is still
larger than the funds available in all but a handful of schemes.
Watson Wyatt estimates the theoretical buyout deficit for the companies
making up FTSE 100 is still a huge £130 bn.
Faced with costs at this level it is not surprising that relatively few
companies have chosen to go down the buyout route. This may change if markets
continue to move in the buyers’ favour.
Late in 2005, in a bold decision relating to the clearance of the sale of the
bulk of the Marconi business to Ericsson, the Pensions Regulator let a chink of
light into this impasse. Until this clearance many people assumed that, if funds
were available, the regulator would insist they be used to provide security for
members of a pension scheme up to the level of security provided by an insurance
But the regulator gave clearance for about £600m to be returned to Marconi
shareholders by way of a special dividend, on condition that just under £200m
was paid into the pension scheme, with nearly £500m placed in an escrow account.
Even if the whole of the escrow was treated as a pension asset, it would only
have covered around 85% of the notional cost of securing the benefits with an
This ground-breaking clearance, and the pent-up demand, has encouraged a
number of new entrants into the pension scheme buyout market: Paternoster, led
by Mark Wood; Synesis, founded by Isabel Hudson and the Pension Insurance
Corporation, backed by Edward Truell. At present, it seems likely that some of
these new entrants will offer conventional insurance products, competing with
Prudential and Legal & General which dominate that market. What will be more
interesting is if they take advantage of the Marconi precedent and offer
companies the opportunity to crystallise their pension liabilities at a
significantly lower cost than the insurance market would charge.
Although this development might be seen as controversial, it could only
happen with the active engagement of the regulator. A more contentious trend is
that of some companies offering pension scheme members financial incentives, in
excess of their normal transfer values, to leave a scheme.
This can be financially worthwhile to the company because, even including the
cost of the incentive, the amount paid would normally fall well short of the
amount an insurer would need to purchase a deferred annuity for the same member.
There are concerns about the amount of information and advice offered to
members to help them weigh up the options. While some commentators have
criticised these arrangements, suggesting the members are giving up valuable
guarantees, others point out that the individuals have a free choice and may
attach a higher value to immediate financial reward than would be implied by the
yield curve on corporate bonds.
Before embarking on any of these exit routes those responsible for operating
a closed defined benefit scheme would be well advised to take some simple steps.
They should make sure that the company’s interests are taken into account where
appropriate. In the past they may have relied on the trustees to do this, but
they have their own responsibilities.
Part of this control, which may need to be negotiated with the trustees,
would be over asset allocation, ensuring that it reflects what the company sees
is an appropriate balance between risk and reward. In addition, time spent
ensuring that membership data is in good order will pay dividends should a later
exit be sought.
Closed final salary schemes have for too long been like Mr Rochester’s mad wife,
locked in the attic, out of sight, in the hope that they will disappear. It
seems the keys to the door may soon be available.
CLOSED FINAL SALARY SCHEMES
OPTIONS GOING FORWARD
Buy out? Has high cost and possible capacity problems, but
offers complete certainty
Transfer? Needs a suitable receiving scheme but can offer
economies of scale
Carry on? Deficits are reducing, but risks remain for
Encourage transfers out? Controversial, but can make
subsequent use of traditional routes more viable
Wait for pension consolidators? Could offer the certainty of
buyout at little more than the cost of carrying on
ACTION UNDER ALL OPTIONS
• Pay attention to discretions
• Take control
• Make sure membership data is tidy
• Adjust asset allocation to achieve balance of risk and reward
Stephen Yeo is senior consultant at actuaries Watson Wyatt
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