Employee benefits: pensions

British Airways, it has been said, basically looks like a pension fund that
happens to fly planes as a sideline. The world’s favourite airline is currently
considering whether to inject more than £500m into its chronically underfunded
pension scheme in order to clear its deficit. In return for this contribution,
it wants to negotiate an increase in the age of retirement, slower rates of
accrual of benefits, and changes to the early retirement rules. What was once an
attractive benefit for employees and employer alike has turned into a millstone
around the airline’s neck.

And BA is not alone. In August, actuary Lane Clarke & Peacock totted up
the combined deficit for FTSE 100 defined benefit pension schemes and reached
the staggering sum of £36bn. It is only a marginal improvement on the £37bn
shortfall calculated by the firm a year earlier. But since its 2005 calculation,
equity markets have continued to climb, fuelling speculation that the deficits
of these so-called ‘gold-plated’ pension schemes could be wiped out.

So could the good times return?

‘Has the crisis passed?’ Mike Smedley, a pensions partner at KPMG, asks. ‘I’d
say definitely not. We are in an environment where deficits are still going up
or not really improving despite the money that’s going in to them.’

He’s not alone in seeing it this way. David Robbins, a research and policy
manager at the National Association of Pension Funds, says: ‘Earlier this year
bond yields were up, the stock market was storming away and there were
predictions that if the trend carried on for another month it would have wiped
out the pension fund deficit. But it didn’t happen. We are not in surplus
territory yet.’

One of the worries about an over-reliance on a rising stock market to wipe
out pension fund deficits stems from the inherently volatile nature of equities.
The Lane Clarke & Peacock figure hides considerable swings in deficit sizes
during the past 12 months. In January 2006, the combined deficit for FTSE 100
pension schemes stood at £54bn; just three months later it had plummeted to a
mere £29bn.

Such swings create huge difficulties for companies as they weigh up how much
cash they should be pumping into the funds. It’s little wonder that most schemes
are now closed to new joiners, and Rentokil Initial’s move to shut its scheme to
existing members could be the first in a long line of closures in the FTSE 100
(see box). Elsewhere, companies like Debenhams are considering similar moves and
Harrods has recently told staff it intends to shut its scheme to all members.

‘We are seeing companies losing patience. Having sat on a deficit for a while
hoping it would go away, they are now saying they will have to do something
else,’ says Smedley. ‘We are seeing as much activity by companies looking to
reduce benefits as we have done at any other time in the past.’

And there are concerns that companies could be seriously underestimating the
liabilities facing their schemes. Pension Capital Strategies, a pensions
advisory division of risk managers Jardine Lloyd Thompson, believes the true
deficit of the FTSE 100 schemes could be as much as £100bn because companies
have underestimated the impact of future improvements in how long pensioners are
expected to live by as much as four years.

The problems are not confined to the largest UK companies, though there have
been improvements in the situation at some of the medium-sized listed companies.
PricewaterhouseCoopers calculated that the total defined benefit scheme deficit
for the FTSE 350 stood at £47bn in September, compared with £65bn 12 months
before. At the same time the funding ratio of assets to liabilities in September
2006 stood at 85%, up from 79% a year ago.

According to PwC, the assets of FTSE 350 pension funds have increased by
around 10%. This is partly due to favourable equity markets but also a result of
increased contributions from employers as the effect of new scheme funding requi
rements, introduced a year earlier by the Pensions Act 2004, kicked in. Also,
some employers made one-off special payments in the run-up to 31 March 2006 to
reduce their levy payable to the Pension Protection Fund.

But even with the reduction in the total size of pension fund deficits, it
would appear that companies have lost their appetite for providing defined
benefit schemes for employees. This may have little impact on younger staff, who
have not grown up in an era of final salary schemes, but will certainly make
companies less attractive to older recruits, who have been entitled to join such
schemes in the past.

PwC’s Marc Hommel says that companies will have to react in a positive way to
attract new recruits. ‘As employers grapple with the role of retirement planning
as part of their overall reward package, expect much more imaginative benefit
designs that enable companies to deliver a wider range of benefits with greater
control of costs and risks,’ he says.

At the moment, though, Hommel believes companies have yet to appreciate the
diversity of the UK’s workforce and are failing to explore the many alternative
options. ‘One-size-fits-all options are less attractive,’ he says.

One significant factor will be how paternalistic companies choose to be. A
generation ago many companies believed that providing a final salary scheme was
the right thing to do. But since then, control of the pension schemes has been
wrested away from the companies through legislation and regulator requirements,
according to Hommell. Given this, it is perhaps not surprising that companies
have looked

to transfer the risk of pension provision away from themselves and on to
their employees by setting up defined contribution schemes.

Alternatively, companies might seek to get out of pension provision
altogether. There has been growing interest in the concept of pension buy-outs,
where companies can pay an insurance company to take on their pension

Equities may well have hit a five-year high, but it may not be enough to
prevent the death of the final salary pension scheme as a prized employee

Too much money chasing too few bonds

Despite worries over the volatility of stock markets, companies could find
their pension schemes locked into equities, according to KPMG.The Big Four firm
says that there is a fundamental flaw in the theory that pension funds will
transfer out of equities and into long-dated sterling bonds once they are in

A study by the firm’s investment consulting team forecasts the likely demand
for such bonds – often considered to be a less risky investment than shares –
will outstrip supply by as much as four times.

KPMG estimates that if pension funds sought to transfer all their equity
holdings into long-dated sterling bonds once they were in surplus, the likely
requirement would be around £515bn.

According to KPMG’s research, the total value of long-dated sterling bonds
currently in existence is around £300bn.Some of these bonds – with an estimated
value of between £150bn and £200bn – are already held by pension funds with
defined benefit schemes.

That leaves between £100bn and £150bn of long-dated sterling bonds available
to satisfy a possible future demand in excess of £500bn.

Patrick McCoy, head of investment consulting at KPMG in the UK, says:
‘Wholesale swapping into long-dated sterling bonds as a low-risk strategy to
plug deficits is just not going to work for UK pension funds with defined
benefit schemes. The bonds are not available. The squeeze in the bond market is
likely to continue to suppress yields.’

Who will follow rentokil?

Only one company in the FTSE 100, Rentokil Initial, has so far announced that
it will be closing its final salary scheme to existing members, but many others
are expected to follow over the next six years.

This is the stark warning from actuarial firm Lane Clarke & Peacock,
which believes dozens of FTSE 100 companies are set to close their final salary
schemes between now and 2012 in an attempt to cut pension costs.The closure of
such schemes – often referred to as ‘gold-plated’ because they guarantee a level
of pension provision regardless of stock market performance – will force
thousands of employees into private pension schemes. In the process, the risks
associated with fluctuating asset values will pass from shareholders to staff.

Lane Clark & Peacock made this dramatic prediction when it launched its
latest review of pension deficits in August this year. Speaking at the time,
partner Bob Scott said: ‘I think that by 2012, the majority of companies that
offer defined benefit schemes to employees will have closed them to new

More than 90% of FTSE 100 companies have a final salary scheme, and most have
closed to new members. But many companies have been reluctant to shut their
schemes completely for fear of staff anger and the resulting adverse publicity.

When Rentokil announced the closure of its scheme, the unions declared the
company had ‘behaved like the vermin it is paid to extinguish’.

Ironically, the predicted growth in the number of schemes closing has been
blamed in part on recent legislation designed to encourage companies to do more
to tackle their pension deficits.

Charlie Finch, a consultant at Lane Clark & Peacock, said: ‘Although the
new legislation makes it more likely that pension scheme members will receive
their promised benefits, the price could be more scheme closures as companies
are forced to commit cash to funding their deficits instead of paying benefits
for current employees.’

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