Pensions deficit: tip of the iceberg

When defined benefit pension deficits first emerged as a significant problem,
it happened quickly. New on-balance sheet accounting disclosures, rising
longevity expectations and falling bond yields were all contributing factors.

The arrival of the Pensions Regulator in 2005 placed an even greater
spotlight on the issue. Investment banks and other advisers have set up varying
advisory offerings and financial products to those affected. This financial
advice is distinct from actuarial and legal expertise received from longstanding
scheme advisers.

However, some commentators argue that such financial advisory services will
be short-lived because the problem might evaporate in the next two to three
years. Reasons for this include rising interest rates with associated
improvement in bond yields and the continued bull-run in the equity markets.

This is a view supported by research from Aon, which found that the total
FRS17 deficit for the 200 largest pension schemes has fallen to just £14bn, its
lowest monthly level since records began. It also showed that 30% of those
pension schemes are now in surplus. While these factors may assuage deficit
levels, the pension deficit issue is a long-term issue in need of a permanent
new advisory need.

One of the main reasons for this is that the direction of accounting
standards surrounding pensions is towards greater prudence and disclosure. Some
accountants have commented that FRS17, while an important step in pensions
accounting, is notable for permitting ‘pre-booking’ of assumed future equity

Another inherently long-term factor is mortality. Views on mortality differ
markedly although it is generally seen as prudent to plan for increasing
longevity and if wrong be pleasantly surprised. The financial markets have not
yet developed an effective method of managing and trading mortality risk.

Increased focus on employer covenant strength, following the introduction of
the scheme specific funding regime of the Pensions Regulator, reminds us that
funding risk or the credit strength of the sponsoring employer is not absolute.

There are growing concerns that we may be reaching the top of the credit
cycle. Over 6,000 defined benefit pension schemes remain operational. Fuller
disclosure of underlying risks and mortality are just some of the arguments for
specialised, expert advice on how trustees and sponsor companies can address
their deficit and look after the interests of scheme members.

Darren Redmayne is MD and head of European pensions
advisory group at Close Brothers

Related reading

Fiona Westwood of Smith and Williamson.