After BHS brought pensions deficits sharply into focus there is an opportunity with the 2017 pensions green paper to make sure pensions provision is fit for the future
This autumn, newspaper headlines informed us that the collective deficit of the UK’s 6,000 defined benefit pension funds had grown by a staggering £100bn in a single month. According to a report by PwC, that brought the total shortfall to £710bn. On some measures the figure is more than £1 trillion.
“Defined benefit (DB) schemes are expensive because of the open-ended nature of the promise they give,” says CBI director for people and skills, Neil Carberry, of the pension schemes that promise to pay out a specific amount for life, based on factors such as employees’ final salary and years of service. “They’re more expensive than people thought when they were created because of longer lives and higher regulatory requirements. This has been compounded in recent years by low gilt rates that mean future promises are assumed to cost more now as the discount rate falls. With all this in mind, most schemes today are in some form of funding deficit.”
Part of the reason is that employees are living significantly longer after retirement. In 1960 the average American, British or Japanese 65-year-old man tended to go on for another 11-13 years. For women, it was 14-16 more years. Today, men can expect to live another 18-19 years and women 20-24 years. The contrast may be especially stark for employees at companies where hard manual work was once the norm.
The other major factor to have increased deficits in DB pensions is a significant downturn in bond yields, which are a critical component in the way the industry evaluates liabilities. The underlying assumption is that the expected returns from secure, long-term bonds go a long way to deciding the true value of a fund. So when these endure a prolonged period in the doldrums, as they have done recently, the amount companies calculate they must pay to cover the shortfall goes up.
By and large, companies now prefer to offer defined contribution (DC) pensions, where the value of the pension is governed by contributions from the employee and employer (along with some investment returns), which are paid into a pension pot. No further promises regarding pay-outs are made, meaning the company always knows precisely what its pension provision costs. These are less risky for employers – although it should be noted that a trend toward DC pensions, has also seen falling contributions from employers as well as risk transfer to employees, , which could leave us with a generation of pensioners who have underestimated how much they would need to fund their retirements.
But the problem of DB deficits might not be so severe as the headlines suggest. “Some understand the way that pension schemes are measured and that this is an estimate,” says Carberry. “But, to others, it’s just like an outstanding debt that somebody owes and that should be paid.” When speaking to the Work and Pensions Select Committee, Carberry said that there is no reason to assume a deficit figure as calculated on a given day is an accurate measure – but rather one of a wide range of possible outcomes. Allowing for this in how we discuss DB pensions is a powerful tool in unpicking the difference between the vast majority of schemes, some of which are in deficit but can escape it through their recovery plan, and the much smaller group where there is genuine concern.”
Carberry says that “just because a scheme is in deficit, is not a sign that the scheme is necessarily unhealthy.” That’s because pension liabilities tend to fall due in a staggered way, over a period of decades. And because low-risk bond yields aren’t the only source of return available.
One thing that can be done immediately, he says, is for the pensions regulator to “remind everyone that you don’t have to price your liabilities strictly on gilts. The legislation is very clear that you don’t have to do that, but everybody does. The regulator should also be extending flexibility in recovery plans where appropriate, so that firms can support both their schemes and the growth of the company. By far the greatest protection any scheme member has is a successful sponsoring employer.”
Willis Towers Watson pensions consultant Mark Duke says that investing in infrastructure might be one way for funds to find more attractive returns and close the deficit gap through asset growth. Opening up more illiquid assets such as property schemes could be another option, according to Carberry. But, Duke warns, it’s possible that the scale of such investments will only be large enough to “scratch the surface.” As things stand, funds are limited to investing just five per cent of their total pot in a single project.
Smaller funds may benefit from some form of consolidation. “We need to ask how we can ensure that smaller pension funds can acquire the expertise needed to access these investments,” says Duke. “That raises issues regarding how we might pool some of these smaller funds so that they can access a higher quality of governance and a broader range of investments. I think that’s a possible direction of travel.”
Another mitigating factor might be for companies to switch from indexing their DB funds with the RPI (retail price index) measure of inflation - which they are no longer required to do by law - in favour of the less onerous CPI (consumer price index) measure.
“For those funds that are a bit more troubled, and need to index at the legislative minimum, it just seems right that they can use the CPI measure,” says Carberry. “But that’s about as far as CBI members would ever go at benefit redesign. There is a strong feeling among members that government should not be looking at allowing companies and schemes to reduce pensions promises that people have already accrued.”
“Probably the vast majority of schemes are in the place where they’re expensive, but their employer – over time and with the right degree of flexibility – will be able to meet the promises of the scheme.”
“The difficulty,” says Menzies chief executive, wealth management, Ben Simpson, “is that there are some very big employers out there with some very big pension schemes attached. In some cases, the pension schemes might be somewhat larger than the company. You’ve got to think about the affordability of the funding plan, which only works if that company is going to be staying in business and able to afford and make those contributions. It’s about good business practice, having an understanding of what the liabilities are and coming up with a sensible, affordable plan to improve the liability position.”
Carberry says: “The challenge is making sure that enough goes into the pension scheme, but also that enough is invested in the company itself to ensure that money continues to be available in the future.”
Sometimes, of course, businesses go bust – as happened this year in the case of BHS, leaving behind a £571m pension deficit and the prospect of a large dent in the government-instituted but privately funded Pension Protection Fund (PPF). “Businesses that fail will always be with us,” says Duke, who points out that there have been no revelations of clear illegality in the run-up to the demise of BHS. “We have a legal infrastructure and a way of protecting people who are members of pension schemes of companies that fail, so I think you have to ask the question: Is what we have enough? There’s a lot of protection already in place.”
“There’s a strong history of government legislating too quickly in pensions and perhaps making the problem worse,” says Carberry, who points to the 1995 Pensions Act, which was brought in as a response to the Mirror Group pension scandal. “That actually led to the legislative scenario that allowed the problems with Allied Steel and Wire to happen. That was what led to the 2005 Pensions Act and the PPF.
“Now we have a stable legislative base that works. The PPF has broadly been a success, although I know it costs money and many members struggle with how their specific levy is calculated. We will continue to help them with that.”
Change for the better
Other factors that may influence the private sector pensions landscape include government’s handling of state and public pensions. And Carberry says he feels as though there is “genuine worry” within the business community as to whether government has a plan for the scale of the pensions costs it’s taking on.
The chancellor has committed to retaining the “triple lock” on state pensions – which guarantees an annual increase in line with whichever is the greater of average earnings, the CPI measure of inflation or 2.5 per cent – until 2020. But in November MPs on the Work and Pensions Committee called for it to be unpicked thereafter.
Early in 2017 there should be a chance for businesses to have their say on a range of issues when a consultation opens on DB pensions with the publication of a green paper. But one thing most in the private sector would agree on is that the less change there is to the tax system with regard to pensions, the better. “There are concerns about whether we are on the brink of yet another major overhaul of the pensions tax system,” says Willis Towers Watson’s Mark Duke. “People would feel very concerned if people’s confidence in pensions saving were undermined by yet another diminution in the tax benefits of saving through a pension scheme.”
It’s possible that the UK will continue to look to innovative legislation from abroad as it weighs up the best way to move forward. Menzies’ Simpson points out that the pensions freedom reforms brought in during 2015 – and which prompted then pensions minister Steve Webb to say pensioners were free to use their DC pension pots to buy a Lamborghini if they chose - were pioneered in Australia. In the Netherlands there is a requirement for pensions to be fully funded at all times, so that no deficits arise – though this comes with greater flexibilities for firms, such as not having to increase pensions in payment if a deficit arises. The Mercer Melbourne Global Pension Index ranks those countries second and third, below only Denmark, which has a system that combines a public basic pension scheme, a means-tested supplementary pension benefit and fully funded, mandatory private schemes run by large funds rather than individual companies.
But, Simpson says, all the consultations and innovative legislation in the world won’t change a simple truth. “You can slice and dice your models in whatever way you want, but there’s no magic solution – other than putting more money in. That’s the underlying issue.”