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Pension deficits: have bean counters got the sums wrong?

Deficits on final salary pension schemes continue to balloon, but some argue unrealistic accounting measures are painting a bleaker picture.

 

by Michelle McGagh on Aug 07, 2017 at 16:27

Pension deficits: have bean counters got the sums wrong?

The unfunded pension promises of FTSE 100 companies continue to grow despite £150 billion of investment as falling bond yields means schemes are running to ‘stand still’.

Over the past decade, FTSE 100 companies have paid £150 billion into defined benefit (DB) pension schemes in a bid to reduce the unfunded liabilities of existing and future retirement pay-outs, according to the latest LCP Accounting for Pensions report.

DB pension schemes, also known as final salary pensions, pay an annual income based on a percentage of final salary multiplied by the number of years worked. These schemes are much more generous than their ‘defined contribution’ (DC) counterparts but are in short supply as the cost of providing DB schemes has grown as people live longer.

It is not only longevity that is causing a headache for companies, the types of investments the pension funds are invested in have pushed their liabilities skyward.

In 2007 FTSE 100 companies had a collective £12 billion pension surplus, but fast-forward to 2017 and this has turned into a £17 billion deficit, despite the £150 billion of contributions.

Pension liabilities now stand at £625 billion, up more than 85% from £336 billion in 2007.

Bob Scott, partner at LCP, said although pension fund assets had increased from £350 billion to over £600 billion in the past decade, representing a ‘healthy compound growth rate of over 6% per annum’, the liabilities had grown even more quickly.

Bonds put squeeze on pensions

The reason liabilities have grown so quickly is because of the way they are calculated. DB scheme liabilities are valued based on the yield available from high quality corporate bonds. This means that when yields fall, as they have been doing since the financial crisis thanks to the Bank of England’s quantitative easing (QE) programme, the value of the liabilities increases, and vice versa.

According to the LCP report, in late 2008 the yield on the iBoxx AA 15-year corporate bond index peaked at more than 7.5% but since then it has fallen steadily until the index hit a low of just under 2% in August 2016.

This poses a problem for pension funds, which rely on bonds to fund payouts. With bonds yielding 7.5%, a pension fund needing to pay out £7.5 million would need to buy £100 million of bonds. But with the yield down at 2%, they would need to buy £375 million of bonds to pay the same amount.

‘This fall in bond yields has led to a sustained rise in liability values that has meant that many companies continue to disclose a deficit despite paying significant amounts into their pension schemes,’ said Scott.

Around 55% of defined benefit pension scheme assets are held in bonds despite these low yields and allocations to shares are falling, from 28% of scheme assets in 2015 to 26% in 2016.

‘The general trend away from equities does appear to have continued with a modest movement of assets out of equities and into bonds and other asset classes during 2016,’ said Scott.

The growing liabilities of pension schemes has not gone unnoticed in government and there have been calls for DB schemes to invest more in infrastructure assets that provide the inflation-linked long-term income they need.

Former pensions minister Ros Altmann has long championed the use of infrastructure investments and said she wanted to see pension funds ‘get involved’ in the £70 billion infrastructure pipeline planned in the UK.

Is it really that bad?

But pension expert Henry Tapper, director of First Actuarial, argued that the outlook for DB schemes wasn't as gloomy as calculated. He pointed to the example of the Universities Superannuation Scheme, whose deficit has soared from £9 billion to £17.5 billion over the last year.

Yet this deficit is calculated by using the 'gilts plus' accounting methodology. This takes the yield on gilts, plus a margin based on their historical relationship with other assets classes, to calculate the assets needed for a pension scheme to meet its liabilities, and, if it doesn't have enough, the scale of its deficit.

But Tapper argued this methodology ignored the type of assets held in the USS scheme, which could deliver a different return to gilts. 'The fund isn't invested in gilts and as its report and accounts confirms, if the fund was valued using a discount rate reflecting the expected performance of the actual assets, it would have a £3.5 million surplus,' he said.

On First Actuarial's calculations, by estimating the future returns of pension schemes not by reference solely to the yield on bonds, but on the expected performance of the assets they actually invest in, UK DB schemes - of which there are 6,000 - were sitting on a £301 billion surplus in June.

Others don't share this more optimistic view. Graham Vidler, director of external affairs at the Pensions and Lifetime Savings Association, said growing liabilities meant there was a risk pensioners wouldn't get their full benefits and existing employees would miss out.

‘The need to pay for past promises could divert employer resources away from the investment necessary to ensure their firms’ future,’ he said.

‘Despite this, these firms are running to stand still as deficit levels remain stubbornly high and members of schemes have just a 50:50 chance of seeing benefits paid in full.’

Companies battle liabilities

Companies have been looking for ways to reduce their liabilities and their contributions to pensions. There are just 27 DB schemes that allow members to accrue benefits, but no companies offer a final salary pension to new recruits.

Broadcaster ITV (ITV), artificial hip and joint maker Smith & Nephew (SN), cruise operator Carnival (CCL), engineer GKN (GKN), insurer Standard Life (SL), and Marks & Spencer (MKS) have all closed their schemes to future accrual over the past year.

Royal Mail (RMG) has said it will close to future accrual from March 2018.

Other companies have taken a different road, with Babcock (BAB), the engineering support services group, putting a cap on the pensionable salary it offers employees. British Gas owner Centrica (CNA) reduced its pensionable salary cap and chemicals company Croda (CRDA) has moved from final salary calculations to a ‘career average’.

Instead employees are offered DC pensions – which are determined by the amount contributions and the performance of the stock market rather than salary and time worked. DC pensions cost employers just 3% of salary costs compared to 55% for DB schemes.

There is a stark divide between DB and DC pensions and Scott said there is no ‘accepted middle ground’ of pension that comes at an affordable cost.

Labour MP Frank Field, chair of the parliamentary work and pensions committee, has argued companies facing big pension deficits should face restrictions over the payment of dividends where there is no recovery plan for the scheme.

As pension deficits have grown, shareholders have continued to receive a bigger slice of the cake, with FTSE 100 companies paying four-times as much in dividends as they did in pension contributions last year.

According to the LCP report, 39 companies have deficits totalling £37 billion and paid £39 billion in dividend last year.

‘Signs are that The Pensions Regulator will get tougher with companies that unduly prioritise their shareholders,’ said Scott.

‘Let’s hope that any extra contributions that companies pay in future will have a bigger impact on the pensions deficit than in recent years.’

19 comments so far. Why not have your say?

dd

Aug 07, 2017 at 18:42

However well any DB scheme is managed, no-one can predict the future. BofE pension scheme invested much in index-linked gilts at one point in time. Those I-L gilts have plummeted in value recently but they continue to pay out... Inevitably such a scheme will show a drop in value.

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Usuallycynical

Aug 08, 2017 at 08:07

Interesting article but sadly unlikely to happen as the funding for global government deficits at cheap levels will disappear if the forced buyers (banks, insurance companies, pension funds etc.) are allowed to invest elsewhere.

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HUFC

Aug 08, 2017 at 13:59

"Around 55% of defined benefit pension scheme assets are held in bonds despite these low yields" - that's the problem, compounded by QE. Whilst your liabilities are rising, that investment strategy is unsustainable & so the sponsoring employer will have to pay more; as required by the Pensions Regulator

Bearing in mind we are in an historically low-interest environment, when yields rise, the problem will diminish - to be replaced by higher interest rate risks for the fund trustees

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Pilgrim

Aug 08, 2017 at 19:13

QE as implemented has been a curious policy little better than a Ponzi scheme whereby HMG bought back its own debt out of the market-place using the Bank of England to acquire Treasury debt. This is all fun, you have to be a real panjandrum to come up with a scheme this daft!

As Mervyn King said the QE operation was to produce benefits in a counter factual manner.

However, without any doubt, through QE the Bank of England did provide a significant support to the commercial banks, but there is little evidence that the benefits extended beyond the financial community. It also produced another benefit; it made the Treasury's books look better but at the same time it hollowed out the books of the BoE.

In the beginning, the BoE explained that QE was just to be a short term measure, and when the sun came out tomorrow, the Gilts would be sold back into the market. While this might have been feasible for small holdings of government paper, the volume of gilts held by the BoE rapidly approached the point in which any attempt to return the gilts to the market would lead to a a price collapse and bankrupt the BoE.

QE also had the predictable and catastrophic effect of destroying the financial model of defined benefit pension schemes. Outwardly successful Companies suddenly found that their rapidly expanding obligations to their own pension schemes were threatening financial viability.

At the outset, the general idea with QE had been that the BoE would produce funds to stimulate the economy. The funds could have been used to accelerate infrastructure projects for example, or industrial developments. In the event, it seems that the BoE lacked the project management skills to supervise or maintain cost controls over real projects and so settled on purchasing gilts in theory that if the BoE couldn't manage real projects, the commercial banks possibly could.

The result of all this is that we are still sitting in a trap with cheap money, and ever increasing public and private debt.

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nickle

Aug 08, 2017 at 20:16

The regulator has it wrong.

Using AA corp bonds as the discount rate for liabilities is the issue. That's an asset used to discount a liability. Hence you get the mess.

What should happen is that the asset rate for the assets is used for the projection of the asset valuations taking into account defaults.

For the liabilities, its the rates specified in the contracts. For example, if its inflation+0.5% you project forward at inflation+0.5%, discount with inflation.

What happens is as the liabilities fall due, the fiddle of using a higher rate (AA corporates with no defaults) on the liabilities, gets exposed.

It's called basis risk.

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Seasoned cynic

Aug 09, 2017 at 09:56

"DC pensions cost employers just 3% of salary costs compared to 55% for DB schemes. Where did 3% come from? That's a pitiful amount to pay into a scheme and like as not will only deliver benefits that are just enough that the recipients are not eligible for additional state benefits in retirement or, if they are, the tiny income will be deducted from those benefits. Yes, you may have deficits to fund in DB schemes but paying a paltry 3% is simply immoral. I fear for the future as DC guarantees precisely ZERO to members.

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dd

Aug 09, 2017 at 11:52

If a company can't afford a DB scheme though, it could be that it will simply have to shed staff or put prices up if it can get away with that in the relevant market. Employment plus a DC pension is preferable to no job, I reckon.

The same could be argued in relation to the public sector.

The question as usual is: "Who will pay?"

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Anthony Tinslay

Aug 09, 2017 at 12:40

All very interesting and clearly different methodology will produce different expectations and forecasts. However the real NATIONAL problem is the unfunded generous pension promises made to public employees and in particular to our elected overpaid and under-worked representatives at Westminster

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nickle

Aug 09, 2017 at 22:05

owever the real NATIONAL problem is the unfunded generous pension promises made to public employees and in particular to our elected overpaid and under-worked representatives at Westminster

1. MPs have a fully funded scheme. The voted themselves more of your money when there was a short fall.

2. Civil servants are owed 1.5 trillion with no assets.

3. The state pension owes 8.5 trillions with no assets.

It's state run pensions that are the problem.

Now do you understand why MPs have a funded scheme?

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Jonathan

Aug 12, 2017 at 11:24

@Pilgrim, yes, you're spot on, QE lowers the yield on bonds (a main asset of pension funds) and creates monetary inflation which is a recipe for the failure pension providers.

Really pension companies should have foreseen this and sold their bonds and bought assets with the proceeds.

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dd

Aug 12, 2017 at 11:30

@Jonathan, yes. If you were brought in to run a company pension fund with a significant proportion of it still in bonds, what would you do now?

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nickle

Aug 12, 2017 at 15:16

@Pilgrim, yes, you're spot on, QE lowers the yield on bonds (a main asset of pension funds) and creates monetary inflation which is a recipe for the failure pension providers.

=============

Really?

Why are the liabilities affected by QE?

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Dennis .

Aug 12, 2017 at 17:40

And no one remembers that Gordon Brown started the taxation of pension fund dividends which had a retrospective effect and lead to the closure of most private sector schemes?

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dd

Aug 12, 2017 at 23:49

Nickle,

I think that the pension liabilities are affected by QE because i) QE reduces the yields on bonds held in large number by pension funds, so pension funds produce less natural income for the pensioners or even for growth of the fund itself, and ii) an increase in the money supply as part of QE can lead to monetary and price inflation if the QE is overdone so the income the fund produces buys less.

The combination of the two makes life difficult for the pension provider.

Perhaps someone can correct me if I am wrong.

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nickle

Aug 13, 2017 at 00:03

There are two parts to pensions.

1. Assets.

2. Liabilities.

Depending on what the pension has invested in, the assets may well be affected by QE.

The liabilities have no connection with QE. None. Zilch. In most cases they are linked to inflation.

So take the discount rate the for liabilities. If inflation is 2% then 102 pounds in a year is worth 100 now. Since the liabilities grow at inflation, the correct discount rate for the liabilities is inflation. There are no assets on the liability side.,

For example, take the state pension. Why not assume the money has been invested in Apple stock, in which case what rate should you use for the liabilities? Assume what you want on the asset side. Zero assets compounded is zero.

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dd

Aug 13, 2017 at 00:05

... and yes, Dennis. I remember that change by Gordon Brown. The change was a deceitful move, a direct attack on the private sector which would not be felt immediately. (Was this when the expression "stealth" tax came into existence?) Then, with nothing left in the Treasury, it was impossible for the following governments to reverse (though there is always the issue of priorities).

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Jonathan

Aug 13, 2017 at 02:03

@nickle, QE lowers the yield on government bonds. It's the same as OMO which is specifically designed to lower the yield on existing bonds and hence lower the interest rate. That's how interest rates are controlled by the BoE.

The expansion of the monetary base that OMO (and QE) cause is the ONLY reason for long term inflation. That's why today everything is 10 times the price it was in the 1970's.

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Kenneth Robertson

Aug 14, 2017 at 10:38

@nickle

You need to discount using the yield on available assets because otherwise your assets and liabilities bear little or no relation to each other, and you don't have an accurate picture of your funding position.

In your example, let's say we have a liability of £102 in a year's time, discounted with inflation to a PV of £100. So we buy £100 of bonds to pay for it. We now have £100 of assets and £100 liabilities - perfect, no deficit!

But oops - our bond is only yielding 1%. So in a year's time we'll only have £101 to pay our £102 liability, and poor Mrs Miggins isn't getting the pension she expected.

On the other hand, if we'd discounted the £102 using the 1% yield on available assets, we'd have bought £100.99 of bonds initially, giving us the £102 that we need to pay the liability when it falls due.

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Pilgrim

Aug 14, 2017 at 12:59

@nickie

Both assets and liabilities are affected by QE.

The liability of a DB pension scheme is determined by the contractual terms of the pension policy. That liability has to be reassessed regularly taking into account changing salaries, inflation forecasts, the life expectancy of present scheme members, deferred pensioners, and current pensioners.

The assets can be revalued from time to time taking into account the current market value and the risk adjusted rate of return. If the rate of return falls below that required to meet the current projected liability, the pension fund is in deficit.

Sovereign bonds (gilts) are seen as the lowest risk form of bond investment and are a core holding in many pension funds. QE had the effect of forcing the price of gilts up, and the resulting level of returns down. This bears most heavily on new contributions because the capital cost of a set level of return has been increased.

The government acturies department has provided HMRC guidance rates of return based upon the yield from gilts. Depressing the yield on gilts through QE has the direct effect of forcing up the cost of pension provision.

The scale of change is illustrated by the shift in GAD rates (August in each case:- 1996 8%, 2000 4.75%, 2010 3.75%, 2017 1.75% ).

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