Indexation degradation

This year could see the government finally have to face up to demands the industry has been making for years in terms of sharing of risk between employers and members of final salary schemes.

That is the view of some pension professionals who see the problems faced by DB schemes as verging on the intractable. Some argue that the size of deficits, and the amounts needed to be paid into them for them to be cleared in anything approaching a reasonable timescale, mean that some form of watering down of benefits, perhaps through removal of indexation, will prove necessary.

The problem is well demonstrated by the issues at HBOS. Its trustees, concerned that the troubled company will be the poor relation in the newly merged business, threatened court action against Lloyds and HBOS over the merger. While it dropped the action, under alleged pressure from the government with regard to further cash to prop up the banks, trustees still intend to press ahead with a revaluation of the scheme’s deficit.

The merger is weakening their covenant, they argue, therefore they must switch to more secure assets. This in turn will push the deficit up from below £200m at the last valuation at the end of last year, to between £3bn and £5bn. A 10 year repayment plan would see Lloyds Banking Group, the parent of the proposed merger, in line to pay perhaps £500m a year into the scheme. Suddenly 20 year repayment plans may look desirable, although the voices of those who say that the inevitable is simply being put off will grow stronger.

The HBOS trustees know their power – while they cannot force employers to pay more in, they do have the right to set the investment policy of schemes, which in turn effectively gives them the ability to move deficits up and down. Michael Deakin, one of the HBOS trustees and a former director of Insight Investment and Clerical Medical Investment Group, is also a director of the Pension Protection Fund. He must be involved in some pretty interesting conversations right now.

The CBI is out in the market calling for calm from trustees over deficits. Extra pressure on firms who run defined benefit pension schemes could weaken sound businesses at a critical time and hamper the UK’s economic recovery, it has warned.

The CBI fears that investors, trustees and the government will overreact to growing pensions deficits caused by the downturn. Government figures show that although in June last year defined benefit pension schemes were £53.4bn in surplus, the tumbling share prices caused by the economic slowdown and credit crunch have pushed them £194.5bn into the red. The CBI fears that investors and trustees will not allow for the longerterm, secure nature of this pensions funding, and will mark those firms down.

John Cridland, deputy director general of the CBI, says: “Longer lives and complex rules have made final salary pensions very expensive at the best of times. Many firms are committed to keeping their schemes running, but that becomes especially challenging during a recession.

“An overreaction to deficits could be a factor in sending some firms under, and leave the rest struggling for capital at a time when they need it most. We urge investors and trustees not to feed the fire. Instead they should step back from these spot valuations, and recognise that the deficits are a snapshot indication that does not reflect the full picture.”

But while the CBI’s point is valid in relation to the large number of healthy companies burdened by, but coping with final salary pension schemes, some argue that the sheer size of deficits at some schemes of industrial giants whose long term future profitability is questionable at best means more radical action may be called for.

“When you look at schemes like Lloyds, HBOS and BA you have to ask how realistic it is that they can really plug these gaps. To clear its deficit it would take BA up to 15 years of putting all its profits into the pension scheme, and that is on the basis that they were maintained at last year’s levels, which seems unlikely. There is a big problem here for scheme members, employers and the Government,” says John Lawson, senior technical manager at Standard Life.

“One way for the government to get out of the fix they are in at the moment is to allow longer correction periods. But these deficits may not be correctible. The question whether you allow benefits to be cut back may have to be faced, a move that could take 35 per cent off costs going forward,” says Lawson.

While the government may feel it is too early to go down the unpopular road of reducing benefits which have been promised to voters just yet, a prolonged deep depression could ultimately force its hand.