Db out in the cold

The lid of the coffin of final salary schemes is by now so studded with nails that there can barely be any wood left visible. But the worsening financial situation, coupled with the government\'s refusal to budge on indexation look set to see 2009 become the year of closure to future accrual.

The NAPF has accused the government of failing to import the bold stance it has taken in other areas of the economy to support employers offering final salary pensions by relaxing rules on indexation.

Joanne Segars, chief executive of the NAPF says: “It is hugely disappointing that the government has not done more to promote risk sharing. In the current economic climate, a bold approach is needed to secure defined benefit pension provision in the same way a bold approach has been taken for other parts of the financial sector.”

Segars’ view is shared by the Association of Consulting Actuaries. Expressing frustration and disappointment at the government’s antipathy towards its risk sharing proposals, ACA chairman Keith Barton says: “Without a new ‘middle way’ option that better allows employers to cap defined benefit costs for the future, the vast majority of private sector employees will be moved into defined contribution schemes, with the volatility in outcomes associated with this design.

“The absence of choice under current legislation leaves few other realistic options – but the absence of choice certainly won’t halt defined benefit scheme closures. Today, we have just 2.7 million private sector employees in defined benefit schemes compared to 7 million in 1967, with now only around 1 million employees in schemes open to new entrants. The speed of closures, given current economic conditions, is likely to accelerate in 2009.”

The switch to defined contribution has been going on for years now, but the worsening financial climate looks set to speed the process on its way, with some predicting an increase in individuals taking their money out of their final salary schemes as they look increasingly poorly financed. Falling pension funding levels and the declining ability of companies to be able to afford to meet their pensions commitments will lead both trustees and well-informed members with benefits above the Pension Protection Fund level to consider carefully the strength of the covenant their sponsoring employer offers.

Aon points out that in the past 12 months alone, total asset losses have now reached £226 billion for the UK privately sponsored pension schemes. Anthony Light, head of covenant assessment at Aon says: “The reality is that the security of pensions benefits is critically related to the strength of the employer providing those benefits. It is essential that both companies and trustees fully understand the impact that broader economic issues are having on the employer’s business.

“The twin pressures of weaker funding levels and weaker corporate financial health mean that employers are facing a potentially unaffordable gap. The key question for trustees and employers as we approach valuations next year is what are the alternatives for companies that cannot afford to meet their pension obligations through cash funding?”

Aon predicts that between 2 and 5 per cent of schemes could go bust in the current recession, although these will be concentrated amongst the smaller schemes with fewer members. Yet nobody knows what level of corporate failure we will see in the coming year. The reason corporate bonds are being held up in some quarters as being such good value at the moment is because they are pricing in ‘unrealistic’ levels of corporate failure.

For corporate bonds to generate the same returns as gilts then there would have to be defaults of around 18 per cent, say bond managers. This compares to defaults around 1.5 per cent in the recession of the early 1990s and only 4 per cent in the Depression of the 1930s. But while corporate bond yields are telling us that corporate failures are likely on a wide scale, the Pensions Regulator is asking trustees to maintain a steady hand at the tiller.

TPR chairman David Norgrove says: “Scheme funding improved between 2005 and 2007 but current economic conditions are more difficult.

“Trustees should not over-react in the face of the downturn, but should ensure they are active and alert to potential changes in the health of the sponsor, and to the funding level of the scheme. In responding to short-term cash flow difficulties trustees should first consider back-end loading recovery plans. Where valuations show a larger deficit, then as we said in our October statement, this may result in longer recovery plans being proposed.”

All this spells more closure to future accrual, an increase in transfer exercises into volatile equity markets and increased strains on the Pension Protection Fund. 2009 promises to be a testing year for those working with defined benefit pensions.