A final farewell?

The latest bad news on final salary scheme funding could mark the final chapter for the sector says John Greenwood

Violent swings in final salary pension scheme deficits are nothing new, but the extent of the about turn in funding levels revealed by Lane Clark & Peacock’s Accounting for Pensions report spells grim news for defined benefit.

FTSE 100 pension schemes had a net deficit of £41bn as at mid-July 2008 compared to a £12bn surplus in July 2007, the largest 12 month swing since the introduction of modern pensions accounting methods in June 2002. LCP says the credit crunch, equity market volatility and rises in expected inflation have all contributed, and points out that the figures could have been even worse.

The sharp plunge in funding levels is despite FTSE100 companies pumping nearly £40 billion into their pension schemes over the last three years, and corporate bond yields have risen to unprecedented levels compared to gilts, cushioning the figures further.

Bob Scott, partner at LCP says: “UK pension schemes of FTSE 100 companies enjoyed a brief period of surplus until early in 2008. Some companies chose to spend their surpluses on various forms of de-risking activity including buy-out, purchasing financial swaps and reducing their exposure to equities. Events of the last year demonstrate the importance of assessing and managing pension risks and being prepared to take opportunities when they present themselves.”

Ros Altmann, the independent pensions analyst is scathing about the weakness of the level of scrutiny that IAS19 provides, and is predicting further closures or buyouts of final salary schemes. “Last year’s ‘surplus’ lulled people into a false sense of security and was probably an illusion. In reality, being in ‘surplus’ on IAS19 is a weak test and does not mean the scheme has enough money to pay all members’ pensions over the longer-term. There is scope to massage the numbers, because of the lack of standardisation of discount and mortality rates used. This creates a misleading picture of pension scheme health,” she says.

Altmann’s concern is that employee security is undermined by the poor level of funding, although in today’s tough economic climate shareholder demands may outweigh those of trustees when it comes to any spare cash. That, says Altmann, means the demise of defined benefit is entering its final chapter.

“It is inevitable that employers will keep on closing schemes to both new and existing members, in the face of so much uncertainty around the funding and costs. Employers will also continue to look for ways to get rid of the huge risks they are facing,” she says.

Scott agrees with Altmann’s downbeat assessment of the situation that defined benefit faces. “No sooner have companies breathed a sigh of relief about returning to surplus but they are back to multi-billion pound deficits,” he says. “With a possible recession looming and the threat of further regulatory intervention, the outlook for continuing defined benefit provision seems rather bleak.”

Altmann sees an upswing in the de-risking activity that has gained traction over the last 12 months, with Lonmin and Friends Provident becoming the first FTSE100 companies to buy out or buy in. Experts also predict an increase in pension transfer activity, with blue chip names getting ready to dip their toes in the business of offloading individuals on a one by one basis by offering them enhanced transfers.

“The bottom line is that companies will become increasingly desperate to find ways to get rid of their pension scheme risks. There is £1trillion invested in pension funds and many large schemes are looking to the new buy-out vehicles to help share the risks. In fact, shareholders have not yet appreciated the very significant benefits to a company if they do manage to buy out some or all their liabilities. The costs of buying out will rise as there may well be capacity pressure in this new market. This will be a particular problem for smaller or very large schemes,” she says.

The LCP report highlights that at least three FTSE 100 companies could have secured their pension liabilities earlier this year in full without having to make additional contributions. The firm says that by mid-July, deteriorating market conditions meant that the opportunity had passed thus highlighting a possible governance gap with regard to the speed of investment decision-making.

But Altmann also predicts that the demand for of annuity-type instruments from the final salary sector will ultimately spell grim news for the wider pensioner sector.

“As more final salary scheme liabilities are converted to annuity-style contracts, there is bound to be pressure on conventional annuity markets with rates worsening overall. This is a worry for future pensioners who will need to rely on annuity markets to provide their pensions. The Government has not yet recognised this looming risk but it is there nonetheless,” she says.