UK: Contributions and deficits to increase

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Nick Bunch reviews the findings of LCP's nineteenth annual report on the UK's defined benefit landscape

The latest LCP Accounting for Pensions report, now in its nineteenth year, highlights the evolving challenges that FTSE 100 companies are facing from their pensions schemes. It is a study of the 83 companies in the FTSE 100 that have defined benefit pension schemes, the problems they face and the action they have taken to resolve or mitigate these problems.

This year we have seen the challenges faced by employers altering dramatically on a day-by-day basis. These challenges were further intensified by troubled financial markets, with poor equity market performance and low bond yields. To add to this picture, we can throw in the growth in life expectancy assumptions and the prospect of auto-enrolment.

To put this in perspective, 19 years ago, when the first report was published, the best funded pension scheme was 190% funded, the average 123% funded and the worst 88% funded. Today, the average scheme's funding level is 88%.

Deficits and contributions
This year, we estimate that the combined IAS19 deficit of FTSE 100 companies' pension schemes was £41bn (€52bn) at the end of May 2012, more than doubling last June's deficit of £19bn. This equates to total IAS19 liabilities of £447bn versus assets of £406bn. This increase is despite many FTSE companies maintaining their contributions at high levels; FTSE 100 companies paid a total of £21.4bn into their pension schemes in 2011, with around £11bn of those contributions going towards removing deficits in their defined benefit schemes rather than boosting benefit accrual for current employees. Some companies made significant contributions including BT, Barclays, Shell and RBS. These four companies each paid contributions into their defined benefit schemes of over £1bn during the year. Since the end of 2011, BT has made a £2bn payment to accelerate the removal of its pension scheme's deficit - the largest ever one-off deficit contribution to a UK scheme.

The increased deficit this year reflects the fact that corporate bond yields are at record lows whilst equity markets continue to perform poorly, as they have done for a number of years. The challenge this poses to the UK's leading companies is compounded by the significant volatility in deficits on a day-to-day basis courtesy of these troubling markets. Aggregate deficits have fluctuated by as much as £10bn in a single day as uncertainty continues to characterise the capital markets. For example, on 1 November 2011, when the FTSE 100 fell by 2.2%, the combined deficit increased by £10.7bn.

Auto-enrolment galvanising action
Adding to the pressure of the deficit figures is the prospect of auto-enrolment. Companies will start to become subject to auto-enrolment requirements later this year, overall pension costs will continue to rise and, unless companies cut back on current benefit levels, annual pension contributions for the FTSE 100 are projected to exceed £26bn by 2013.

The end of final salary schemes
LCP's 2012 report has shown that the ongoing trend to reduce levels of defined benefit provision has continued and, for the first time, not one of the FTSE 100 companies examined remains committed to offering a final salary scheme to new employees. Indeed, most FTSE 100 companies now offer new employees a defined contribution scheme under which all of the pensions risk is passed to the individual. In part, this move is due to rising life expectancy, with the average man who reaches the age of 65 now expected to live until over 87, based on current estimations.

Despite this trend, and the undeniable fact that we continue to age well, a small minority, including Tesco and Morrisons, continue to offer an element of defined benefit pension provision thereby providing added security for their employees. This shows that some companies are making an effort to innovate in so far that these challenging times allow. It remains to be seen whether pensions minister, Steve Webb's well-publicised enthusiasm for so-called ‘defined ambition' schemes will lead to more companies following this route.

CPI to RPI benefits some
As reported in LCP's survey last year, the move to CPI inflation has meant lower liabilities for many companies and, as reports have indicated that the gap between RPI and CPI could widen in future, companies have assumed even lower levels of future indexation. This means further reductions in costs for companies, but at the expense of FTSE 100 pension scheme members who will receive even lower benefits than expected. One of the biggest winners of the change to CPI indexation was BT, which saw a £3.5bn swing in liability value in its favour as a result.

Equity holdings - lowest since 1993
FTSE 100 pension schemes continue to withdraw from equity markets with just 35% of assets being held in equities at the end of 2011, compared to 43% in 2010 and nearly 70% a decade ago. To some extent this reflects the changing nature of pension schemes, as an increasing proportion of liabilities now relate to former employees. Some companies made dramatic changes, including Aviva, which reduced its UK schemes' equity holdings from 26% to 7% during 2011. Those companies heavily invested in equities were most likely to see deficits rise in 2011, but some companies with smaller equity holdings saw a reduction in their deficit. Prudential, which has less than 20% of its scheme's assets in equities, saw a 21% improvement in funding level over the year.

What does it mean?
The overall picture is challenging. On the horizon is European IORP II legislation. This would mean the same of pension solvency requirements for pension schemes as for insurers' liabilities. Up to £200bn in additional funding may have to be found over the next 20 years should such an approach be extended to pension schemes.

As companies struggle to meet the demands of committing more company resources to make existing benefits more secure, it is clear that they will become less able to provide benefits for current and future employees. Auto-enrolment will extend basic pension provision to many more people but the extra costs may well lead companies to level down their existing commitments. As a result, we can expect more cutbacks in the benefits for future service with a corresponding negative impact on current employees' income in retirement.

Nick Bunch is partner at LCP, a member of the firm's scheme funding group and co-author of its Accounting for Pensions report


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