Pension surpluses are the next big ‘pension scandal’, according to Aon’s investment consulting head Ian McKinlay.
Speaking at a conference in London recently, McKinlay told delegates that companies are being forced to plough money into pension funds at a time when interest rates are low and liabilities are inflated. “With a more prudent funding regime now in place, the risk of creating future surplus is now very real,” McKinlay says.
Because pension funds are “ring-fenced”, surpluses are trapped, McKinlay said.
Meanwhile, the surplus cash put in by employers could have been better used to invest in the business. “I think surpluses are the next big pension scandal,” McKinlay said.
According to Hewitt principle consultant Kevin Wesbroom: “The bizarre thing is what we’ve seen over the last four months of this year, is deficits being eroded at a very significant rate in UK pension plans.”
This has been due to good equity performance but, more importantly, rising interest rates driving down liabilities. “We have clients where pension deficits might have even halved over that period of time,” said Wesbroom. “We are not there yet,” he added with regards to reaching pension surpluses.
“The key aspect is the long-term interest rate. But it could be that if we move back to a higher interest rate environment, then we could see deficits being eroded and the possibility of surpluses re-emerging.”
According to Watson Wyatt senior investment consultant Hemal Popat, pension surpluses would be “a nice situation to have”, but trapped surpluses would not.
“A small surplus is undoubtedly a good thing as it provides greater security of benefits for members. But from a company point of view, a large surplus can become a misallocation of scarce company funds, and is value-destroying for shareholders.”
Popat continued: “The majority of schemes are still in deficit on an accounting basis, so widespread surpluses are probably some way off. But if bond yields increase in the near future, funding levels could improve quite quickly for many schemes.
“Maturing schemes will be increasing their bond allocations currently which would also have the effect of reducing the risk of significant surpluses or deficits arising in the future,” he said
He added that pension surpluses are on the radar and being taken into account.
Aon estimates that a typical scheme has a 60% chance of being in surplus within 10 years, and a 25% chance of being more than 120% funded.
“The ‘surplus funds’ scenario is clearly in the interests of the members, so no reasonable trustee is going to consider how to avoid it,” said Aon. “It is therefore up to employers to look at the issue.”
McKinlay said that while the Pensions Regulator would probably welcome surpluses, companies have largely not recognised this issue because their thinking has been too “short term”.
The Pensions Regulator said: “It pension_surpluses is not something for the regulator have an opinion on.” Meanwhile, the Department for Work and Pensions did not respond to questions on the matter.
According to Popat, Watson Wyatt has found in their discussions with finance directors that almost all are concerned about the possibility of long-term over funding.
“This is due to the ‘one way valve’ effect of pension scheme funding, ie, it is easy for a company to put money into the scheme but hard to remove surplus funds.”
Wesbroom said: “We’ve been
telling our clients that ‘this is one
of a number of things that you should be taking into account when you’re discussing what to do with the deficit’.”
Some companies are being advised to strike a deal with schemes ahead of them ploughing large sums of money into the funds. Part of this deal could relate to accessing some surplus money that is ring-fenced.
According to Aon, employers should adopt contingent funding and investment strategies, which act to lock in out-performance, enabling contributions to be reduced at that time.
“The challenge is how to provide security without making unnecessary cash contributions that become trapped. The answer is … ‘contingent funding’.”
According to Popat, contingent funding mechanisms, such as escrow accounts, can provide a partial solution to this situation, although they come with their own complexities and may be less tax efficient than directly funding a pension scheme.