The collapse of companies like BHS and Carillion focuses attention on a key dilemma faced by pension fund trustees and regulators. Demand too much from the sponsor and you risk a cut in business investment or, worse, insolvency; demand to little and you risk tipping the balance away from pension beneficiaries and in favour of sponsors and shareholders.
In a world that has demanded greater levels of robustness of financial institutions since the 2008-09 financial crisis, regulators are also faced with how to calibrate the funding requirements of pension funds.
The UK Pensions Regulator (TPR) took the opportunity last year to warn sponsors of the need to balance dividends and deficit payments.It found that UK FTSE 350 companies prioritised dividend payments over deficit reduction measures in the years 2011-16. The ratio of deficit contributions to dividends fell from 10% to 7% over that period.
Attempts by the European Insurance and Occupational Pensions Authority and others to align pension fund solvency metrics with those applied to insurance have met with a barrage of robust objections to approaches that do not take into account the distinct characteristics of pension funds.
Clearly, pension funds that took timely action before the crisis to hedge liabilities will be in a better financial position than those that took the full brunt of the effects of quantitative easing and lower rates on their liabilities. Also, where pension funds were implicitly or explicitly encouraged to hedge using the same financial instruments (UK Gilts, the euro swap curve), the cumulative herding effect of buying those instruments and the consequent depression of their prices also has to be taken into account.
“UK DB schemes manage £1.5trn for 11m people, so prudent financial management is critical”
A Bank of England staff working paper* maps granular data from TPR against Thomson Reuters corporate data to assess the effect of pension deficits on investment and dividends. A sample of about 270 typically large FTSE 350 companies, excluding financials, was assessed, representing about a third of aggregate defined benefit liabilities and a quarter of the aggregate deficit. For the first time, the authors were able to isolate the effects of mandatory contributions and the lengths of recovery plans.
The authors found that addressing pension deficits has lowered dividends by 3% and business investment by 2.5% since 2009. Also, the effects on investment would have been worse had TPR not been flexible in allowing sponsors to extend recovery periods. Firms with larger pension deficits on average paid lower dividends but did not invest less.
Overall, TPR has balanced often conflicting demands for short-term deficit repair with long-term business investment. The UK’s 6,000 private- sector DB schemes manage £1.5trn (€1.7trn) for 11m people, so the need for prudent financial management has never been greater.
*Growing pension deficits and the expenditure decisions of UK companies, BoE staff working paper 174, 2018
Liam Kennedy, Editor