The last few years have seen troubled times for all involved with the management of defined benefit (DB) pension plans within the UK, with large numbers of employers either closing their DB plans to new entrants or shutting down their plans for future accrual altogether. Based on the National Association of Pension Funds (NAPF) survey, 13% of DB plans closed to new entrants in 2001, 19% in 2002 and 26% in 2003.
These closures have usually been accompanied by the introduction of defined contribution (DC) plans, resulting in lower contribution levels and increased member risk.
Following press coverage of companies winding up their DB plans without enough money to pay members the promised level of defined benefits, the government introduced legislation requiring solvent employers to meet the full insurance cost of buying out accrued liabilities. This effectively means that companies are now locked in to their existing DB commitments.
For those DB plans that are still open to future accrual, various measures may have been taken to make the risks more manageable. Such measures include:
o reducing accrual rates
o increasing member contributions
o removing favourable early retirement terms
o redefining a lower pensionable salary
So what has precipitated this ‘crisis’ in UK DB pensions? The UK has much higher levels of equity investment than most other European countries. For example, at the end of 2001 the average asset allocation for the UK was 71% equities, compared to 34% in Sweden, 35% in Switzerland and 50% in Holland. This means the UK has been hit hardest by the recent falls in the equity market. The average return for a UK pension fund was –3.8% in 2000, –11.9% in 2001 and –18.1% in 2002. This has significantly eroded the funding position of all but the most conservatively-invested plans.
The effect of a volatile and falling equity market has been highlighted by the introduction of the new UK pension accounting standard, FRS17. FRS17 requires that liabilities are valued by reference to yields on corporate bonds, but assets are measured at their (equity) market value. This means that there is a high level of volatility in the deficits disclosed under FRS17. Although full disclosure under FRS17 has not yet been widely adopted, the figures included in the notes to a company’s accounts demonstrate the impending negative impact on the company’s finances.
Various factors have contributed to recent increases in the valuation of DB liabilities. Increases in life expectancy have increased the calculated liabilities of some plans by as much as 20% compared to previous assessments. This is compounded by lower bond yields, and fixed pension increases within a low inflation environment.
The Pensions Act 1995 was introduced in 1997 in the wake of the Maxwell scandal. This placed extra burdens on both trustees and employers. In particular, the act made pension increases compulsory (previously discretionary) and removed much of the flexibility over funding DB plans.
The regulatory environment in the UK is excessively complex. Attempts to simplify integration with state benefits, the state benefits themselves and the tax regime have so far only added further complexity, although a further government simplification initiative is currently underway.
The future remains uncertain for DB pension provision within the UK. Solvent employers may prefer to run off closed plans rather than pay insurance costs, but there is little incentive to re-open DB plans. Current DC alternatives are inadequate, and the government must eventually intervene on this issue, but minimum DC provision seems more likely than compulsory DB.
Steve Hitchener is an actuary with Barnett Waddingham in the UK, part of the EURACS network

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