Owner Management
Pensions: black holes cause grey hairs.
Black holes and grey days
After years of being urged to save for their old age, employees are now finding that their nest egg is smelling distinctly rotten. Anthony Harrington investigates the black holes
There has probably never been an era where pensions, both corporate and individual, have been so up in the air, and in which the future for long term savings has been so unclear. The UK's largest companies have been devastated by the appearance of huge deficits in their pension funds. Stakeholder pensions have, by common consensus, failed. Final salary schemes are being closed or wound up and the public in general are probably more sceptical about the value of long term savings now than they have ever been.
Robson Rhodes partner Ian Hill points out that while the government may want the public to do more to help themselves, it is heading for a real problem as it tries to get out from under the state pensions burden. "The plain facts of the matter are that by 2015 there will be the same numbers of people on pension as there are at work. By 2050, the tables will have turned completely and we can expect to find that ratios have switched to two thirds on pension versus one third at work."
The figures just do not stack up to allow the state to continue to pay pensions out of current revenues into the distant future. At the same time, however, the government will face tremendous pressure from an ever increasing and ever more powerful grey vote to do something serious about making pensions sustainable. This, Hill suggests, should be seen as the backdrop to the government green paper and to moves such as the introduction of stakeholder schemes.
The pressure from the grey vote may not be overwhelming as yet, but politicians can see the writing on the wall. This may well not be good news for finance directors and company boards, since companies have no vote and represent a relatively easy target for politicians looking for a solution to the pensions crisis.
Australia introduced stakeholder schemes well before the UK, and within a few years the government there moved to impose compulsory contributions by companies. Many pensions experts in the UK believe that this move to compulsory contributions, from either or both the employer and the employee, is inevitable here too.
Hill points out, however, that it is not just the government that has some difficulties to resolve. The pensions industry itself has a growing credibility problem among low salaried and middle ranking staff. It is becoming increasingly plain that for anyone retiring in a few years time, the pot of money required to support a reasonable lifestyle is starting to climb to stellar figures. Some analysts put the figure as high as £3500,000 for a pension of under £32,000 a month. "There is now a real issue as to how the pensions industry stays credible through the current cycle of negative equity returns and low interest rates," Hill says.
He points out that if one takes the introduction of stakeholder pensions as the culmination of any number of pensions think tanks and initiatives, the net result of all this innovative thinking has been a huge disappointment. Figures released by the British Association of Insurers show that 95 per cent of all the stakeholder schemes companies have been compelled by law to make available to staff have no members. Unless the government has compulsory contributions somewhere up its sleeve, it is hard to see how stakeholder pensions are going to be rescued.
He points out, however, that stakeholder schemes have had successes - quite apart from the huge impact they have had in reducing the cost of all pensions products with their 1 per cent cap on charging. "It is actually quite easy to argue that concurrency, or the ability for those earning less than £330,000 a year to both take out a stakeholder plan and to be a member of an occupational pension plan, has done more for the lower to middle paid employee than all the proposals in the current green paper," he comments.
Far and away the biggest concern to many finance directors, however, is the much publicised black hole in the funding levels of any number of final salary schemes. Three years of declining equity markets have left many companies with huge notional deficits in their schemes. One of the ways in which this is now having a substantial impact is in merger and acquisition work. Target companies now have to be very carefully vetted to establish the nature and extent of any shortfall in their pension funds.
Andrew Pickin, corporate finance partner at law firm Shoosmiths, says: "The black hole problem can kick an otherwise perfectly attractive deal completely into touch." He points out that the Midlands tends to have a number of companies which in the past have employed large numbers of staff. The textile and steel industries are obvious cases in point. These types of company, with large liabilities to existing and active members, tend to be very vulnerable to the black hole problem. "The generous pension provisions made by these companies were not a problem in the 1980s, but now they have turned into an absolute nightmare," he says.
Pickin points out that company directors who are also trustees of their company pension fund can find themselves in a particularly acute conflict of interest. As directors they have to look after the interests of shareholders. As trustees, they have to look after the interests of the scheme members, and these two sets of interests can be in sharp conflict one with another.
"We see a number of directors where we have to tell them that the best thing for them to do is to resign their trustee status. Questions such as what capacity the company has to meet its pension fund shortfall can be embarrassing for them to have to deal with. They know too much as directors to keep a straight face as trustees."
There is no doubt that even employees who have taken on trustee status can find themselves with horrendous dilemmas. The duty to act in the best interests of the members means that trustees whose schemes face really serious shortfalls can find themselves in the position of a major creditor. They may well have to look seriously at the question of whether putting the company into liquidation would not generate a better position for the majority of the scheme members than allowing it to try to work off the debt.
Pickin says: "Generally what happens when these situations arise is that the trustees will appoint an independent firm of accountants to look at the company. This can lead to the blunt question: 'If we kill it now, what do we get?' And you then get a dialogue with the directors who will say do you really want to do this or can we find a middle road?"
One of the compromises that many companies are now making is to give the trustees a lump sum for the pension followed by some sort of best efforts promise for the future. Trustees who can't come to a decision as to where their duty lies in these complex circumstances can go to the courts and ask for guidance as to whether they are within their rights to ratify a particular deal, points out Pickin.
The black hole problem is often exacerbated by the gilts matching issue. This is where the trustees exercise their rights, after a deficit comes to light, to move funds from the high risk equity arena into gilts. This of course provides protection against further falls in the world's stock markets. But it ensures that the fund will henceforth achieve only very modest rates of growth, so as the fund's liabilities increase, the black hole gets even bigger, and the resulting contribution from the company gets even larger.
"We have found situations where the directors start their negotiations with the trustees thinking that the deficit is £31m and after the switch to gilts a new valuation puts the deficit at £31.5m or higher. These are all consequences of the current dilemma," he notes.
Despite the undoubted problems with final salary schemes in the present regulatory climate, which exposes any funding shortfall mercilessly, Michael Calvert, UK head of pensions with the law firm Reed Smith, argues that it is still possible to operate an affordable scheme that guarantees employees a pre-determined pension. The advantage of maintaining some form of defined benefit scheme, he suggests, is that it plays extremely well with employees at a time when many are seriously concerned about their financial well-being after retirement.
Calvert points out that research by the actuarial consultancy Hazell Carr shows nearly 20 per cent of companies with final salary schemes intend to close them to new members later this year, and that 13 per cent of schemes already closed to new members are likely to be wound up completely within 12 months.
Instead of joining the rush to close final salary schemes, however, he argues that companies should consider alternatives such as reducing the accrual rate of their final salary scheme from the present one sixtieth of final salary to, say, one eightieth. Such a pension would be worth 25 per cent less over 30 years, but it would still be a defined amount. Other alternatives are making only a percentage of pay pensionable or asking employees to pay a higher rate of contribution.
These options are worth considering because, as Scott Morton, principal consultant, KPMG Pensions, observes, winding up a final salary scheme tends to be expensive for a variety of reasons - not least because of the administrative and consultancy fees involved. "The regulators are trying to make the process somewhat easier. But what no one can avoid is the fact that closing or winding up a defined benefit scheme crystallises the scheme's liabilities and raises an immediate debt on the employer," he warns.
Of the two "closure" options, winding up a scheme or closing it to new members, the second option tends to be more of a favourite with companies largely because it does not crystallise the debt. Provided the company scheme trustees leave a substantial portion of the fund in equities, the company retains the chance of seeing its funding shortfall diminish or vanish when favourable market movements return.
However, Morton warns that even closure has its perils. Apart from the obvious fact that the deficit can worsen further if markets continue to fall, companies have to take into account the fact that closure gives them a more clearly defined set of liabilities. "It follows from the fact that the liabilities become more tightly defined that the trustees will be under some compulsion to switch more of the investment to gilts anyway, so removing the chance for a significant gain from any upward movement in equities," he comments.
David Sweeney, regional financial planning manager at Grant Thornton's Birmingham office, argues that both companies and lower paid employees have some difficult decisions to make now that stakeholders seem to have failed.
"It is probably sensible for finance directors to rest on the fact that the company is not responsible for pensions other than its occupational schemes. What staff outside the occupational schemes do is down to them, just as it always has been. For individual employees, however, they will need to look very carefully at whether any long term savings they go in for will actually make them better off, as opposed to simply stinting themselves in the present," he says.
Sweeney says experience shows that individual investors opt for low risk approaches and get low returns, whereas pension fund trustees take a higher risk profile and get a higher rate of return. This means that there is definitely scope for better advice to individual investors. However, it remains unclear that companies should get involved in giving advice to employees, even if advice becomes deregulated, as is recommended by the Sandler Report on individual pensions.
At present financial advice can only be given by authorised financial advisors. Sandler wants to see simplified regulated products introduced, and sees the company as an ideal forum for distributing those products. Deregulating advice will enable companies to get involved in helping their lower paid employees to do something other than simply rely on state aid.
Pension promise
The government has just announced that it is taking emergency action to stop solvent companies from leaving black holes in their final pension schemes. A whole new package of measures are designed to grant the "best possible protection to workers".
However opinion is divided. The report has brought negative responses from some pension fund advisors who believe that new regulations will force them to recommend more stringent funding levels, lead to the combined deficit across the UK pensions industry increasing and in employers opting for cuts in future benefits.
Measures include introducing a Pensions Protection Fund to guarantee members a specified minimum level of pension and requiring solvent employers who choose to wind up their schemes to meet their pension promise in full. The report also revised the priority order which applies on wind-up to ensure the fairest possible sharing of assets.
Source Harvey Ingram Owston
Standard bearers feel the weight of accounting changes
Contrary to common belief the proposed new accounting standard FRS17 is not due to come into force until 2005 but it has already caused reporting problems for those companies which have chosen to follow it now, says Maralyn Thomas, partner at law firm Harvey Ingram Owston.
However, for those companies which have not chosen to follow it yet, relief could be on the way, she says.
"Even though 2005 is not far away, companies may be pleased to hear that changes have been proposed to FRS17, so it may not yet come into force in its present troublesome form. And companies can, for the moment at least, choose not to follow it yet, but wait and see what changes might be made to it."
Thomas echoes the view that many companies are trying to ease the situation by closing their (sometimes very generous) final salary schemes to new members, by scaling back the benefits payable from those schemes and even by winding their schemes up altogether.
"None of these options is an easy one for companies to follow," adds Thomas. "They all have their own legal and employee relations implications and those issues do need to be handled very carefully. But we have found that, with goodwill on all sides, solutions to the problems of pension schemes which are in deficit can be found. Under-funding problems should be addressed as early as possible."
Thomas says the Department for Work and Pensions and the pensions regulator are both aware of the difficulties which under-funded pension schemes are facing. They know that trustees are concerned about members who want to transfer their money out of pension schemes. Thomas says the concern is that if transfer payments are made on the current statutory basis for calculating "cash equivalent" transfer payments this could have an adverse effect on the pension scheme's already difficult funding position.
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