CASE STUDY 16

Companies Still Failing to Fill the Funding Gap

Lucy Warwick-Ching

The dire state of Britain's pensions system was highlighted this week as new figures revealed that the black hole in company pension schemes is getting deeper in spite of a steady rise in equity markets.

Pension fund contributions by companies in the FTSE 100 index were at a similar level in 2004 to the previous year, at £11.4 bn. But after meeting the cost of new pension promises and interest on last year's deficit, less than £1 bn was left to reduce the £60 bn underlying deficit, according to research from RBC Capital Markets.

John Ralfe, an independent pension consultant and author of the research note, says although many companies have been increasing contributions, they have often done so after a full or partial contributions holiday. “This stops the deficit increasing but does nothing to reduce it,” he says.

The size of the companies' pension liability is particularly important when seen in relation to the assets held by that company. “Many companies have huge pension liabilities – far bigger than the assets they have to pay them,” says Donna Bradshaw, independent financial adviser at IFG Group. “This could leave thousands of workers in a parlous state if their employers suffer prolonged bad trading and go under – as has happened with MG Rover.”

Five companies – British Airways, BAE Systems, ICI, Rolls-Royce and British Telecommunications – account for 20 per cent of the overall FTSE 100 liabilities and deficit under FRS17 accounting guidelines.

BA, which a couple of years ago had a market capitalisation smaller than the deficit on its pension fund, had a deficit equal to 66 per cent of its market cap in June this year. While its shares were worth £3 bn, the deficit was almost £2 bn. Like many other companies it no longer lets new employees join its final salary schemes, but existing employees can still contribute.

“The biggest risk for pension schemes, aside from equities crashing, or longevity of pensioners, is whether the company will be around in five or ten years' time to pay the benefits,” says Tom McPhail, pensions expert at Hargreaves Lansdown. “Companies have overreached themselves with their promises over the past decades and they could find these promises very difficult to fulfil.”

Pension funds have been battling a double whammy of falling stock markets that reduced the value of their assets, which are largely invested in equities and historically low bond yields, which effectively raise the cost of funding pension payments and therefore increase their liabilities. This, combined with increased life expectancy, means that companies are having to contribute about 50 per cent more to their pension funds than they did 15 years ago.

The RBC Capital Markets research preceded an announcement from the government on Wednesday that its new pensions safety net is now likely to cost more to fund than the £300 m a year originally estimated. The pension protection fund is designed to safeguard staff pension entitlements if an employer goes bust.

The fund also confirmed this week that companies in danger of going bankrupt, or whose pension schemes were underfunded, would have to contribute much more to the fund than stronger firms.

Of the five companies mentioned in the RBC Capital Markets research as having the weakest pension funds, not one has a credit rating higher than BBB+, two notches above the lowest investment-grade debt.

Ralfe believes that the continued high weighting in equities for many of the pension funds is partly to blame for the huge pension fund deficits. He says FTSE 100 companies for the most part appear to be hoping that strong rises in equities markets will bail them out.

“Some companies act as though a pension deficit can be plugged by holding a high level of equities and hoping for the best,” he says. “Holding equities is not a substitute for increasing contributions.”

He believes that UK pension schemes still hold too little in long-dated and index-linked bonds and says that a pension scheme should “hold matching bonds to back the pensions already being paid”. He makes the point that “simply to match the pensions in payment today, UK pension schemes need to make a switch, of 20 per cent, or £125 bn, from equities to bonds,” says Ralfe.

But not everyone agrees. “The notion that you can switch the risk by switching from equities into bonds is dangerous,” says Ros Altmann, a pensions specialist and former adviser to the government on pensions. “The most important thing is to create a diversified portfolio so as to protect the downside as well as allow for any possible upside.”

The good news is that the dramatic deficits are not uniformly spread among FTSE 100 companies. About 30 companies account for the bulk of the problem while the rest, making up 75 per cent of the FTSE 100 market cap, have a deficit of just 5 per cent or less of their market cap.

“Although many companies have recently increased their regular contributions, more should be following GlaxoSmithKline's lead in making consistent contributions to reducing pension deficits,” says Ralfe. “Over the last three years, it has quietly made a total contribution of £1.6 bn, a net reduction in its underlying deficit of £650 m, leaving the latest deficit at £1.5 bn.”

He expects more large one-off contributions from the stronger companies over the next few years, leaving pension holes increasingly concentrated in the weaker FTSE 100 companies.

Experts hope to see an increase in deficit contributions once the protection fund moves to a risk-based levy, which will impose an explicit cost on companies running a pension deficit. The Pensions Act 2004 which comes into effect in September is also expected to increase contributions. The new regime represents a dramatic shift in the balance of power in determining pension scheme funding with pension trustees being given greater powers to decide a company's contributions to its pension scheme.

“There will be a two-pronged approach to increasing contributions,” says Steve Leake, principal at Punter Southall. “Companies will have to provide an estimate of the assets needed to make provision for the benefits when they fall due. They will have to come up with a recovery plan which will set out the manner and time-frame in which the deficit is to be eliminated.”

He says that trustees will be encouraged to remove any deficit as soon as practicable. “Under the new rules, where trustees and employers cannot agree on an acceptable funding plan, the regulator [The Pensions Regulator] will be able to intervene. The body's powers include setting the contributions, stopping or changing the future accrual of benefits and even winding up the scheme,” says Leake. These pressures could prove the last straw for those companies who still offer defined benefit pension schemes. Some 68 per cent of defined benefit schemes are closed to new entrants and 10 per cent closed to new accrual of benefits, according to a recent survey by the Association of Consulting Actuaries. “From September it will become obvious to the workforce what state their pensions are in and will cause a lot of alarm,” says Leake. “Unless companies appear to be doing everything they can to close the gap between liabilities and deficits there will be an outcry from members.”