The FINANCIAL — According to Mercer, despite an estimated £15bn per annum having been paid into the pension schemes of FTSE350 companies, the size of defined benefit (DB) pension scheme deficits has increased by £34bn (or by 50%) over the last 5 years, before allowing for the impact of the UK referendum outcome.
The increase in the deficit comes despite companies have contributed an estimated £75bn of cash to DB pension schemes, equivalent to almost 5% of value of the liabilities.
Mercer’s analysis (Chart 1) shows that there was a deficit in the DB pension schemes of FTSE350 companies of £64bn at the end of 2010 corresponding to a funding level (ratio of the value of the scheme assets to the value of the scheme liabilities) of 88%. At the end of May 2016 the deficit was £98bn, with a corresponding funding level of 87%.
Adrian Hartshorn, Senior Partner at Mercer and leader of the UK Financial Strategy Group said, “Despite many billions of pounds of company contributions, DB pension deficits remain stubbornly high. The high deficits are a result of the increase in the value of pension scheme assets not having kept pace with the rising cost of providing pension benefits caused by persistently low (and falling) interest rates. Contributions paid by companies are therefore simply being used to fill an ever increasing gap between the value of the assets and the value of the liabilities. Add to this the impact of people living longer and a range of other costs and it is easy to see how contributions are simply swallowed up.”
Pension liabilities have mushroomed in the past 5 years with the value of the defined benefit pension scheme liabilities for the FTSE350 increasing by 44% since 2010. In contrast, the market capitalization of the same companies has increased by 10% over the same period. Consequently pension scheme liabilities now represent 40% of the market capitalization of FTSE350 companies compared to 30% at the end of 2010 (Chart 2).
According to Mercer, for the outlook to become more positive for the UK’s pension schemes, interest rates would need to rise more quickly than markets are expecting. In addition, equity markets and other ‘growth’ asset classes would need to perform strongly over a prolonged period of time and the life expectancy improvements that have been observed over the last 20 years would need to slow down. If one or more of these elements fails to materialise then pension scheme deficits (and the cash contributions required to fund them) are likely to worsen.
“Pension schemes are an important part of a company’s balance sheet and financing structure. Given the complex nature of pension scheme debt, companies often underestimate the positive impact that proactive intervention can have on managing the risk and cost of pension deficits,” said Mr Hartshorn. “There are a number of approaches that can be used to manage the financial risk posed by pensions including hedging, cash flow driven investing, risk transfers, insurance transactions, alternative financing or the use of member options. Some solutions are popular with members, for example 40% to 50% of members typically engage in member option exercises.”
The most meaningful step changes are often achieved by combining several approaches, either in a single project or over several years,” concluded Mr Hartshorn. “The final piece in the jigsaw often being a buyout transaction, which completely removes the risk, an area Mercer is particularly familiar with having lead all five buyout transactions over £1bn that have been completed in the UK.”