Most companies have closed their defined benefit (final salary) pension schemes to new members, but only 10% have closed the schemes to new accruals, according to the latest pension trends survey from the Association of Consulting Actuaries (ACA).
Furthermore, most employers still have no exit strategy for these schemes, despite viewing them as unwanted burdens, says Aon Consulting.
In a recent survey, Aon found that 43% of companies regard their closed defined benefit (DB) schemes as unwanted legacies, with this figure rising to almost 60% where the scheme has been closed for five years or more. Despite this, around 70% of companies have no strategy for managing their pensions legacy.
“The typical scenario is that a company with an unwanted defined benefit scheme has closed it to new members, provided a money purchase scheme for new people and let the old scheme whither on the vine,” says Paul Belok, principal & actuary at Aon Consulting. “But the DB scheme is not just going to disappear. If there are employees in there building up benefits, the closed scheme is going to be around for at least 10 years – and that is probably a conservative estimate.”
In light of its findings, Aon Consulting has urged companies to plan a way out of their unwanted DB schemes, to reduce the financial burden and uncertainty they create. “Companies need to be aware that it is likely that costs will even escalate due to a lack of new money flowing into a scheme, creating an increased reliance on company contributions and investment returns,” says Belok.
The financial impact of an unwanted legacy
Donald Duval, chief actuary at Aon Consulting, points out that a company which doesn’t have a strategy for managing its pensions legacy is likely to get a poorer return on its assets and to have higher liabilities than one with an exit strategy. To assess the possible financial impact on companies, Aon Consulting analysed the position of the 200 largest DB pension funds, which have total assets of £400 billion. For 50 of these funds, the pension fund is bigger than the company’s market capitalisation.
“If the difference [in return on assets] is only 10%, this translates into a lost opportunity of £28 billion for UK companies,” says Duval. “Where the pension fund is bigger than the company, then an extra 1% performance in the pension fund should translate into more than 1% on the share price.”
Planning a final exit
In planning an exit route from a DB scheme, a company should have clear objectives, with a timescale for achieving them, and an understanding of the investment and funding policies they will need, says Belok.
The most obvious way to finally shut the book on a DB scheme is to close it to new accruals and move members to an alternative defined contribution (money purchase) scheme. Although only 10% of companies have taken this route, the chief executive of the National Association of Pension Funds (NAPF), Christine Farnish, recently predicted that most private sector employers will do so by 2010.
But it’s not a straightforward option. “It may be seen negatively by employees, who are becoming more pensions literate,” says Belok. “There may be rules in the pension scheme that complicate matters. Also, the employer will have to look at possible compensation to scheme members, which may need to be negotiated on a case by case basis.”
It’s impossible to estimate exactly how much this exit route might cost companies, as every scheme – and every member – will give rise to varying compensation amounts. But it’s clear that in general terms, the costs of closing a scheme with many members may currently outweigh the benefits. The latest figures from the NAPF show that there are still 8.6 million active members in the UK’s 11,638 defined benefit pension schemes. However, as schemes dwindle it becomes more palatable to close them to new accruals, says Belok, as there are fewer employees to compensate. “Companies have to weigh things up. Perhaps for some the pain of closing the scheme isn’t worth the benefit at present, but there will probably be a tipping point in the future.”
If and when a DB scheme is closed to new accruals, the link to future salary growth – in line with FRS17 – will be removed from the company’s balance sheet. This saving will be countered by the compensation costs, which may be accounted for in the profit & loss account, or in extraordinaries. “The net effect may be neutral depending on levels of compensation,” says Belok. “But the advantage is that the company will have crystallised benefits under the DB scheme and removed uncertainty, making the liability more manageable.”
Reducing the financial burden
Companies that are not yet ready to head for the final exit door have various options for reducing the burden of unwanted DB legacies. One strategy that is being widely adopted is to increase employee contributions, thereby reducing the employer’s liability. The latest ACA survey shows that the average employee contribution to a DB pension fund has increased from 4.3% of earnings to 5.5% since 2002, with 44% of companies reporting an increase in employee contributions.
There are also changes companies can make on the investment front to ease the DB burden. “Many schemes are not cutting edge in terms of investment policy,” asserts Belok. “By putting more focus on the scheme’s investments, many companies could probably get a better return for the same level of risk.” One strategy to consider is liability driven investment, which is becoming something of a buzz-phrase in pension circles. A liability driven investment strategy has a ‘transparent’ link between pension fund assets and liabilities. “Companies can use various swaps and other vehicles to match out projected liabilities,” explains Belok. “It’s basically a hedging policy. Many schemes have a pseudo hedge that isn’t as accurate as it could be. There are ways of making it more accurate.”
Companies with large funds might consider investment arrangements which link income to group mortality rates. “BNP tried to introduce a mortality bond, which paid an income stream linked to national rates of mortality,” says Belok. “BNP withdrew the bond due to lack of interest, because it didn’t meet the needs of pension schemes. It was based on national figures, not the mortality rates within a scheme. But for larger funds, there is an opportunity to look at arrangements tailored to individual circumstances, which would help to fund liabilities and manage them.”
The ACA says that some companies are making changes in the normal retirement age (NRA) to reduce forward liabilities. “Currently, 75% of schemes have an NRA of 65, with 25% having an NRA between 60-65,” says the association. “Some 15% of firms are looking to change their retirement age, with the vast majority presently being in the band with an NRA below age 65.” In addition, around 10% of DB schemes have changed the accrual rate, says the ACA, most commonly reducing it from 1/60th of final salary for each year of membership to 1/80th.
Another area to consider when trying to reduce the DB burden is trivial commutation – whereby a company can pay pension benefits as a lump sum to members who have very small pension funds. It will become more difficult to take this route when regulations change in 2006, warns Belok. “There is a window of opportunity at present”.
Belok also suggests that in some circumstances, members who have left the company but remain in the scheme could be encouraged to take a transfer value, which would typically be less than the balance sheet liability. However, he counsels caution, as the company would need to take account of best advice requirements in accordance with Financial Services Authority regulations. “Companies could encourage ex-employees to take this option if it is genuinely in their best interests, but they have to do the right thing.”