Liability stormclouds gather

The ever-changing surplus or deficit of FTSE 100 pension schemes continues to fascinate the market on a day-to-day basis.

In early January, Aon Consulting reported that the total aggregate pension deficit of the FTSE100 had fallen dramatically over 2007 from £40bn to £2bn – a combination of increased active management, liability-driven investment strategies, favourable equity markets, rising interest rates and last but not least, an additional £7bn contributed by the companies themselves.

But before there was chance to break out the champagne, in the week beginning January 21, Aon reported that sharp falls in the FTSE had caused UK pension deficits to rise by £15bn in a single day, and again by £9bn the following morning. In just one week UK pension schemes lost £40bn, wiping out all the 2007 gains. And within these disparate outcomes lie some troubling thoughts.

Many UK pension schemes have over half their assets in equities – a consequence of their long-term perspective, adherents argue, which allows them to ride out most bear markets.

In the short-term, however, volatility in the markets can materially alter the valuation of a pension scheme from one day to the next. It is a headache for many finance directors, who are left with an uncontrolled liability on otherwise well-managed balance sheets. Even worse, timing becomes everything, with those with a reporting date of December 31, for example, potentially much better off than their peers with March year-ends.

For both finance directors and trustees it becomes extremely difficult under these circumstances to determine the ability of a closed end pension scheme to pay its annuities forty years down the track. Throw in the common belief that the economic environment in 2008 is likely to be far less favourable and more volatile than recent years, and a reversal of fortune seems inevitable, even on an IAS19 basis.

The waters are muddied further by a more fundamental problem – for most schemes, liabilities are calculated with insufficient frequency, using out-of-date longevity assumptions and often presenting a less than prudent valuation of the true costs of delivering pensioners full financial security. Yet, companies can’t avoid the most up-to-date longevity assumptions forever, and will eventually have to account for the much larger deficits on their balance sheets.

A buyout valuation, which implies more cautious longevity assumptions and paints a truer picture of the hidden arrears, would increase the figure for most FTSE100 pension deficits significantly by a quarter or more.

It is a stark reminder of the need to stabilise pension portfolios and opens the question of whether corporate sponsors, charged with looking after a broad church of stakeholders and not just pensioners, are the best people to manage pension schemes. Would pension transfers via the corporate or insurance buyout market to dedicated specialists improve the situation for scheme beneficiaries?

Doing so certainly would provide trustees with the security of knowing members’ benefits are better secured. It would also help troubled finance directors: de-coupling schemes from balance sheets would improve corporate sponsors’ credit ratings and their ability to raise finance.

And it would remove the situation where, in a falling equity market with a commensurate fall in the valuation of a scheme’s assets, a board looking to invest in its business would also find trustees coming cap in hand. Above all it would enable management to get on with running their business, free from the distractions of administering a pension scheme.

And if a final reminder was needed, it is worth noting the Pension Protection Fund publishes a monthly estimate of the deficit of 7800 schemes, based on the amount needed to buy out 90pc of their entitlements up to a maximum of £26,000. Even on this very modest measure, schemes swung violently over the year from a surplus of £8.4bn in December 2006 to a deficit of £19.6bn a year later, falling nearly £120bn over the last six months alone.

Now, that is a scary thought for all concerned.