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  • Defined Benefit

How to approach spiralling DB deficits

As deficits hit a record level, PP looks at the impact on funding negotiations

  • Natasha Browne
  • 03 February 2015
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Pension deficits across private sector defined benefit (DB) schemes hit a new high in January. The latest pensions risk survey from Mercer showed a 25% increase across FTSE 350 schemes between December 2014 and January 2015 alone.

Figures from JLT Employee Benefits (JLT EB) summed the problem up, revealing a 70% hike in total scheme deficits since January 2014, while the combined s179 deficit of schemes covered by the Pension Protection Fund (PPF) is at a record high of £367.5bn (see chart). These schemes boatsed a small aggregate surplus just over a year ago.

The primary causes are low interest rates and the Bank of England's (BoE) quantitative easing (QE) programme. More recently, sovereign and corporate bond yields have been hit by Eurozone deflation and the ECB's decision to finally begin €60bn (£45bn) per month bond-buying exercise. While higher bond values often increase the value of scheme assets, they have a stronger effect on liabilities, which are measured against bond yields.

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Investors had been banking on the BoE raising the base rate at various points throughout last year but this never came to pass. There is subdued enthusiasm about the economic recovery, despite improved GDP data and signs of real wage rises (which would also increase DB liabilities). So should schemes finally accept the ‘new normal' and plan for historically low rates of 2%?

Hymans Robertson partner Jon Hatchett says schemes have to ask how confident they are about rates going up. "How much economic exposure do you want for that? Do you want £100m of exposure, or £200m? How willing are you to back interest rates going up faster than the market predicts and if you're not, what might be effective ways to hedge rates if you're actually taking more risk than you want?" he says.

Hatchett is unsure if there is a ‘new normal'. But he adds: "Over the next five years, interest rates certainly could rise faster, we could get more normal economic growth, more normal inflation, the bank may be able to raise base rates and then long-term rates will follow, but it doesn't feel like a certainty."

Trustees and sponsors need to understand the risks they are taking whatever the outcome, says Barnett Waddingham's Nick Griggs (pictured). "They may have the belief that things will revert back to normal and gilt yields will rise. But if things don't, they need to ask if they are happy with the risks they are taking and making sure that the scheme can survive, and that the employer will be able to afford the contributions, if yields do stay at this level," he says.

The sponsor covenant

The Pensions Regulator's (TPR) DB funding code of practice means trustees need to be more mindful of their employer's sustainability when asking for higher contributions. As such, strained funding positions can create tension between the trustees and the employer. This is especially true where the scheme is considerably larger than the sponsor. JLT EB director Charles Cowling says: "If the business does go under, a huge potential debtor is the pension scheme. The members would lose out, so the trustees are in a very difficult position as to how to push, and how far to push, the employer. If they push too hard, it may not be in the members' interests."

A key part of balancing this relationship is strong communication. The business needs to be kept informed of any widening funding gaps, rather than being suddenly hit with figures detailing the state of the scheme. Hatchett says: "With the stronger relationships, there's sufficiently good information sharing and sufficiently good commonality of objectives that this isn't sort of a surprise for anybody. Both the company and the trustee are looking to stably fund the scheme over the long term despite the fact that we're clearly at a market low for interest rates. Where there's not a good relationship to start with, clearly bad news is not going to help."

Schemes that had their valuations last year may need to look at their funding positions again. Rates took a dive in the final quarter of 2014 and continued to drop into 2015. Griggs says: "The difficulty is those who had 2014 valuation dates will have seen and started to focus on an initial position. They need to look at the extent to which they've seen the funding position deteriorate further since the valuation date and how they reflect that in the contribution rates that they agree."

Weathering the storm

Last month, BT agreed to pay £1.5bn to help plug the £7bn deficit in its DB scheme, bringing forward some of the contribution to claim tax relief before corporation tax is cut in April. Other sponsors may or may not take a similar approach. However, Griggs says: "If trustees aren't getting what they want, they need to ask what else the company can give by way of security. Will contingent assets be put on the table by the employer so in that doomsday scenario you've got some added protection?"

A healthy employer is in everybody's interests, Griggs adds, because it can afford to make contributions. This can be achieved by lengthening the funding plan. Cowling adds: "There are things that you can do to flex, like recovery periods - you just accept that you're going to pay for longer rather than increase contributions."

Separate data from JLT EB has found fewer than one in four FTSE 100 firms have open DB plans. Spiralling deficits will do nothing to reverse this trend. Cowling also points out higher earners have been discouraged from pensions because of tampering with tax relief. He says: "All the key employees and members of the board are less protective of ensuring that old style DB benefits are maintained. DB provision in the private sector within the next year or two will be all but gone. And then we've got years and years of managing legacy liabilities."

Hatchett says trustees need to treat the trend in rising deficits seriously. "I'm not saying that there should be a knee-jerk reaction to that, or that there's a magic bullet solution. I think what you're looking for is schemes to try and fix this problem over the long term, to manage down to an appropriate level the degree of risk they're taking between their assets and their liabilities," he says.

This can be achieved with liability-driven investment (LDI) strategies, as well as through gilt purchases or de-risking like buy-ins. Hatchett adds: "Look at that range of options to try and get better hedged over the course of time. Markets will go up and down, and that shouldn't be surprising. But it's about finding a strategy where you can ride those waves smoothly enough."

This article was originally published on 3 February. It was updated with new figures on 10 February.



PP Liabilities and Bulk Annuities Forum 2015
 

Professional Pensions is holiding the Liabilities and Bulk Annuities Forum on 19th March. To find out more about the conference, click here.

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  • quantitative easing
  • JLT Employee Benefits
  • Hymans Robertson
  • Barnett Waddingham
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