Companies with defined benefit schemes continue to face the squeeze. Pension deficits for FTSE 100 firms have grown to their highest levels and it is little wonder that many companies are desperately looking at ways of reducing the burden from their balance sheets.
ITV is the latest company to try and offload some of its deferred members. It has asked pensioned employees to give up their inflation-linked pensions for a one-off uplift. It has offered one 74-year-old pensioner member of its scheme a 23 per cent rise to his annual income now if he is willing to forgo his guarantee of a 5pc rise in income each year. The letter says he will start to be worse off after about 11 years.
Experts expect more such ideas to follow as even more final salary schemes bite the dust, and it is easy to see why companies offering them are under pressure to offer incentives to deferred members. In a clear illustration of how unaffordable defined benefit schemes have become for many companies, KPMG’s fourth annual Pensions Repayment Monitor has found that, for the first time, FTSE 100 companies are likely to spend as much on paying the pension promises to past employees as they are on current employees’ benefits.
The allocation of businesses’ defined benefit cash spend between new benefits for existing employees and deficit funding (for past employment) is expected to move from a “normal” 2:1 ratio in previous KPMG Pensions Repayment Monitor surveys to 1:1 over the next year and is set to reach 1:4 within five years according to KPMG’s projections. At that level, £4 of every £5 spent on defined benefit pensions will be for past liabilities, not new benefits.
Mike Smedley, pensions partner at KPMG in the UK, said: “It is unprecedented for companies to be spending as much or more on their defined benefit pension benefits for previous employees than for current staff. The fact that we are now reaching this point graphically illustrates the increasing unaffordability of defined benefit schemes. Unless companies and their pension scheme trustees can work together to ensure that pension funding can be managed in a way that does not impact on companies’ wider financial flexibility, this is likely to result in more and more companies opting to close defined benefit schemes altogether.”
One method that is being increasingly being used to reduce pension scheme liabilities is to offer enhanced transfer values to deferred members. As Corporate Adviser highlighted last month, the dramatic changes in bond yields is beginning to make ETV exercises an attractive option to companies.
Hymans Roberston says that to be attractive to a member, an enhanced value offer needs to be higher than their liability shown on the company’s balance sheet. If a member accepts the offer and takes the transfer value, the excess amount goes through as a loss in the P & L account.
ETV exercises will begin to look an attractive option to companies because corporate bond yields have fallen sharply, meaning that pension liabilities shown on company balance sheets will rise dramatically. Companies with significant deficits will no longer be able to hide behind high bond yields, while enhanced transfer values will be closer to the value shown in company accounts.
Aon Consulting says it has been approached by a number of companies looking to offer ETVs, with the drive to do so coming from the company, not the trustees. However, it said that the motivation for an employer to want to engage in an ETV exercise is not purely to reduce a deficit. “Companies are saying to us that we have this risk and we can’t tell how it’s going to impact company accounts. They want to know how we can help them manage away the risk,” says Sarah Abraham, consultant actuary at Aon.
Abraham uses the following example to explain why ETVs are not only about reducing the funding level of a scheme. If a company has assets of £70,000 and pension liabilities of £100,000, it has a funding level of 70 per cent. If enhanced transfer values are paid such that liabilities are reduced by £10,000 and assets are reduced by £7,000 then it has £63,000 worth of assets against liabilities of £90,000. The deficit has been reduced by £3,000 but the funding level is still 70 per cent.
Abraham said: “Even with the same funding level, the size of the deficit has reduced. Therefore, the exercise is beneficial to the company even if the funding level is not improved by the exercise. This example highlights why ‘improving the funding levels’ isn’t the only reason for carrying out the exercise.”
A handful of companies in the past have tried the normal transfer route, but this carrot has not surprisingly proved unsuccessful because a large number of employers will not be tempted to leave a final salary scheme and the benefits that come with it.
Rash Bhabra, head of corporate consulting at Watson Wyatt says: “A normal transfer value is a pension scheme’s ‘best-estimate’ of the cost of providing a member with a pension. This, however, is usually lower than the price the scheme would be charged by an insurance company, which would be looking to make a profit, for taking on that liability. It is that difference in costs where the enhanced value sits – potentially, both the pension scheme and the scheme member get a better deal.”
There are typically two routes for ETVs. The employer might put extra funding into the scheme to allow enhanced transfer values to be paid (or might give members a payout outside of the scheme). In this case, paying the enhanced transfer value would lead to a one off cash payment from employers. The other option, which is less popular, is giving the pension pot an uplift.
Consultants say that a cash lump sum is often the preferred route because the chances of take up are far higher – after all cash is a tangible asset that a member can relate to.
It was the route that Intercontinental Hotels took last autumn. It offered its deferred members 25 per cent cash lump sum on top of the normal transfer value. The group will not say how many members took up the scheme but said that it paid out £10m in ETVs, which was what it had expected to pay out in total.
A spokeswoman says: “We offered a cash lump sum, subject to the usual taxes, which could be taken as cash or transferred to a third party. The proposal was beneficial to everyone, to the company, to members and to the plan itself. Uptake was in line with expectations.”
Cash may be the easier sell, but some advisers worry whether it is in the best interests of the member. “The practice of enhancing a transfer value is probably better for the member than offering an actual “cash in hand” incentive payment, as this could be spent now, at the expense of the client’s future pension,” said Lee Smythe, adviser at Killik & Co.
The legacy of the pensions misselling scandal runs deep and consultants across the board insist that financial advice should be a core part of the ETV process.
Bhabra added: “We always encourage employers to offer scheme members independent financial advice if they are interested in taking an enhanced transfer value. It is important that people are in a position to make informed decisions. Our advice is that companies should not allow members to take an enhanced transfer value offer unless they have received financial advice.”
Abrahams is equally insistent and said that accepting an ETV is not always an inferior choice and the view that a DC scheme is worse than a DB scheme is ‘misplaced’. She added: “You have to ensure members are fully aware of the implications and understand what they are being offered. You should have a helpline to answer member queries and offer financial advice.”
Advisers might be wary at the prospects of advising on a DB transfer, but such are the regulatory guidelines in place following the pensions misselling debacle, few expect there to be a backlash in years to come.
“Legal action against advisers is unlikely because the area is so heavily regulated. The assumptions used for the critical yield analysis are dictated by the FSA and to advise on pension transfers you need to be qualified to a very high degree,” said Laith Khalaf, pensions adviser Hargreaves Lansdown.
“Although there are rigorous checks in place where advice on transfer is given, there is no requirement for advice to be taken before accepting a transfer. We will not accept transfers from final salary schemes unless advice has been taken, to ensure that the client understands the risks involved.”
INVESTING ETV POTS – WHAT STRATEGY SHOULD MEMBERS ADOPT? THE EXPERTS’ VERDICT
“After the “R U Owed” campaign of the last pensions’ transfer scandal, advisers run scared of offering advice from DB schemes. I suspect that many individuals will remain in failing DB schemes simply because it is far easier for advisers to tell them to stay where they are.
“If we do arrange a DB to DC transfer, it is invariably invested cautiously – but then everything should be invested cautiously at the moment. Our portfolios are very focussed on corporate bond funds, absolute return and multi-asset funds, physical gold and physical platinum, with a bit of pharmaceutical and oil equity exposure.
“We don’t trust the latest equity rally. As ever, individuals will have their assets within a pension fund invested dependent upon the length of time they have until retirement and their attitude to risk. The most important decision as far as the adviser is concerned is to try to determine what exactly is low risk and what is higher risk than the risk models would suggest.”
Andrew Merricks, Skerritts Consultants
“The decision to transfer is a difficult one. It is based on a critical yield analysis – how much annual growth would the investor need to make from a DC scheme to match the benefits from their final salary scheme? If it is less than 7 per cent, we consider recommending transfer, subject to other considerations such as the length of time to retirement. The advisory process does not take account of the risk of the employer going bust however, and we do find some clients will insist on transferring regardless of the critical yield and our recommendation not to transfer. We will not accept transfers from final salary schemes unless advice has been taken, to ensure that the client understands the risks involved.
“Once the decision to transfer has been taken, the fact the money has come from a DB scheme should have no bearing on the investment recommendations. The client has a DC pension pot and the usual considerations of length of time to retirement and attitude to risk kick in. Younger investors can afford to take more risk, investing heavily in equities and emerging markets. Investors with less than 10 years to retirement should look to have a lower risk portfolio including equity income funds and managed funds, with an increasing shift towards bonds and cash as they approach their retirement date.”
Laith Khalaf, Hargreaves Lansdown
“We are seeing more activity in the area and receiving more enquiries from trustees wanting to get rid of people from their scheme – if they can. We are quite cautious in moving people away from DB schemes as you can imagine. It is a hot potato with all the regulatory requirements, but nevertheless people are interested and need advice.
“Most tend to take the Sipp route because of the open architecture available rather than traditional managed funds.
“Most clients are being cautious with portfolios at the moment and it is no different with DB transfers – they want to protect what they have.
“When it comes to accepting a transfer it is less about trying to increase benefits and more about maintaining the status quo and protecting what you built up in the DB scheme.
“We are starting to drip feed a little money into the market, as there is a feeling that if you don’t, you could get left behind.”
Nick Oliver, Brewin Dolphin