Employers and pension fund trustees will often have to choose between dramatically higher contributions and leaving their schemes in deficit for much longer when they agree new funding plans based on current market conditions, according to Towers Watson.
Pension schemes typically undergo an actuarial valuation once every three years and most commonly assess their funding position at 31 March or 5 April. For many of the schemes who must devise plans to repair deficits measured in late March or early April 2013:
• Remaining on track to pay off deficits within the timescales previously agreed could require employers’ annual contributions to double.
• Alternatively, avoiding any increase in contributions could force trustees to put back the dates by which they expect their schemes’ shortfalls to be eliminated by a decade or more.
One reason for this is that index-linked gilt yields have fallen to record lows at the worst possible time for the employers concerned.
Towers Watson says that, in most cases, both assets and liabilities will have increased significantly since March/April 2010 but that deficits will be much bigger in cash terms and therefore harder to pay off. The precise impact will vary a lot from one scheme to another and even between the two most common valuation dates, with snapshots taken on 5 April looking worse than those taken on 31 March.
John Ball, head of UK Pensions at Towers Watson, said: “Many employers will find that the substantial sums injected into their pension schemes have not even allowed them to stand still. If a scheme’s plan to clear its deficit is behind schedule, the response will usually involve some combination of pedalling harder to catch up and accepting that it will take longer to reach the destination. This is an uncomfortable trade-off, so there may be more interest in alternative solutions such as using some of the employer’s other assets to shore up the pension scheme as well as paying in cash."
Based on the position at its valuation date, the market value of the assets a scheme holds is compared with an estimate of how much it would need to cover all future pension payments as they fall due, which must be calculated using assumptions that have been chosen prudently. Employers and trustees then agree a ‘recovery plan’ to repair any deficit.
On 5 April, the annualised real yield on twenty-year index-linked gilts fell to a record low of -0.58 per cent pa: pension schemes who lend money to the Government can expect to get back significantly less than Retail Prices Index inflation, to which some pension benefits are linked. Recent strong returns from other assets, such as equities, can also cause schemes to assume that there is less scope for these to grow quickly in future. The lower the rate of return that a scheme assumes it can earn before investments must be cashed in to pay benefits, the bigger the value of its liabilities will look.
John Ball said: “In the Budget, the Government indicated that it wants the Pensions Regulator to be more sympathetic to employers’ growth plans when it polices pension scheme funding strategies. Record low interest rates mean that there will be a baptism of fire for this new approach.
“It is not clear precisely what the Government wants to achieve – for example, whether it wants to reduce employer contributions, stop them from rising too quickly, or simply ensure that the Regulator does not shoe-horn schemes into assuming that their investment strategies will always deliver the same margin above gilt yields regardless of market conditions. The significance of its announcement probably has as much to do with the tone as the content. When companies think about their red lines for negotiations with trustees, they will be well aware that the Government appears to be striking up a more employer-friendly tune.”
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