Taking a step back, it is a ridiculous concept that many of the UK’s largest businesses are listing their defined benefit (DB) scheme as one of their top risks. However, with the changes in pension legislation and financial markets over the last twenty years, this is unfortunately the reality.
We are in a period of massive uncertainty for UK businesses and there is no clear consensus in relation to how markets will react over the next few years. Against this backdrop, the risks companies are exposed to through their DB schemes are massive. Our annual review of the pension obligations of FTSE350 companies highlights the significant impact current deficits are having for some, but not all, of these large employers. Given the size of many DB schemes, significantly more companies could find themselves under pressure from their pension scheme if some very plausible economic scenarios play out over the next few years.
This of course focuses on the downside risk - there is also the possibility that financial markets will react more favourably than expected over the next few years, resulting in the persistent deficits that have been such a drain on corporate cashflow being cleared more quickly. For most, taking some level of rewarded investment risk is necessary to make their DB scheme sustainable, but corporates need to ensure that a messy exit from the EU or a second credit crunch will not be catastrophic for their DB pension scheme. In such an uncertain environment, many companies will be looking to understand the impact of various economic and political scenarios for their core business and for many, the DB scheme should not be a secondary consideration.
There remain plenty of opportunities for companies to manage and reduce their risks and there are hints that affordability for the FTSE350 companies improved over 2016. Some of the highlights from our report include:
- Deficit contributions as a proportion of free cashflow reduced to 5% in 2016 (from 9% in the previous year).
- Benefit payments from the FTSE350 defined benefit (DB) pension schemes increased by 15% in 2016, almost certainly reflecting an increase in transfer value payments to defined contribution (DC) schemes.
- Recent data suggests that improvements in longevity appears to have slowed significantly in recent years. If this had been recognised in the FTSE350 2016 financial statements, this would have reduced the aggregate deficit by around £10 billion.
- DC schemes now account for nearly 40% of FTSE350 companies’ pension cost, as the move from DB to DC continues at a pace.
DB pension scheme risk exposure
There are a number of actions that companies can take to reduce DB pension scheme risk and some of these are discussed in our report. Of particular interest at the moment is the opportunities presented by the introduction of the pension flexibilities for DC schemes. Members transferring their benefits from DB to DC reduces the risk of DB pension provision for companies and can lead to an improvement in the scheme’s funding level. Many companies are therefore putting in place processes to support members in making the move from DB to DC (e.g. setting up a Flexible Retirement Option).
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With benefit payments from the FTSE350 DB schemes increasing by around 15% in 2016, it is likely that a number of these companies have already put in place such processes.
DC schemes – the future?
Most companies have taken the first step to contain their DB pension scheme risk by terminating future pension accrual. Therefore, it is perhaps no surprisethat DC schemes now account for nearly 40% of FTSE350 companies’ pension cost (compared to around 20% in 2010). However, with this being one of the main points of discussion in the intergenerational fairness debate, the relative generosity of the two different pension arrangements will continue to be scrutinised. The step up in the minimum auto-enrolment contribution rate is a small step in the right direction to redress the difference. Nonetheless, most commentators will argue that there is still a long way to go and it will be interesting to see whether, in the future, companies again look to offer some form of pension guarantee to attract and retain the best employees.