The last year has seen the biggest sustained improvement in the funding of UK defined benefit (DB) pension schemes since the global financial crisis.
After over a decade of falling bonds yields and similarly falling funding levels, we have seemingly entered into a new economic landscape where interest rates are on the ascent and the resulting increase in discount rates is materially reducing DB pension liabilities.
In an otherwise gloomy economic environment, with a cost-of-living crisis and fears of a sharp recession on the horizon, the improved health of DB pension scheme funding levels may be one consolation for sponsoring employers. The improvement in funding positions could provide companies with an opportunity to flex DB pension expenditure during a challenging period for business, while the ultimate goal of an insurance buyout could now be within reach for many.
In this analysis of the DB pension schemes of the FTSE 350 companies, we examine the impact of the recent economic changes on the journey to the DB pension endgame, and consider some of the risks and opportunities along the way.
The analysis below is based on market conditions up to the end of August 2022, so does not take into account the recent financial market volatility. However, the overall conclusions from the analysis remain unchanged. Please discuss the particular circumstances of your scheme with your local Barnett Waddingham consultant.
Our DB End Gauge index provides a measure of the average time to buyout for the FTSE 350 DB pension schemes. The chart below shows the sharp fall in the average time to buyout for these schemes over the last year.
At the end of August 2022, we estimate that the average time to buyout for the FTSE 350 DB pension schemes was just under 7 years – a reduction of around 3 years compared to the position at the start of the year.
This dramatic fall has largely been driven by the significant changes in financial markets, in particular the steep increase in the yield on bonds over the year. This is illustrated in the chart below, alongside the change in long-term market-implied inflation expectations.
While the position is volatile, at the end of August long-term bond yields have increased by over 2% p.a. since the start of the year, while long-term inflation expectations have remained broadly static. For the average FTSE 350 scheme, these financial market movements have reduced liability values by over 30%.
With growth markets overall remaining relatively flat over the same period, schemes with low levels of interest rate hedging will have been the main beneficiaries of the sharp increase in bond yields.
Financial market changes have provided a welcome boost to the funding position of most schemes, and some may now find themselves within touching distance of their endgame objective (whether this is buyout, self-sufficiency or some other measure). This cohort of schemes should be taking swift action to lock in the recent funding gains and ensure that the necessary preparation is undertaken to achieve their objective.
However, the reality for most schemes is an endgame target that is still some distance from being met. These schemes will need to rely on a combination of factors to achieve that target, including:
Companies and trustees will want to ensure that a robust plan is in place that provides the optimal combination of the above factors, taking into account their respective risk appetites. In the following sections, we explore the impact of two of these factors - company contributions and investment returns - on the journey to endgame for the FTSE 350 DB pension schemes.
The chart below shows the estimated aggregate deficit contributions paid by the FTSE 350 companies into their DB schemes over the period since 2009, with some of the larger one-off contributions highlighted.
Clearly the deficit contributions paid by the FTSE 350 companies have provided significant support to these schemes over a challenging period financially for DB scheme funding (with over £80bn paid during the last decade alone).
Looking forward, if the recent improvement in funding levels is maintained, and more and more schemes achieve full funding on their technical provisions basis, we expect the aggregate level of deficit contributions to fall.
However, the fact of the matter is that most schemes still have some way to go before reaching their ultimate endgame target. Our calculations suggest that the aggregate buyout deficit for the FTSE 350 DB schemes was around £90bn at the end of August. Even if full funding has been achieved on a technical provisions basis, companies may see value in paying further contributions if this accelerates the time to achieve the scheme’s endgame target.
Our DB End Gauge index assumes that current company contribution levels continue until buyout is achieved. As mentioned above, the index suggested the average time to buyout for the FTSE 350 schemes was just under 7 years at the end of August. However, in the extreme scenario of company contributions ceasing completely, this would increase the average time to buyout to over 11 years, showing the significant reliance on sponsoring companies to navigate the final steps to endgame.
The chart below shows the proportion of schemes achieving buyout within particular timescales depending on the level of contributions paid by the sponsoring employer.
The chart shows that if current contribution levels continue until buyout is achieved, around 76% of the FTSE 350 DB schemes can expect to be fully funded on an insurance buyout basis within the next 10 years. This figure reduces to around 62% if contributions cease completely.
Doubling current contribution levels would result in around 64% of the FTSE 350 DB schemes being in a position to buyout within the next five years.
Whether further contributions are deemed to be an appropriate means to close the gap to endgame will depend on a variety of factors, including the company’s risk appetite and wider business needs (such as the need to reward shareholders and invest for the future).
One other key factor will be the affordability of contributions. At a time of significant economic uncertainty, companies will need to carefully prioritise the competing demands for capital, but in some cases further DB pension expenditure could prove valuable if this significantly reduces DB pension risk and balance sheet volatility.
The charts below show the aggregate cash holdings and the aggregate dividends paid by the FTSE 350 DB pension scheme sponsors over time.
While the economic outlook is challenging, the FTSE 350 DB scheme sponsors look to be in a strong position based on their 2021 financials. These companies reported aggregate cash holdings of around £1.3tn of cash in 2021 (a 16% increase on the previous year), with dividends rebounding to around £70bn after a slump during the Covid-19 pandemic.
When these financials are set against the context of shrinking DB scheme deficits (we estimate that the aggregate buyout deficit has halved to around £90bn since the start of the year), the funding of the FTSE 350 DB schemes looks more manageable than it has done in some time.
As mentioned, DB pension schemes will be contending with various other demands on company capital, but as an illustration of the scale of the FTSE 350 DB pension liabilities, our calculations show:
As well as contributions from the sponsoring employer, investment returns will be the other key factor underpinning schemes’ journey to the endgame. Put simply, higher expected investment returns should mean a shorter endgame journey but also a wider spread of potential outcomes due to the associated investment risk being taken. Deciding on the appropriate balance of investment risk and how this varies over time is a crucial decision for any journey plan.
The chart below shows how the average asset allocation has changed for the FTSE 350 DB schemes over the years:
Clearly a significant amount of risk has been removed from DB scheme asset holdings over the past ten years, as schemes have sought to better match their liabilities. However, despite the significant de-risking that has taken place, most FTSE 350 schemes continue to be exposed to the vagaries of investment markets.
Given the challenging economic outlook, we have assessed the impact of two plausible (if unlikely) economic scenarios on the endgame journeys for the FTSE 350 DB schemes:
The chart below shows our estimate of the impact of these two economic scenarios on the average time to buyout for the FTSE 350 companies.
Under both scenarios, the average time to buyout roughly doubles, with the stagflation scenario having a slightly more severe impact than the hard landing scenario. This shows that, despite many years of investment de-risking, there remains a significant level of investment risk for the FTSE 350 DB schemes, particularly when assessed relative to buyout funding. Companies should ensure that they are comfortable with the level of investment risk being taken given their objectives and risk appetite. Where this is not the case, companies should proactively take action to agree an acceptable investment strategy with the trustees.
For companies wanting to reduce DB scheme investment risk and/or contributions but not wanting to jeopardise achieving their funding objective within a reasonable timeframe, the establishment of the capital-backed journey plan market could provide an innovative solution. A capital-backed journey plan involves a third-party investor managing the scheme’s assets for a defined period and guaranteeing to achieve a particular funding or investment outcome at the end of the period. This guarantee is supported by a capital buffer fund that is available in the event of significant underperformance. In return, the third-party investor is entitled to any excess return above the guaranteed level outcome.
The capital-backed journey plan market is developing quickly, with each provider offering slightly different propositions. While capital-backed journey plans will not be suitable for all companies, for some these will be an excellent way to manage the DB endgame journey, with the potential to achieve a guaranteed funding or investment outcome with very limited downside.
Our analysis shows that the FTSE 350 DB scheme sponsors have taken a big step forward in the journey to the DB endgame over the past year. All DB scheme sponsors should be taking proactive action to understand the opportunities presented by the materially altered financial landscape. For those organisations with a robust journey plan and monitoring process in place, these discussions will have been automatically triggered by recent events. For others, recent market events have shown the value in having a clear decision-making framework to capitalise quickly on opportunities as and when they arise.
For schemes where the endgame target is still some distance away, a clear understanding of the factors that are expected to close the gap is essential. It is also important to understand the levers available to influence the endgame timescales, whether this is investment risk, contributions or liability management exercises. Companies and trustees will want to ensure that the agreed endgame strategy provides the optimal combination of these factors, taking into account their respective risk appetites.
The data used for this analysis has been collected from the accounts of FTSE 350 companies for their 2021 year ends (i.e. up to and including the year ending 31 December 2021). Liability values on a buyout basis have been estimated by approximately updating these results and using Barnett Waddingham’s view of average buyout pricing. Asset values have been estimated using index returns and the asset split disclosed in the pension disclosures. The current level of deficit contributions have been estimated based on information set out in the pension disclosures.
Lewys Curteis
Principal,
Employer Consulting
Simon Taylor
Partner,
Employer Consulting
Our monthly index provides an estimate of the average time for UK pension schemes to reach a sufficient level of funding to buyout their liabilities with an insurance company.
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