Business Analysis: Companies start to fill £40bn hole in pension schemes

After years of denial, deficits start to be addressed but there is still a long way to go

After several years of apparent denial, many of the UK's largest companies have finally begun to take responsibility for the gaping holes in their pension funds.

After several years of apparent denial, many of the UK's largest companies have finally begun to take responsibility for the gaping holes in their pension funds.

Last week, Royal Bank of Scotland ­ which until recently boasted a £2bn pension fund deficit, one of the 10 largest in the FTSE 100 ­ announced it was ploughing £750m into its scheme. Last year, Marks & Spencer became one of the first companies to raise debt specifically for the purpose of paying down a proportion of its then £1.2bn pension fund deficit.

At the last count, Lane Clark & Peacock, the actuaries, estimated that amongst companies in the FTSE 100 alone, there is a collective deficit of more than £40bn. And while this has fallen from a peak of more than £55bn two years ago, a sizeable part of the remaining hole will not disappear without serious financial contributions from the companies involved.

John Ralfe, an independent pensions consultant, says that while progress is finally being made, there remains a long way to go before most deficits are anywhere close to being wiped out completely.

"Just about everyone is now getting to stage one, which is admitting that this isn't going to just go away of its own accord," he says. "Three or four years ago, people were saying that it was just because equities were down, and thought all they needed to do was wait for them to pick up. But that's not the case."

Mr Ralfe points out that while the collapse in equities played the major role in catapulting pension funds into the red, it is unlikely to be their recovery alone which will put them back in the black. In fact, with Britain now in a sustainable period of low interest rates and low inflation, equity returns are likely to remain much lower than they were historically. Furthermore, increasing life expectancies are ensuring that liabilities continue to grow.

The likes of RBS and M&S ­ which have clearly woken up to these realities ­ are likely to save themselves a nasty shock when new regulations come into force this year.

For years, UK regulations have stipulated only that pension schemes must abide by the so-called "minimum funding requirement" (MFR) ­ an outdated measure which makes unrealistic assumptions about future investment returns, and in effect gives companies the green light to run their pensions at a hefty deficit.

As of later this year, however, stricter regulations are to be put in place, ensuring that pension funds make a more realistic assessment of their liabilities. While the final details of this new regime have yet to be decided upon, companies that are still clinging to the MFR rules will be in for a nasty surprise.

BT, for example, which boasts the FTSE 100's largest pension deficit of £5.1bn, has agreed to pay about £230m a year between 2003 and 2018 to help close its black hole, ensuring its scheme is funded up to the MFR. While it made a much larger one-off contribution into the fund in 2003, of £742m, this was simply advance payment of its annual commitment. To compensate, it made only a very small contribution into the fund last year, and plans to make practically no contribution during 2005 ­ a decision which may come back to haunt it.

Mr Ralfe believes the differing attitudes across Britain's largest companies will create a polarised market. "What we're going to have is the haves and the have-nots," he says. "Those companies that are able to, that are financially strong, will reduce their deficits. Then you'll have those who don't have the capacity to raise money, which will be left struggling.

"The overall [FTSE 100] deficit will be lower because companies like RBS will shove pots of money into their schemes. But the deficit that is left will be more concentrated and more toxic, because it will be concentrated amongst companies that are less credit-worthy and financially strong."

The story will not end there. Another feature of the new regulations will be the increased power of trustees. Bob Scott, a partner at Lane Clark & Peacock, explains: "Some pension funds have the rules written so that the company can set the contribution rate. But under the new rules, trustees will have the power to ensure companies make a proper contribution to the fund. And if the two parties fail to agree, the trustees can ask the regulator to intervene."

Mr Scott says that, as one of the pension regulator's principal duties is to prevent companies dumping their pension fund liabilities on the Pensions Protection Fund, it will be more than likely to side with the trustees ­ pushing companies to take full responsibility for their pension deficits.

As a result, those companies that are not living up to the higher standards set by the likes of RBS and M&S will come under pressure from trustees to pull up their socks.

As the story of WH Smith showed last summer, many pension fund trustees already have the power to scare off potential buyers of their company. With the venture capitalists Permira unwilling to come up with extra cash for WH Smith's pension fund, its takeover bid for the retail group collapsed. And, according to Grant Thornton, a third of venture capitalists recently said they would not consider investing in a company with a pension deficit.

Those companies which fail to make pensions a priority at board level over the coming months will find themselves facing a much greater problem over the longer term.