Business Analysis: UK plc's pensions deficit swells to £61bn as people live longer

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The Independent Online

The enormous hole in Britain's largest pension funds is still growing, with almost half of the 100 largest deficits increasing last year, according to new research by The Independent.

The enormous hole in Britain's largest pension funds is still growing, with almost half of the 100 largest deficits increasing last year, according to new research by The Independent.

In the first ever comprehensive review of the UK's largest final-salary pension schemes - published ahead of the pension fund industry's annual conference in Manchester on Thursday - some 46 of the 100 funds with the largest deficits were found to have increased their unfunded liabilities in 2004.

The survey looked at all 700 companies in the FTSE 350 and FTSE Small Cap, as well as the UK's 100 largest private companies. In total, the 100 largest deficits amounted to £61bn, of which the top 10 alone accounted for almost half.

The results highlight the increasingly bleak picture facing UK final-salary pension schemes, revealing that many funds are only just beginning to update the redundant assumptions that they have used to assess their pension liabilities over the past few decades.

Although UK and global equity markets rose in 2004, many deficits continued to grow as pension funds finally recognised improving life expectancy statistics, and acknowledged that nominal asset returns are now much lower than they were in the 1980s and 1990s.

"There is a continual process of catch-up going on - today's approach to funding and solvency would have been alright two or three years ago," said John Ralfe, an independent pensions consultant. "People have still got a series of pain barriers to go through."

While an increasing number of funds are now taking responsibility for their pension deficits, Christine Farnish, the chief executive of the National Association of Pension Funds, admits it is disappointing that the industry is still so far behind. "It's very scary," she said. "You can see there's a huge legacy here that corporate Britain has now got. The amount of money required is significant, and it will have to come out of what otherwise would have been invested in growing businesses. So we've got quite a serious economic problem here."

The survey also reveals that many of funds with the largest deficits remain wedded to investing the vast majority of their assets in equities. Some 48 of the funds with the largest deficits have more than two-thirds of their portfolios in stocks and shares, increasing the risk of a sharp jump in their funds' deficits if markets fall.

Mr Ralfe, who famously oversaw the switch of the entire Boots pension fund into bonds in 2001, saving the fund from the ravaging that most of its peers sustained at the hands of the equity markets in 2002, believes some companies are still taking unnecessarily high risks with their pension fund assets.

"Look at asset allocation from the viewpoint of shareholders," he says. "People buy a share, because they believe the company has a competitive advantage in its core business. People do not buy it to get exposure to a badly run unit trust. Companies should not be willing to take on financial risk in their pension schemes they are not prepared to take on directly."

The companies that look most precariously positioned are those whose equity pension fund assets equate to a large proportion of their market value.

Although the likes of HBOS and Centrica have more than 75 per cent of their pension funds invested in equities, their schemes' shortfalls pale into insignificance when compared with the size of the companies that they are a part of. However, companies such as Uniq, UK Coal, BAE Systems and MFI Furniture are taking on a much more real risk. The equity assets of these four pension schemes are equivalent to more than 30 per cent of their companies' market value. In this context, MFI could be said to be little more than an investment fund that just happens to sell home furnishings on the side.

Ms Farnish points out that new legislation for pension funds, which is to be introduced this autumn, will force schemes such as these to reduce their risk profile. The rules have yet to be finalised, but they are expected to stipulate that firms will have to take a "prudent" attitude to risk, rather than the hit-and-hope approach that MFI and BAE are taking.

The new rules will also put greater pressure on companies to put plans in place to repair their deficits. Ms Farnish says that companies that have been keeping large positions in equities, in the hope that this will save them from having to repair the deficits from their own balance sheets, are likely to be in for a rude awakening.

But she points out that many funds have been trying to make the shift out of equities, but have found their path hampered. "It's a timing problem they have," she says. "One of the problems has been, do you sell [out of equities] at a time when bonds are very expensive for what they are. And there isn't exactly an oversupply of assets which help pension funds match their liabilities."

This may at least be about to change. Later this month, the Government is expected to make its first trial release of longer-dated bonds, "longevity bonds", to help pension funds to try to match their liabilities with a greater degree of certainty. It may be several years before there are enough of these bonds available to satisfy the enormous demand.

With or without longevity bonds, companies will come under increasing pressure to remove the risk from their pension funds.

The new Pensions Protection Fund (PPF), which was launched last month to act as a safety net for final-salary schemes that are wound up in deficit, says its risk-based levy will act as another incentive for companies to act responsibly. "Pension fund deficits are an important issue facing occupational pension schemes," it said. "Scheme underfunding will be one of the factors that the PPF will take into consideration when setting the risk-based levy. Reducing deficits will therefore be in the interests of pension schemes."

But getting to grips with exactly which funds represent the greatest threat remains no easy task. The new Pensions Regulator, chaired by David Norgrove, believes it will take two years before it has a fully comprehensive view of all the potential pension fund risks in the UK.

Commenting on The Independent's survey, the Regulator said: "This survey helps to highlight the challenges facing those tasked with running occupational defined benefit pension schemes. Significant underfunding in a particular scheme or a higher-risk investment strategy would be factors that might lead to a scheme being given a higher risk rating and therefore being subject to closer regulatory supervision.

"The Pensions Regulator's priority would be to try and make sure that members get the benefits they are entitled to whilst doing whatever is possible to avoid a scheme needing to enter the Pensions Protection Fund."

Pension funds have already begun to take on an increasingly important role in merger and acquisition activity over the past few months, playing a part in the aborted takeovers of companies such as Marks & Spencer, WH Smith and Woolworths. With most deficits still on the rise, pensions are likely to become a factor in the vast majority of debt restructurings, flotations and acquisitions over the next decade.

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