David Prosser: If BT needs pensions advice, why not give Babcock a call?
Wednesday 13 May 2009
Outlook It is difficult not to feel sorry for Ian Livingstone, the chief executive of BT, who must tomorrow make the best of results for the telecoms giant that no one expects to make pleasant reading. It's less than a year since Mr Livingstone stepped up to the top job, having previously been a widely acclaimed leader of BT's retail division, and the problems he now surveys from this lofty perch – a pensions black hole and an underperforming Global Services unit – are very definitely not of his making.
Of the two issues, BT's pension problem is the most serious. Goldman Sachs reckons the company's gross pensions liability, following the mandatory three-year review just completed, could be as high as £8bn, requiring an annual contribution of £640m from BT to fill the gap. How the new chief executive responds to that challenge will set the tone at BT for several years to come.
One approach would be to apply the sort of innovative thinking Mr Livingstone was known for in his BT Retail days. And if he wants an example of a forward-looking pension solution he could employ, he need look no further than a contract announced by the engineering company Babcock yesterday.
The deal struck by Babcock, with an as yet unnamed provider, doesn't reduce the company's pensions bill – in fact it has probably risen slightly – but it does provide insulation against unpleasant surprises that might emerge over the next three or four decades.
The big pension headache for companies such as BT and Babcock in recent times has been not so much stock market volatility – investment returns fluctuate wildly but still conform to some long-term assumptions – but rising life expectancies. Those darned employees have just turned out to be much healthier than pension plan trustees ever expected, and if you're an employer that guarantees pensioners a set level of income until their dying day, undercooking on life expectancy projections has a rather unpleasant effect on the company finances.
Babcock's plan to avoid falling into the same trap in the future is to offload all its longevity risk to a third party. It is paying this provider enough to fund the pensions of all its current pensioners, based on existing assumptions about how long they'll live. If they turn out to live longer, the provider picks up the tab.
It is a straightforward gamble. Babcock's trustees are effectively confessing that they are so worried about the potential cost of rising life expectancies they are prepared to suffer a small rise in their current liabilities – the longevity swap gives the other side some margin for error – in order to negate the risk of a much bigger rise in the future.
It's the pension scheme equivalent of a fixed-rate mortgage. Those who fix the cost of borrowing for a period know their gamble may or may not pay off, depending on how variable interest rates move, but like the certainty of knowing exactly what their future costs will be.
The Babcock deal marks a step change for defined benefit pension schemes. For the past 18 months or so, the vogue has been for full-scale pension buy-outs, with specialist providers and insurers competing to take on the full liabilities of occupational funds.
A year ago, the buy-out business was so competitive that companies were able to offload pension liabilities for a song, effectively paying specialists to take on the investment risk of running a pension scheme while getting longevity risk thrown in for nothing. That model has changed in tougher economic times and there have been markedly fewer buy-out deals completed so far this year.
By contrast, interest is growing in the "longevity swap", as Babcock describes it, with advisers predicting deals on pension scheme assets worth up to £10bn this year alone. This deal is the first but similar contracts might be struck between any number of employers and a big life company, with the transaction structured as an insurance policy, or with an investment bank, in which case the contract looks more like something from the swaps market. Either way, the effect is the same: a cap on upside risk from rising life expectancies.
Sadly for Mr Livingstone, this sort of insurance won't solve BT's most pressing problem, which is its enormous pension funding deficit. But it might just stop the deficit getting any bigger in the years ahead. And that would be progress.
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