Jeremy Warner: Public sector must follow private one in addressing pensions

Wednesday, 8 April 2009

Outlook Tricky things, pensions, and getting trickier all the time to judge by the legion of British companies that are going to have to agree "recovery" plans with the pensions regulator over the coming months to address a shortfall in funding.

With falling asset values and interest rates on top of the already acute problem of funding increased longevity, these deficits, thought to have been largely fixed only a few years back, have been rising like topsy again, piling pressure on corporate Britain to increase its contributions at a time when profitability is being poleaxed by the recession.

Related articles

One case in point is British Telecom (BT), whose triennial actuarial review is expected to reveal a pension fund deficit which has swollen from £3.4bn three years ago to between £5bn and £10bn when it is announced with the annual results next month. To address this deficit, BT will have to increase its contributions to the fund by at least £500m annually for some years.

Ignoring the problems of "Global Services", the core BT telecoms business is holding up better than you might expect, given the plunge in consumer demand across the economy, but £500m is still an awfully large sum of money to find out of free cash flow expected at a little over £1bn for last year. By the time BT has honoured pledges to pay down some of its debt, there won't be much money left for anything else.

All hope of maintaining the dividend, still thought a possibility a few months back, has gone up in smoke. Shareholders should brace themselves for receiving little more than a third of what they were getting.

Despite everything that is said to the contrary, customers generally get a good deal out of the UK telecoms industry. Prices are lower than almost anywhere else, and broadband penetration and availability is higher. Regrettably, what's good for the customer doesn't seem to be at all good for BT investors. As one major BT shareholder puts it: "Customers get a good deal, employees get a good deal and pensioners get a very good deal. Seemingly the only people cut out of the largesse are the shareholders."

At just 80p, BT's share price is now more depressed than at any time since privatisation in the early 1980s. Forget the recession. That's the least of BT's worries. Instead, the share price reflects the fact today's BT works chiefly for the benefit of those in its defined benefit pension scheme. BT is hardly alone. With the recession biting hard at corporate profits, the pensions regulator recently told companies if the decision is between paying dividends and topping up the pension fund, the pension fund must come first.

Many companies used to treat their pension obligations in an unacceptably casual way as just another form of subordinated creditor. But now pension regulators are swinging too far in the opposite direction. I'm not sure they are getting the balance right. Any company that fails to pay a decent rate of return on its equity is unlikely to be in business for very long, and, if it goes bust, then there's no sponsoring organisation left to fund the pension scheme.

Much of the accounting for pension deficits gives an exaggerated idea of the size of the problem. In an actuarial valuation, a view is taken of the likely long-term returns on the fund's assets. Trustees demand that this view is extraordinarily conservative. In most cases, it tends to be quite a bit lower than historic rates of return.

Down the line, we may therefore be confronted by a situation where much of the band-aid now being applied proves to have been unnecessary. The debate will then be about what to do with the surplus, as it has been at various other points in history. In this sense, pensions regulation seems to conform to the same pattern of the solvency and accounting regulation that has governed the banking sector: it is highly pro-cyclical. Companies are being asked to patch up their pension funds at a time when they can least afford to.

Virtually all the pensions regulation introduced by the present Government has turned out to have the opposite effect to the one intended. Rather than bolstering defined benefit pension arrangements, it has succeeded only in making schemes even more unaffordable, causing a rush among companies to close schemes to new members and in some cases new accruals.

It is no coincidence those companies with the most acute pension problems tend to have been formerly state-owned, such as BT and British Airways. When the Government privatised the company, it also privatised their pension costs. Quite a con trick it was too. At the time, no one imagined these legacy costs would become such an issue. Yet at least these now private sector companies are dealing with the problem. At huge cost to investors, contributions have been increased and in many cases benefits have been cut. There is no evidence of the public sector similarly getting to grips with the burgeoning size of its unfunded pension liabilities.

The private sector has faced up to the costs of its pension commitments and put its house in order. Despite the fact public debt is spiralling out of control, the Government shows no sign of wanting to tackle the problem. Why would it? Those who make the decisions benefit from the millstone of public sector pensions that future generations of taxpayers are being saddled with.

The last official estimate of unfunded pension liabilities in the public sector by the Government – in March 2006 – put the cost at £650bn, which is close to half GDP. In fact, this almost certainly underestimates the scale of the problem. According to the CBI, if the same methodology as used in the private sector to calculated pension liabilities were applied, the truer number would be close to £1trillion.

In all public sector pension arrangements, employee contributions nowhere near cover the projected future costs of providing the pension. Instead, the liability falls on the taxpayer. Most workers in Britain are not members of any final-salary pension scheme, yet they are expected to bear a substantial part of the costs of such arrangements for public sector workers.

It's no wonder the Tories have hit on pensions reform as potentially such fertile ground politically. No one wants to deprive public sector workers of hard-earned benefits, but everyone has to live within the confines of what's affordable. Only around a fifth of the labour force works in the public sector. Even if all of them were to vote Labour in defence of jobs and benefits, it would not be enough to keep a pensions reforming party out of power.

Many of the same measures to limit the build-up of pension liabilities as have been introduced by private sector companies urgently need to be repeated in the public sector. These include raising the age of entitlement from 60 to 65 and the removal of index linking. It may also be necessary to close final-salary arrangements to new members.

In the meantime, investors in BT must just grin and bear the legacy pension costs that privatisation and the subsequent tonne of pensions regulation has burdened them with.

SEARCH FOR EXECUTIVE JOBS

Travel Planner