Why FDs need to consider options in a time of uncertainty

A couple of decades ago, very few people would have predicted that defined benefit (DB) pension provision would be listed as one of the main risks facing UK companies. Nevertheless, Nick Griggs, Partner at Barnett Waddingham, believes this is now, unfortunately, the reality for many companies.

With Brexit negotiations beginning in earnest, this is a period of extreme uncertainty for UK businesses. The potential impact of Brexit on the core business of companies will evidently be at the top of every finance director’s agenda. However, it is likely the impact on the DB scheme will only be a secondary consideration, despite the significant risks that these schemes present. For many companies, this should not be the case.

Barnett Waddingham’s annual review of the impact of pension provision on companies, within the FTSE350, highlights the continued strain caused by DB pension provision. However, on a more positive note, the research also identified a number of opportunities available for companies to manage and reduce the risk associated with their DB schemes. In a time of such uncertainty, it is certainly a good time for finance directors to be considering some of these options.

Managing and reducing DB pension scheme risk 

Transfers from DB to DC

Over the period between 2014 and 2016, benefit payments from FTSE350 DB schemes increased by 30%. This is a significant escalation, and can almost certainly be attributed to an increase in transfer value payments to defined contribution (DC) schemes following the introduction of the pension flexibilities in April 2015.

From a company’s perspective, members transferring their benefits from a DB scheme to a DC scheme can lead to an improvement in the funding level of the DB scheme, and entirely removes the risk of the promise made to the transferring member, therefore removing the risk associated with longevity, inflation and investment. It is unsurprising, therefore, that many companies are now putting a process in place to remind members of the options available to them in respect of their retirement benefits, leading to an increase in the number of transfers away from DB schemes.

An increase in benefit payments should focus attention on the pension scheme’s investment strategy. As schemes continue to mature, cashflow management will become ever more important. We would recommend that finance directors take an active role in determining their DB scheme’s investment strategy and, in particular, ensure they are comfortable with the level and type of risk being taken.

Longevity changes

Another positive trend to emerge over the year related to life expectancy. In particular, data released early this year suggested that, across the UK population, longevity has not improved over the past five years. The vast improvement in life expectancy has been one of the main contributors to the increased cost of DB pension provision over recent decades, so any slowing in this trend should, from a DB funding perspective, be welcome news for companies.

When negotiating the level of deficit contributions or preparing the annual pension disclosure, the assumption relating to life expectancy can be very material. Finance directors should consider whether it will be possible to recognise any slowing in longevity improvements when deciding upon the actuarial assumptions. Our data suggests the aggregate FTSE350 pension deficit would have reduced by £10bn if the slowing in life expectancy had been recognised in 2016.

DC schemes – the future?

One of the first steps companies can take to contain their DB pension scheme risk is to close the scheme to future benefit accrual. Some high-profile companies closed their DB scheme over the 2016 financial year, Tesco being one example, so it is no surprise that DC pension scheme costs have increased significantly in recent years. DC schemes now account for nearly 40% of FTSE350 companies’ pension cost, compared to around 20% in 2010.  With the minimum auto-enrolment contribution rate set to increase over the next few years, this trend looks set to continue, but it will be interesting to see whether or not, in future years, companies look to differentiate themselves by offering some sort of pension guarantee.

You can find the annual survey here.