Over the past three years, the U.K. has been at the forefront of changing attitudes about the cost of pensions. There have been many heated debates about several issues, notably between those who argue that benefits should be fully funded and invested in bonds with minimum risk and those who advocate a minimum current cash flow commitment from a company combined with exposure to higher-performing asset classes.

The debate has resolved in favour of requiring companies to change how they disclose pension liabilities in corporate financial statements – and in favour of boosting regulatory attention to the level of security that members of defined benefit (DB) schemes should expect. Companies with DB pension schemes in other countries should ponder the likelihood of similar changes occurring elsewhere and investigate possible first-mover advantages in order to mitigate the impact.

Features of U.K. pensions

The U.K. pension system is distinctive in having very high levels of funded DB employer-sponsored pension commitments. The chart below shows that gross private sector liabilities amount to about 30 per cent of the overall value of major U.K. corporations compared to 13 per cent in the U.S. This arises largely from the decision of most major employers to provide their own schemes in place of a significant portion of the State retirement benefits in exchange for lower payroll taxes.

Pensions in the U.K. are generally a bigger issue compared to market capitalisation than in the U.S. or indeed in France. Germany looks to be much more risky because of the lower level of funding, but it is important to remember Germany’s different culture and practices, whereby full liabilities are recognised on corporate balance sheets and an insurance scheme is in place in the event of company insolvency.

Assets have typically been invested mostly in equities, and the typical U.K. company’s balance sheet has shown little on-balance-sheet pension asset or liability. This has tended to conceal the off-balance-sheet leverage implied by assets not closely matched to liabilities. Member security has typically been limited to the amounts committed as cash funding, with no system of employer insolvency insurance. Indeed, until the mid-1990s, insolvency situations typically led to a loss of protection against future inflation. Given the high levels of inflation in the U.K. at the time, this represented a significant safety valve for employers. It is possible that the degree of perceived fairness in terms of sharing the pain among members in these circumstances led to only muted public concern.

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Preparatory conditions

During the 1990s and running into the early 2000s, a significant part of the linking of benefits to inflation moved from being discretionary to becoming guaranteed. Coupled with this, the U.K. economy successfully moved into a lower-inflation, lower-interest-rate environment that turned previous partial inflation-linking guarantees into effectively full-inflation guarantees. Pension scheme members are living longer, and both equity and bond markets have shown signs of higher capital values based on lower long-term expected returns. The implications of some of these early changes were discussed in some places, but the full implications of funding, investment, accounting and level of benefits accrual were generally ignored. At the same time, U.K. businesses were substantially restructured, which often led to separation of legacy pension liabilities from the original sponsoring businesses.

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The perfect storm

A perfect storm requires the confluence of several significant factors. In this case, the key factors were the negative manifestation of market volatility, significantly increasing long-term benefits costs and greatly enhancing expectation of security:

• Equity markets, and therefore typical pension scheme asset values, fell dramatically during 2001/2002.
  
  
• Long-term costs became much clearer as evidence of improved life expectancy and adoption of costing methods based on long-term bond yields (which were now much lower) gained ground.
  
  
• Political capital had been invested in ensuring that pensions should be secure, and so a small number of high-profile corporate collapses in which significant benefits losses became concentrated on particular individuals (who had also lost their jobs) became politically unacceptable.

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Political response

The government was forced into a reaction:

• Solvent employers could not escape their pension commitments other than by securing insurance-company annuities for all liabilities, at a cost typically 40 percent in excess of FRS17/FAS87 liabilities and 100 percent in excess of the previous exit costs.
  
  
• The Pension Protection Fund (PPF), a mutual insurance fund akin to the U.S. Pension Benefit Guaranty Corporation, was set up to cover members against sponsor failure, paid for by levies on other schemes based on the size of the deficit and the perceived riskiness of the sponsor.
  
  
• A new regulator was set up with powers to interfere in corporate transactions that might be seen as increasing the risk of sponsor failure, especially those involving increased leverage and the return of funds to shareholders.
  

• Trustees were given more power over the setting of contribution rates, with signals that accepting correction of deficits over any period longer than 10 years might represent inadequate use of their enhanced powers.

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Financial economic viewpoint

The financial economics view emphasises that pension liabilities should always be regarded as a form of corporate debt and that shareholders might be better off taking equity risk themselves as individuals. However, what has been interesting about the regulatory changes in the U.K. is the way in which they have affected the trustees (acting as fiduciaries) and the regulatory authorities. For example:

• The price of escaping from pension liabilities now tracks insurance company annuity rates, which are based on bond returns.
  
  
• Accounting standards are clearly based on mark-to-market liabilities.
  
  
• The levy for PPF purposes is structured such that the cost of maintaining a deficit increases as the sponsor’s riskiness increases, much like other types of debt that a sponsor holds.

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Changes and consequences

As a result of all this, changes in attitudes and culture are leading to specific changes in behaviour in the U.K. Different countries will start with a different mix of these problems, and the effects will depend on how and when legislators react. But the direction of actions on the part of legislators seems fairly clear, and there should be many issues where multinational companies might review their policies or approaches to their advantage.

Looking first at the reactions of the government, we can draw a number of key points:

• Those managing pension schemes have been given stronger powers to act independently from the sponsor, and are encouraged to argue for the correct funding to the scheme, to keep the security of the sponsor under review; and, if necessary in times of difficulty or change, to call in the government regulator.
  
  
• Governments and legislators are forced to intervene if significant numbers of members lose large amounts of benefits. Aging populations also imply aging electorates.
  
  
• On the positive side, there seems to be a glimmer of awareness by the government that it can play a helpful role by increasing the supply of long-dated government bonds to meet the growing demand for these types of assets as pension liabilities rapidly mature.
  
  

Turning to the changes in attitudes and actions of companies and others, we note the following points:

• Companies are considering the management of pension deficits in a holistic way as part of their own corporate balance sheet. There is clear evidence that strong companies are deciding to pay significant contributions to improve funding levels because it is advantageous to their whole enterprise.
  
  
• There is an increasing trend towards companies taking decisions to change benefits after considering all the appropriate measures of pension costs. Benefits decisions are being made in terms of not only the immediate funding costs of the benefits but also the assessment of the longer-term commitment measured by market-based accounting cost or even, in some cases, the cost of buying out the benefits within an insurance company.
  
  
• The U.K. regulatory environment is having a significant impact on business decisions. For example, the regulator is intervening directly by mandating levels of extra funding in return for consent to business transactions.
  
  
• There is increasing concern, and many specific actions are being taken to ensure that decisions about funding or investment are being made by the appropriate person, independent of other influence. Whilst in most cases the relationship between trustees as fiduciaries of the scheme and employers as sponsors is becoming more positive and cooperative, the separate roles are being far more clearly identified. There is a much higher degree of sensitivity to both the flow of confidential information and potential conflicts of interest.
  
  
• Attitudes toward investment risks are changing, and employers in particular are contemplating a preference for less risky, more closely matched investment strategies. This contrasts with the past, when management typically pushed for an asset mix strategy that implied the minimum current cash flow requirement.
  
  
• Most schemes in the U.K. operating on a defined benefit basis have been closed to new members for some time, and a trend is emerging of closing those schemes to future accrual of benefits for existing members. An emerging consequence of these changes is that the aims and objectives of pension scheme members and managers are departing radically from any alignment with the current corporate objectives of the sponsors.
  
  
• The existence of many closed, frozen or very mature pension schemes on a DB basis has raised the importance of insurance issues, such as obtaining longevity coverage, or using other instruments to manage financial risk (for example, swaps designed to hedge long-term interest-rate volatility).
  
  
• Alongside the interest in specific risk mitigation, there also seems to be increasing interest in taking a wider view of investment strategies and broadening out from a simple equity versus bonds choice into a much wider range of asset classes.
  
  
• Many people believe that a bubble has developed in the long-dated bond market as regulatory support for new thinking has expanded the demand ahead of a fresh supply from borrowers. Long-dated government bonds now yield 1 percent or less in real terms. But this situation may be maintained for many years given the volume of pension scheme assets that might be switched from other asset classes. There is little sign of corporates taking advantage of the implied opportunity to borrow cheaply from the funds of other companies. So those that switched funds first (when gilt yields were 2 percent or more) may be proved smart in their timing as well as having added shareholder value by reducing risk.

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Lessons to learn

There is much food for thought for those in other countries who may well be at different stages of developmental thinking. No two pension systems are the same, but with the benefit of 20/20 hindsight, the following overarching lessons are readily apparent:

• It has proved difficult to cope with changes that have been brought about in several areas of concern simultaneously. It would clearly have been more helpful if the changes imposed by the government in the areas of financial security, decision making and the regulation of business transactions had been introduced step by step over a longer period of time. But perhaps such changes occurring at the same time as some fundamental demographic and market shifts are not unexpected, because that is just the way politics works? Little changes suffice until the pressure for real change becomes too powerful and the dam bursts.
  
  
• If lack of transparency in funding and accounting means that extra benefits can be granted at less than full economic cost (such as guaranteed inflation indexation instead of discretion), corporations will come under pressure to do this without a corresponding reduction in other benefits.
  
  
• Hiding risk in off-balance-sheet vehicles, such as equity-invested pension schemes, can work well for a time, but the approach is exposed to low-frequency/high-severity external events. Sponsors may take advantage of freedom whilst it lasts but should be sensitive to the consequences of a sudden reversal.

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