As I write, the eurozone’s attention has shifted away from Greece and back again, with some sort of major credit or currency event now seeming inevitable, and then onto Spain, whose banks are weighed down by property loans that look precarious in a country where more than one million properties sit empty and where unemployment has reached 24% (50% for under-25-year-olds). While the news frenzy reaches levels not seen since the collapse of Lehman Brothers in 2008, let us take a step back and consider the effect that the euro crisis and market volatility are having on defined-benefit (DB) pensions in the UK.
The crisis has driven gilt yields to historic lows, with 15-year UK gilts now yielding 2.2% (the average this millennium is 4.5%). This is great news for gilt investors. If you had been holding gilts for the past five years, your total return would have exceeded 50%. But how safe are these returns? Normally, plunging yields reflect increased credit-worthiness. So are you more likely to get your money back from the UK government in 2012 than before the financial crisis? No. The plunging yields merely reflect the lack of safe-haven investments available. Many, except the pensions regulator, expect yields to revert.
Equity markets are currently some 10% off their recent peak, with significant short-term volatility caused by stimulus-hungry traders.
Because of these market factors, a typical scheme’s funding level has deteriorated by 18% over the past three years. The pensions regulator was so concerned that it issued updated guidance for valuations in the current climate. While technical provisions cannot be eased and a bounceback in gilt yields cannot be assumed, there is some increased flexibility in recovery plans. So bigger deficits need not lead to unaffordable cash contributions – a welcome aspect for employers that are struggling to generate sufficient returns.
What can DB sponsors do to control the ballooning pensions issue? Well, most have already tackled benefits for active members. I expect more corporates to close to accrual altogether and to see a raft of member-incentive exercises that reduce certain risks, such as removing inflation risk via pension increase exchange, or remove risk altogether, such as enhanced transfer values and flexible retirement options.
Pensions minister Steve Webb’s industry code of practice on such member options was published in June. Arguably, the optimal time for these exercises has already passed, given the current cost of getting these exercises away – the eurozone-related low-yield problem again. However, the code recognises that these options are still legitimate tools, and largely reinforces good practice in the industry. It is certainly challenging to get a decent return from these exercises, but they still give savings versus buy-out liability measures.
In the meantime, employers must also contend with regulatory change. Auto‑enrolment is now only months away. Placing the emphasis for pension provision on individuals and the employer, and away from the state, is the correct approach, given expected demographic change and the perilous state of public finances. However, even with the easing of the minimum contribution requirements in the early years, the initiative comes at a bad time, especially for those facing some of the largest increases in pension cost and administrative burden, such as retailers with low pension-participation rates and high staff turnover. One cannot help but think that auto-enrolment will lead to more pay freezes as employers adjust to their new cost structures, further turning the screw on consumers’ real purchasing power and so on the UK’s emergence from the recession.
While there are clearly challenges ahead for DB scheme sponsors, the best thing that could happen for sponsors and members is a solution to the eurozone crisis, even if that means a break-up, and a return to economic growth in the UK. An environment that encourages investment and improves flexibility in the labour market is required to prevent the UK following its European neighbours. In the mean time, expect a few more months of volatile markets, fluctuating funding levels and opportunist headlines.
Naz Peralta is a director in KPMG’s corporate advisory pensions practice in London. The views in this article are the author’s own, not those of his employer