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The Actuary The magazine of the Institute & Faculty of Actuaries

Pension funds and companies: friends or foes?

Funding a pension promise is a risky business. The promise is made now but it is impossible to know what it will cost as the pension may not be due for up to 60 years. An estimate of the money needed is set aside in the pension fund and invested.
Pension trustees have the responsibility for safeguarding the money in the fund and keeping a watchful eye on it. They must always be ready to ask the employer to provide more money if the fund appears to be inadequate to meet the promise.

A long-term business
In this safety-conscious, risk-averse, and short-termist age, many employers have found the risks too much to bear. It is not that the risks themselves have increased, more that our accounting and actuarial methods have focused increasingly on the short term and led to wild swings in contribution rates. We have lost the sense that funding pensions is a long-term business, that investment markets rise and fall outside anyone’s control, and that travelling hopefully, with the eyes open, is all that can be done in the journey to ensure that the promised pensions are paid.
Companies have made and continue to make definite promises about the pensions they will pay. Having done so, they need all the support they can get to discharge their responsibilities and to overcome the difficulties that they will experience. There remain many such defined benefit schemes in operation in the corporate world. Many are still open to new business while others may be closed but have thousands of members whose pensions need to be safeguarded as well as can reasonably be achieved. The numbers could expand again in future if the corporate world can learn to recognise the long-term nature of the funds and devise new methods to handle the inherent short-term risks and uncertainties. This would be a considerably more responsible course of action for employers to take than giving up and passing the obligation for pensions back to the employees, who are much less well equipped to handle them.

The Pensions Regulator’s statement, issued in May last year, sets out how defined benefit schemes will be regulated. The prime responsibility for safeguarding members’ benefits lies with the trustees of the scheme, but ultimate responsibility is the employer’s. After all, the employer puts up most of the money for the scheme as part of the employment contract and it is the employer’s promise that has to be honoured. The statement contains the welcome recognition that pension trustees must ‘take full account of affordability for employers’ and ‘that a healthy ongoing business will be in the best position to ensure its pensions obligations’.
Most schemes at present have a shortfall. The measurement of that shortfall depends crucially on the assumptions about future investment returns and mortality. Too much caution about future returns creates huge apparent deficits in corporate pension schemes and greatly adds to our collective gloom and despondency.
The choice of assumptions is crucial. Cautious assumptions, and the action that follows, will improve the risks within the scheme in favour of the pensioner, although too much caution will deter employers from providing such pensions and no reasonable set of assumptions can produce absolute certainty.

Trustees and bankers
Pension trustees are charged with managing the pension scheme on behalf of the employee members and with negotiating and agreeing with the employer a plan for eliminating any shortfall. Of course this plan will change every time the shortfall is measured afresh. Today’s shortfall will never be eliminated as such, because each new valuation will reassess the position and today’s shortfall could be replaced by a different shortfall or even a surplus. Pension trustees are thus placed in a similar position to the company’s bankers. The relationship is fluid and even where no shortfall is recorded the pension scheme’s success will usually depend on the company’s continuing support. Where a pension scheme shortfall exists, it is now clearly recognised as a debt due from the company, just as a bank borrowing or overdraft is. But there are fundamental differences between the handling of the two sorts of obligation.
Banks have no particular interest in the long-term survival of the company, except as a source of revenue. A bank agreement will contain a range of covenants, which are designed not so much to keep the company in good health as to provide a lever for protecting the bank’s position if the going gets rough. Conditions are made such as the level of assets the company must maintain and the level of profits relative to interest payments. If these covenants are observed, the company’s finances will be sound and the bank’s money will be safe, though its profit margins might well be slim.
If the covenants are breached, the stage is set for a renegotiation of the bank’s terms, with high fees to the bank, to advisers, and to lawyers, and probably leading to higher margins on future interest payments. Often these costs can of themselves weaken the company further and tip it further towards eventual insolvency. But during the process the bank has protected its position and taken a due, and increased, reward for the greater risk that it will not get its money back. If the company goes under, so be it. That is a risk of the banking business.
Pension trustees are in a wholly different position. Like a bank, the pension scheme may be owed money by the company. But there the similarity ends. The pension scheme trustees must do nothing that unduly weakens the financial strength of the employing company. The regulator’s code of practice recognises this:
trustees should take into account the employer’s business plans and the likely effect any potential recovery plan [for the pension scheme” would have on the future viability of the employer.
The trustees must also block any deliberate weakening of the company’s finances unless the scheme’s finances are adequately bolstered to compensate for the increased uncertainty about future funding. Insolvency of the employer usually spells large shortfalls for the pension scheme as it is wound up and the available assets are shared out between the beneficiaries: both the pensioners and the current employees. It is the celebrated cases of insolvency that have done so much to inspire the protection that now surrounds pension schemes.
Cases such as WH Smith’s pension fund trustees’ requirements blocking a leveraged acquisition of the company have hit the headlines. Less dramatic events must also occupy the pension fund trustees’ attention, such as Vodafone’s intention to increase gearing by higher dividends and a return of capital, or Cable & Wireless’s intention to reward management significantly if the share price hits agreed targets.
Pension trustees thus have an onerous responsibility. They are required to safeguard the interests of the pension scheme members, but they need to beware of acting like bankers in doing so. Trustees need to understand the company’s financial position and its future financial plans. They need to come to an agreement with the company, which may range a good deal more broadly than a simple schedule of contributions designed to clear the shortfall of the moment. That agreement may cover financial measures such as asset and interest cover, changes of control, corporate acquisitions and disposals, dividends, and so on. But the intention here will genuinely be that the company should maintain those measures as an assurance of its good financial health. The aim will not be to impose greater costs on the company in bad times. Instead, trustees should be looking for substantial injections into the pension scheme when the company is prospering, with alleviation during stormy weather.

Guidance for trustees
Is it fair to expect trustees to shoulder this responsibility without proper assistance and guidance? Doubts have been cast on whether they have the requisite time or skills. Like company directors, they need expert advice the interests of their beneficiaries demand no less. The task of negotiating and securing a suitable finance package from its bankers by a struggling company would never be left to non-executive directors, no matter how wide their experience and competence. Pension trustees need just as much support in safeguarding the interests of their members.