There has recently been a great deal of media coverage on the subject of Pension Fund deficits whether relating to individual companies such as BHS or Tata Steel or the industry as a whole. As a trainee Chartered Accountant, I spent a lot of my time auditing a number of clients’ schemes and have maintained an interest in the subject.
The attention has tended to focus on the Defined Benefit (“DB”) schemes which flourished in the period up until the mid-nineties. In such an arrangement, the employee was typically promised a pension of a fixed proportion of their salary in the period leading up to retirement. During the period of employment, monthly contributions are typically put into a separate trust, whose assets will be used to provide benefits in due course.
The idea is that these contributions are invested and the income is reinvested so that through capital growth and retention and reinvestment of income the pot grows and is sufficient to pay the benefits in the post retirement period.
At any point in time a valuation of the scheme can be carried out. The value of the pot together with assumed growth and future contributions is compared to a calculation of the amounts due having made a series of assumptions about final salaries, life expectancy and future investment returns.
During the 70s, 80s and early 90s interest rates were higher than they are now which reduced the actuarial liability and the stock market enjoyed a period of sustained growth which meant that the value of the pot could be projected to grow at rates of 7 to 8% or more per annum. Accordingly the schemes were often in surplus as the projected value of the assets exceeded the actuarial value of the liabilities, especially when the future liability was discounted back at a similar annual percentage rate.
Since then a number of major changes have occurred:
- The tax credit/relief associated with dividends is no longer available to pension schemes (the so called “Gordon Brown raid on Pension Funds”). This reduced the investment return and hence the growth in the value of the “pot”;
- Interest rates which fluctuated between 5% and 15% (or more) per annum throughout the 70s, 80s and 90s have now been at or below 0.5% per annum since 2008. This has meant that the value of the actuarial liability is much larger than it would have been in the past – for example a recent Hymans Robertson report attributes £70 billion of the estimated total Pension Scheme deficit of £945 billion to the recent reduction in base rate from 0.5% to 0.25% and associated quantitative easing programme.
The deficit figures being talked about in the press: £571 Million for BHS, £700 million or potentially in excess of £7 billion on a buy-out basis for Tata Steel and £945 billion for the UK Defined Benefit industry are huge, but, where does this ‘black hole’ come from? There are two ways to fund a defined-benefit scheme:
- Firstly, you could assume the scheme will continue for the long-term future, investing in a diversified pool of assets, which are expected to produce long-term, positive, real rates of return and paying out benefits when they are due.
- Alternatively, you could fund the scheme so it has enough at any one time to wind up and buy out all of its benefits via an insurance company. A valuation done on this ‘buy-out basis’ would be based on gilt rates of return, and, as these are currently low by comparison with historic or equity growth rates, it would place a much higher value on the liabilities since insurance companies are required by law to invest most of their assets in gilts (which currently provide negative real rates of return).
It is unquestionable that the BHS Pension Scheme deficit would be smaller had the company paid more into the scheme, but how much of the deficit is due to:
- A deficit calculation on a buy-out rather than an ongoing basis;
- current interest rates – (no one would have projected interest rates of 0.5% or lower when the BHS scheme was in surplus in the early noughties);
- the cumulative effect of losing the tax credit on dividend income for 20 years since 1997; or
- pensioners living longer?