Since the financial crisis, defined benefit pension schemes have been a large and stubborn headache for companies. During this period, the value of pension scheme assets fell, which increased deficits. At the same time, a decline in business profitability and cash generation restricted companies’ ability to fund the increasing deficits.
But the picture looks to be finally changing. Research shows that companies’ ability to support their DB pension obligations improved dramatically in the second half of 2013 and is close to reaching pre-recession levels.
Previously, most commentary about the relative risk of DB schemes had concentrated on the size of the pension deficit. Our view is that it is more important and useful to measure whether a company has the ability to pay its obligations and how quickly this is likely to happen, rather than just measuring the size of the deficit.
To do this, we consider the key components of employer support: a company’s net assets, operating profit, profit before tax, cash from operations and market capitalisation. We then measure the relative strength of each component against the company’s pension scheme obligations, giving a Pensions Support Index score out of 100.
The prosperity period up to June 2007 saw the pensions index reach its highest point of 88.1. This was driven by improving company performance and an increase in the value of pension scheme assets as a result of the strong economy. The regulatory changes (the Pensions Act and formation of the Pensions Regulator) meant schemes were starting to use higher funding targets, which were met with higher cash inputs by businesses.
The recession affected the index severely, with a 24.2-point drop between June 2007 and March 2009 to 63.9. There was a gradual recovery from March 2009 to March 2011, driven primarily by a 46 per cent increase in the FTSE 350 index over the period, which in turn led to an increase in scheme assets and the market capitalisation of sponsoring companies. At the end of 2011, however, the index fell to 67.8 as a result of a decline in gilt yields, caused by quantitative easing. This increased the discounted future value of liabilities and led to an increase in pension deficits.
Since 2011, the PSI had remained relatively flat but showed a seven-point improvement over the second half of 2013, reaching a score of 83 – the largest positive six-monthly movement since December 2009, driven by improving company performance and a decrease in pension deficits.
This improved score means most companies in the FTSE 350 with DB obligations are in a stronger position to fund their pension deficits. They can use this outlook to show scheme trustees that employer support is stronger than it has been historically.
It is positive to see the strengthening of the UK economy is starting to feed into improved company performance and more manageable pension deficits for FTSE 350 companies. Given the forecast for gross domestic product remains strong, we anticipate this improvement to continue.
Improving confidence in the economy has helped generate an uptick in capital market activity (for example, initial public offerings) and mergers and acquisitions transactions over the past 18 months. The 64 UK deals completed in the fourth quarter of 2013 made it the best quarter of 2013 in terms of M&A volume.
For stronger scoring companies, understanding the impact on DB schemes in these situations will be vital for trustees to ensure a transaction is not reducing the likelihood of members’ benefits being paid. If there is a material impact, trustees and management teams will need to agree on the size of the detriment and whether any mitigation is required to shore up the employer covenant.
Companies at the lower end of the scale may miss out on M&A opportunities if purchasers are reluctant to take on the risk of poorly supported DB schemes. It is important that companies consider ways to improve the balance between the employer covenant and pension liabilities, and look for innovative ways of overcoming this hurdle to a potential transaction.
The Pensions Regulator has set out its new funding code of practice for DB schemes, which focuses on establishing a more solid link between the employer covenant, funding and the investment strategy (integrated risk management). This approach will offer more flexibility for higher scoring companies, which should be making the most of their covenant strength when taking decisions on scheme investment strategy and funding assumptions. Better recognition of covenant strength could allow employers to invest in future growth, which may improve the covenant and lower the need for increases in deficit reduction payments.
Conversely, decisions made in relation to investment strategy and funding are likely to face more scrutiny from weaker scoring companies. Trustees with weaker employers will want to ensure they have understood specific risks associated with their employer and how these risks affect the scheme. They will also want to consider whether the overall level of investment risk is appropriate.
The Pension Protection Fund has confirmed plans to use a new Experian model to measure insolvency risk. The PPF has published a consultation on how the new model works, how existing ratings will change and how levies will be affected.
We anticipate this change will have the biggest impact on lower scoring companies with poor company performance, and we encourage companies to take action in considering how this will affect their PPF levy.