PPF deficit figures presage hard times for funding and dividends

The pensions lifeboat’s latest figures show that the total deficit for the 5,945 funds included in its 7800 Index rose from £376.8bn at the end of July 2016 to £459.4bn at the end of August.

The recent falls in gilt yields should serve as a wake-up call to many pension schemes to review their investment strategy

Boris Mikhailov, Aviva Investors

Pension deficits have continued to rise in light of recent events, including the Bank of England’s decision to extend quantitative easing and cut the base rate.

Experts have advised schemes to revisit risk and continue monitoring the strength of their covenant, but some of the main issues facing schemes and companies in the next few quarters involve the threat to company dividends and difficult funding talks.

Difficult discussions ahead

The funding targets used by pension funds are calculated differently, but employers and trustees can expect some tricky conversations about how quickly these deficits should be paid off, according to Graham McLean, head of pension scheme funding at Willis Towers Watson.

McLean noted that there has been a “fair amount of debate about how inflated or real the size of the deficits is”.

But “however you measure them, it’s a very difficult time” and “we’re in for a very difficult round of valuations” in terms of the size of deficits and the contributions that are needed to plug them over an appropriate timescale, he said.

Difficult funding negotiations are not the only challenges an increasing number of schemes and their sponsors may come across. Company dividends may also be under threat as a result of soaring pension liabilities.

“This is where it’s very very difficult for trustees,” said McLean.

Source: LCP

Deficits and dividends

"There is certainly pressure on trustees to fill those deficits as quickly as they can; and that inevitably focuses attention on what the company is doing with cash that is not going into the scheme,” he said.

A decision then has to be taken about how such cash is divided between investment in the business – which might be available to the scheme in the longer term – and using it for dividends or payments up through the corporate chain, said McLean.

“Taking a balanced view, trustees will have to look at the effect on the sponsor’s business if those dividends are constrained because of the pension scheme,” he added.

Dan Mikulskis, managing director and head of DB at consultancy Redington, also commented on the effect of soaring liabilities on company balance sheets. “It’s been a very bad summer for DB pension schemes,” he said.

Many underhedged schemes carrying out an actuarial valuation in the next few quarters may face “larger deficits, larger contributions, potentially longer recovery plans, and/or looking to try and generate more investment returns”, said Mikulskis.

He noted that schemes with large deficits plus the effect on corporate balance sheets may lead to more UK companies warning over dividends.

“If pension contributions double… which they may have to in some firms, then it certainly stands to reason that that will put pressure on the dividend,” he said.

According to Boris Mikhailov, senior investment strategist at Aviva Investors, pension funds and sponsoring companies need to bite the bullet and make difficult decisions to address the funding hole.

“It is Groundhog Day for pension schemes,” he said.

Following Brexit, and with gilt yields expected to remain low for longer, funding negotiations are likely to be more challenging, “particularly for those underfunded pension schemes whose sponsors’ covenant have weakened since their last valuation”.

“The recent falls in gilt yields should serve as a wake-up call to many pension schemes to review their investment strategy,” he added.

Mikhailov said it may look counterintuitive to be hedging now at a time when gilt yields are at such low levels.

“However, not addressing this issue risks further funding volatility in the future, which may be even more difficult to control.”