Affordability of FTSE 350 defined benefit pension promises has retreated to levels not seen since the global financial crisis, a new report has found, putting pressure on trustees of mature schemes.
PwC’s Pensions Support Index fell 13 points last year to 69 per cent, as flatlining corporate health was unable to offset ballooning deficits.
It was the largest fall since the start of the 2008 financial crisis, leaving questions over the extent to which companies will be able to fund their promises.
What I worry about is not necessarily FTSE 350 companies, it’s the other schemes in the UK
Jonathon Land, PwC
The Pensions Regulator estimates that 5 per cent of schemes are at risk of falling into the Pension Protection Fund, but has also recently taken a strong stance on companies paying out large dividends while committing to long recovery plans.
Mature schemes are at risk
No one actually knows exactly how many scheme sponsors will become insolvent, according to Jonathon Land, PwC’s pensions credit advisory leader.
“But what [the index] shows is the position is certainly worse than it was a year ago, and markedly so,” he said.
Market capitalisation of FTSE 350 companies increased over 2016, in part due to the falling value of the pound since last year's EU referendum.
But other measures of corporate health, such as net assets, operating profit, profit before tax and cash from operations remained flat, while slumping long-dated interest rates grew deficits.
“What I worry about is not necessarily FTSE 350 companies, it’s the other schemes in the UK,” said Land. “Have they really appreciated the problem that they’re now facing?”
Schemes with strong employer covenants and immature liabilities may be able to ride out the phenomenon of falling interest rates, according to Land.
Trustees should plan ahead
PwC urged mature schemes in particular to monitor their covenant, assessing the likelihood of becoming cash flow negative and planning investment strategy accordingly. It suggested the use of so-called matching-plus assets to generate return while securing cash flows.
“You’ve got to be looking at the strength of your employer,” said Land. “Many in the FTSE 350 are now doing that, my question is, to what extent are the rest of the schemes in the UK following suit?”
Of course, monitoring the covenant cannot be the magic cure for scheme underfunding.
“Monitoring the covenant is something that trustees clearly need to do, but of itself it doesn’t actually do anything,” said Clive Gilchrist, managing director of Bestrustees.
Gilchrist said that trustees should be wary of crowding, and of liquidity demands, before rushing into often illiquid matching-plus assets.
“A lot of schemes have a plan to work towards buyout at some point. Now, if you’re going to do that and it’s in 15 years say, you can’t buy a 30-year infrastructure fund,” he said.
Putting a target date on the scheme’s ambitions would help trustees to match the liquidity of their investment strategies to their maturity, he argued.
Deficit contributions low compared with dividends
The picture of DB affordability may be more complex than is suggested by average indexes such as PwC’s.
The Pension Regulator’s tranche 12 analysis released last week found that, where companies had paid both dividends and deficit repair contributions in each of the past six years, the median DRC to dividend ratio has declined to 7 per cent from 10 per cent in 2014.
Employers urged to actively manage covenant
Employers and schemes must take a more active approach to managing their pension liabilities to improve covenant strength, experts say.
“The level of contributions compared to profits is actually quite low at the moment,” said Redington’s head of DB pensions, Dan Mikulskis.
He welcomed the regulator’s apparent intention to review dividend policies on an individual basis rather than imposing limits on DRC to dividend ratios.
From a scheme perspective, he said that good strategy should be judged by its impact on the chances of paying all pensions, rather than by looking at deficits.
Where the scheme’s sponsor covenant is more relevant to its future health than investment strategy, Mikulskis recommended seeking financial security via measures like asset-backed funding.
However, he cautioned: “You do have to be careful in that, depending on the relative size of scheme to the sponsor, those sorts of things could actually damage the credit rating of the employer.”
