The Decline of Defined Benefit Schemes
Regulation and Decline

Gordon BrownThe above plot shows the decline in the number of active members of private sector occupational pension schemes with the dates at which new regulations were introduced. The decline in fact began in 1994 and accelerated in 2001. Despite this evidence the main reason frequently quoted in the popular press is the "£5 billion raid on pension funds by Gordon Brown". The fact is there are many reasons as explained below but the dramatic falls in share prices in 2000-2003 and 2008-2009 together with the the introduction of FRS17 and the increase in longevity have had a far greater influence.

Taxation of Surpluses and Pension Holidays
Nigel LawsonBack in 1988 Nigel Lawson decided to tax pension fund "surpluses" to prevent companies using the pension funds as a money box for tax avoidance purposes. This tax threat subsequently led companies to adopt a much tighter rein on the pension funds on the grounds that they had to "use it or lose it" to the Inland Revenue. However the IR valuation above which tax would be levied was made on a much more conservative basis than that used for the Minimum Funding Requirement valuation so there was really no justification to run the funding level right down to the MFR which many companies were doing. (In any case only about 30 pension funds out of the 100,000 schemes had ever been taxed under these rules.)

During the early 90s companies were using these alleged surpluses for "industrial restructuring", i e offering very generous early retirement schemes to employees in their 50s for "downsizing" or so that they could be replaced by younger less expensive recruits.

In the late 90s when the equity market was booming the companies also awarded themselves "contribution holidays" which in some cases were later extended to their employees as well. This meant that labour costs were held artificially low and those companies thereby gained a market advantage and greater profits which in turn boosted share prices. Not paying any contributions into the pension schemes soon became the norm, a habit it proved difficult to break.

The right of companies to use their fund's "surpluses" in this way was challenged in the courts by pensioners but although they won in the High Court and the Court of Appeal this was eventually overtunred by the House of Lords decision in 2001.

As far as the pension funds were concerned it would have been much wiser to allow the surpluses to build up in anticipation for the inevitable fall in the stock market. It is estimated that the long-term impact of the contribution holidays from 1987 onwards amounted to £18.5bn and has accounted for around 30 per cent of the current deficit in pension funding. In at least one instance a company in purchasing another one along with its pension scheme was able to siphon off more than it paid for the company in the first place and the pension scheme now has a deficit which exceeds that sum whereas if the holidays not been taken it would not be in deficit now.

The Causes of Closure

 

It is estimated that the long-term impact of the contribution holidays from 1987 onwards amounted to £18.5bn and has accounted for around 30 per cent of the current deficit in pension funding.

See also:

ONS podcast on scheme membership (22 June '11)

BBC MoneyBox "The Death of Final salary Schemes" (28 April '11)

and

Selected Statistics on Occupational Pension Schemes

 

"The £5 billion Pound Raid"
In 1993 Norman Lamont reduced the value of tax credit on share dividend payments for pension schemes to 25% which later provided Gordon Brown with the idea of abolishing it altogether. This he did as soon as Labour came into office in 1997. The CBI welcomed the move though the consultants, Arthur Andersen, had spelt out the possible dangers for pension schemes to the Treasury. At the same time the new Chancellor reduced the Advanced Corporation Tax (ACT) paid by companies, perhaps believing that companies might pass some of this saving to the pension funds to compensate the latter for the loss of the tax credit income. That just didn't happen of course but in any event on average individual pension funds have suffered a loss of less than 0.5% a year which is insignificant when compared with the losses due to the over-exposure of most funds to falls in the value of equities.
Furthermore as Paul Myners pointed out this is also roughly the amount of money wasted on transaction costs by pension funds.

However the removal of ACT relief did turn out to be a death blow for many smaller pension schemes which were struggling in 2000 to 2003 and whose sponsoring employers could not benefit from the supposedly offsetting corporation tax cut as they were not making much if any profit. 

 

Norman Lamont

Norman Lamont

followed by

Gordon Brown

The Minimum Funding Requirement
The 1995 Pensions Act had introduced the "Minimum Funding Requirement" for occupational pension schemes as a result of the Robert Maxwell pension scandal. Its very name induced people to believe that henceforth their scheme assets were safe from predators like Maxwell if it was "fully funded" on the MFR. Although the Institute of Actuaries quietly pointed out that this was in actual fact far from being the case, by allowing "surpluses" to be defined in an over-optimistic way it encouraged the culture of extensive contribution holidays.

This situation was then made worse by the present government, following pressure from the NAPF, by actually reducing the MFR level by up to 19% in 1998 and by a further 8% in March, 2002. This move was designed to ease some of the pain caused by the removal of the dividend tax credits in 1997. The MFR funding requirement typically then covered no more than about 50% of the guaranteed liabilities. Thus pension fund assets were reduced to levels which no longer matched the liabilities and when the stock market fell between 2000 and 2003 companies faced the prospect of having to pay huge sums to restore even this lowered MFR level.

Belatedly in September 2005 the Pensions Act 2004 replaced the MFR by a "scheme specific funding requirement" to ensure that pension funds are maintained at a more realistic level in future.

 

Robert Maxwell

Robert Maxwell

Stock Market Crashes: 2000-2003 and 2008-2009
In 2000 the average pension fund had 60-70% of its assets invested in equities with some even investing up to 90%. This is on the grounds that in the long-term, they will generate higher growth than the alternatives such as corporate bonds and government gilts. The greater the investment returns the less the company then has to provide in contributions to the fund. However, the reason equities have higher returns than bonds is that they have higher risks.

In 2001 the Boots pension fund moved all its assets into bonds to protect them from the coming fall in share values which many analysts predicted. In general though most fund trustees continued to follow their investment managers' advice to maintain high levels of equities, this type of investment being hugely profitable for them. At the peak the UK pension funds held a total of about £800 billion of assets of which about 70% was in equities and the total assets value dropped by about 30% to about £560 billion.

Following the recovery in 2004-2007 some funds did make small reductions in their holdings of equities but many did not do so only to be hit later by the even more dramatic fall in the FTSE100 index of 40% from 2008-2009. Even when the shares began to recover somewhat the pension funds were hit yet again by the fall in the discount rate used to calculate the liabilities.

 

 

Accounting Standards
The new Financial Reporting Standard 17 phased in from 2000 - 2003 required companies for the first time to declare the extent of their pension fund assets and liabilities in their annual accounts. (It's since been replaced by the very similar international standard, IAS19.) These standards have been heavily criticised because they require companies to use discount rates based on AA rated bonds which is very misleading as this understates the liabilities and deficits. Moreover exposing a pension scheme's deficit on the company's annual balance sheet initially reduces a company's profits and possibly restricts its ability to pay dividends. In stable market conditions the future effect of the pension scheme on the company accounts would be small. When, on the other hand, stockmarket conditions or interest rates fluctuate during an accounting period, a company's reported results could be grossly affected by its defined benefits pension scheme. Thus many companies felt it might be best for their long term viability to discontinue this type of pension scheme altogether and replace it with a Defined Contribution (DC) scheme where all the investment risk falls on the individual.

 

Increased Longevity
When final salary pension schemes were first conceived they were based on a much shorter life expectancy than exists today. They were designed to reward employees for a lifetime of service whilst also ensuring their loyalty and the retention of skills and experience. People are now living much longer and expecting to retire earlier. Pensions were never meant to last for 30 or 40 years. Fund actuaries were very slow to react to this and typically increased their assumed expectation of life for a 65-year-old male to slightly over 15 years. However new data published in 1999 indicated that this person’s life expectancy had by then risen to almost 20 years, and was set to continue rising steeply for those employees who would not be retiring until well into the 21st century. An extra five years is an extra one-third on the time the pension was due to be paid. That extra cost of living longer comes to around 30% on the liabilities of a typical pension.

For those taking early retirement, the effect is greater. There is quite a lot of evidence that life expectancy can go up for those who retire early, so long as they’ve got enough to live on comfortably – though it does go down if they're poor, unemployed and depressed. So the early retirements offered in the early '90s during the "industrial restructuring" were potentially hugely expensive for pension schemes and it is somewhat doubtful that the actuarial calculations of these additional liabilities were adequate.

 

"In 2006, 76 of the 93 companies surveyed were still using mortality tables from 1994" - Financial Times, 4 August, 2010

The Actuaries
The actuarial profession must also shoulder at least some of the blame for the decline in DB schemes. As noted above they continued to use out-dated mortality assumptions in their determinations of the funds' liabilities when they were long past their sell by date. (They in turn would blame the Government Actuary's Department or the Office for National Statistics for this.) In addition they had over time during the boom years developed a culture in which there was a tendency to give the employers, who they regarded as their customers, the figures they wanted just by making less than prudent assumptions used to calculate the scheme's liabilities and thus boost the surpluses. This serious conflict of interests between the trustees and the sponsor was highlighted by the Morris Review of the Actuarial Profession which made recommendations which were incorporated in to the 2004 Pensions Act but not before the damage had been done. It has now been made clear that the actuarial review is undertaken on behalf of the trustees though the sponsor is free to engage his own actuary if he so wishes.

Sir Derek Morris

Increased Costs
Increased bureaucracy and over regulation are often cited as an additional reason for closure. The Pensions Act 1995 required schemes to provide increases on pensions in payment in line with the Retail Prices Index up to a limit of 5% whereas previously company schemes were free to offer no increases at all or as an optional extra for which the employee paid a higher contribution. This 5% cap was later reduced to 2.5% in the 2004 Act following intensive lobbying by the CBI concerned about the increasing cost of the schemes.

Many of the prescriptive safeguards introduced in the 1995 Pensions Act did impose additional costs on pension funds, particularly the smaller ones. Although the original intention of the 2004 Pensions Act and subsequent acts was to reverse this trend it may well have actually made matters worse. Nevertheless the costs of running these schemes are not really significant: the cost for the smallest with up to 500 members is £200 per member pa and for the largest, 40,000+, just £10.

 

Restrictions on Higher Earner's Pensions
In 2004 the government imposed a £1.4 million cap on the pension pot of the higher salary levels. This was then followed by tax changes that reduced the tax relief for higher tax band causing some directors to close their employee's pension schemes as they sought alternative nest eggs for themselves elsewhere.
Unsurprisingly this has been seen as a rather unseemly "toys out the pram" reaction on the part of those who already had enhanced arrangements in their "top-hat" schemes for their own pensions anyway. The pension pot cap has since been raised to £1.5M and only affects 10,000 of the top earners in the country.

 

The Pension Protection Fund
The Pensions Act of 2004 also introduced the Pension Protection Fund to provide a safety net for the members of pension schemes of companies which became insolvent. This is funded by levies on the companies operating DB schemes and thus represents yet another burden which has accelerated the closure of these schemes. (If several large companies do become insolvent there are considerable doubts as to whether the PPF will be sustainable.) An element of the PPF levy on a company scheme depends on the size of its deficit so the more vulnerable a company becomes to insolvency the higher the levy it has to pay, a situation engineers describe as "positive feedback" which generally results in catastrophic failure.

 

Conclusion
Thus there are many reasons for the accelerating decline of final salary pension schemes. Running these schemes has been likened to riding a bicycle: you are fine providing you continue to pedal but if you stop pedalling ( i e close a scheme to new members or take pension holidays) you will start to wobble when going uphill and you may eventually fall off.

Closure doesn't in fact result in any immediate gains for the sponsor. There is not only the reduction in the income stream from the new active members but also the "intergenerational" risk sharing inherent in DB schemes. The contributions from the active members eventually falls to zero and the fund then becomes more dependent on the continued support by the sponsoring company. Unless it can afford a "buy-out", i e to sell the scheme to an insurance company, any scheme deficit will continue to plague the annual accounts for several decades.

Back

 

A Wobbling Penny Farthing

 

See also the Pensions Article in Having their cake.. by Don Young, formerly HR Director of Thorn-EMI