Neil Campbell recommends addressing pensions risks...

Neil Campbell recommends addressing pensions risks in the same way as other threats to future business viability

At the end of July, the Confederation of British Industry published research results which estimated that UK businesses were collectively facing a £160bn black hole of pension fund deficits, as calculated under FRS 17, the new accounting standard for pension costs. FRS 17 prohibits firms from smoothing out stockmarket volatility and will also require any pension fund deficit or surplus to be disclosed on the company balance sheet. These estimates are the culmination of a series of events that significantly alter the way in which UK businesses must now assess and manage the risks associated with running a defined benefit pension scheme for their employees.

During the '80s and '90s, many employers took advantage of the reverse scenario, where pension fund surpluses arising from higher than expected equity market returns allowed them to reduce or suspend their pension scheme contributions. Since then, however, a chain of events has resulted in a situation where many companies now theoretically face bankruptcy as a result of funding deficits in their pension schemes.

Traditionally, the management of pension fund risk has been left to the trustees of the scheme and their advisers. While the individuals who sit on pension trustee boards may also be executives of the company, their duty as trustees often differs significantly from their executive role. It is inevitable that conflicts will arise.

Ultimately it is the shareholders of the company who will meet the financial consequences of the pension fund trustees' investment decisions. Assuming that shareholders invest in a company for its ability to derive profits from a given market, the potential for reduced dividends arising from these investment decisions seems somewhat incongruous.

It is vital therefore that companies start to assess and manage the risks associated with sponsoring a defined benefit pension scheme in the same way that they would address any other risk that seriously threatens the future viability of the business. This involves a fundamental reassessment of pension assets and liabilities and is based around the following beliefs.

  • Pension deficits should be viewed as another form of corporate debt.
  • Pension fund assets and liabilities should be treated as if they were part of the company's balance sheet.
  • The market will reward those companies whose decisions regarding plan design, funding and investment are based on sound economic principles.

    As finance directors have woken up to the potential impact of pension fund deficits on corporate performance, some companies have sought to address the issue by either closing the pension scheme to new entrants or winding it up. Unsurprisingly this has proved unpopular with employees, and poor industrial relations also carry inherent business risks.

    As a result, in June this year the Government announced, with immediate effect, legislation that would prevent solvent employers from walking away from accrued pension liabilities without first ensuring that these were met in full. In practice, the cost of this will be prohibitive for most employers.

    Pensions risk assessment
    A detailed assessment of pensions risk, based on corporate risk objectives, is therefore the first step for companies wishing to tackle this issue. This, combined with a detailed assessment of each of the alternative future pension strategy options, will allow key decision makers to understand the true nature of pensions risk and its potential impact on their organisation. Such an assessment would help the business to:

  • Model future pension expenses and cash requirements
  • Model future pension balance sheet provisions
  • Understand the potential effect of pension deficits on distributable reserves and dividends
  • Integrate the results with business planning models
  • Communicate with all relevant stakeholders about the impact pensions risk has on the business
  • Identify risk management tools to mitigate risks

    Managing pensions risk
    Most pension schemes are affected by three factors that are beyond the company's control, namely inflation, interest rates and asset prices. The volatility of these factors has a proven impact on the volatility of corporate cash flow, business ratios and dividend payments. Indeed the CBI research indicates that the extra company contributions required to plug the current black hole will total £8bn in 2003, increasing to £12bn in 2004 and £16bn in 2005.

    With specialist advice however, companies can manage the cost and volatility of pension schemes through two main strategies, namely plan design and investment strategy.

    Plan design - Future plan design is the primary way for companies to reduce the cost and associated risks of future employee pension provision. Through detailed analysis of the available options, the company can evaluate the optimum strategy to offer attractive benefits that are valued by employees at reduced cost and risk to the company.

    Investment strategy - When evaluated in isolation, the trustees' asset allocation strategy provides an optimal portfolio for a given level of assumed risk; it does not however protect the employer from either systemic risk or the inherent volatility underlying equity investments.

    Current market conditions and the scrutiny of pension plan assets and liabilities by rating agencies, analysts and other investors mean that a fundamental change is required in the way in which pension assets are managed. Companies must find a way of convincing trustees to shun traditional investment objectives that focus on investment returns and to begin to manage pensions risk much like any other financial risk.

    Forget for a moment that these risks are associated with the sponsorship of a company pension scheme and ask how a corporate treasurer might manage them. The likely answer will either be a) accept the risk or, b) manage the risk through the use of asset/liability management techniques or financial derivatives.

    In conclusion, pensions risk under the current regulatory structure arguably represents one of the most significant business risks facing UK companies today. Those that are best able to tackle this risk will be the business success stories of the future.

    Neil Campbell is employee benefits consultant at Deloitte & Touche, E-mail: