The row over the BBC’s decision to cap its final salary pension schemes in April 2011 and close it to new employees is evidence of the contentious nature of the subject. Such is the dissatisfaction of BBC staff over the proposed changes that they have threatened industrial action.
Criticaleye, in association with BDO, have assembled a group of experts to help executives in the assessment and management of the risk inherent in their defined benefit (DB) pension schemes.
In preparation for an event on the subject on 26th October 2010, we have asked the speakers, and other members, to give us a preview of their thoughts in the form of an article. This Community Update draws predominantly from that article.
Richard Farr of BDO, the first speaker at the event, looks at the issues for management, trustees and banks and explains why an unattended DB pension scheme is as risky as ignoring a 200kg gorilla in your garden.
Explaining the analogy, he argues that the size of the deficit that many companies face, the fact that directors can, in certain circumstances, be held personally liable for any shortfall, and the possible conflicts of interest around DB pension schemes, mean that they have the potential, if unchecked, to cause huge damage to you and your company.
He suggests that, should you open your curtain one morning and see a 200kg gorilla in your garden, you would be unlikely to close it and check again in three years time... Yet, effectively, that is the decision corporates and trustees are taking when they leave their DB pension schemes to tick over between triennial reviews and valuations.
Of course, there are good reasons why CEOs and CFOs don’t address their DB pension schemes as fully and frequently as they would like. There are governance and strategy issues all the way from the boardroom to the shop floor, differing valuation methods that make it hard even for a CFO to keep track of liabilities and, of course, the rather more pressing need to steer your business through exceptionally challenging times. Add the fact that DB pension schemes are operating on a 20-30 year timeframe, or longer – perhaps with little demands on current cash flow – and the temptation to leave the gorilla in the garden is easy to see.
One of the speakers, Geoff Eaton, CEO, Uniq Plc, who is currently dealing with this issue, comments: “For many companies with legacy pension schemes, the scale of their deficits has become disproportionate to the scale of the surviving employer covenant. The treatment of this pension deficit as a debt threatens the solvency of the employer. To help employers and trustees optimise the value of the business and to judge what is in the best interest of members, there is a need for a clear set of guidelines. Uncertainty caused by disproportionate pension deficits undermines business confidence and limits the potential for value creation for the benefit of all stakeholders.”
The credit crisis has exposed the real risk in defined benefit pensions and this has raised awareness among all the stakeholders – from shareholders and trustees to lenders and potential new recruits. Investors and management talent are going to be wary about getting involved with companies who haven’t faced the future with clarity.
Lady Barbara Judge CBE, Chairman of the Pension Protection Fund, commented, “Understanding the risks that pension schemes are exposed to, and taking appropriate action to mitigate those risks, is a huge challenge for pension scheme trustees and the sponsoring employers, but a challenge that is crucial to maintaining confidence in occupation pensions and ensuring that the ‘pensions promise’ is secured. A better understanding of the UK pensions universe has also improved the PPF’s understanding of the risks to which it is exposed - our very own gorilla in the garden. This improved understanding has enabled us to develop and articulate a funding strategy that formalises our aspiration to fulfil our responsibilities over the long-term. Furthermore, through the provision of a flexible and concise risk monitoring framework, the funding strategy provides a basis upon which we can effectively assess and plan for our future and the future of those who will be dependent on us for their security in retirement.”
We asked Professor Steven Haberman, Deputy Dean & Professor of Actuarial Science at Cass Business School for his thoughts... “I believe that we have allowed inappropriate accounting measures to dictate how we see and assess the viability and financial strength of defined benefit pension plans. I believe that this inappropriateness is a contributory cause (not the only one) of the demise of defined benefit pension plans that we are currently witnessing. Further, the use by actuaries of terms like ‘valuation’ has not helped in this regard in that they have masked the true nature of the scheme funding exercise, which is instead concerned with long-term budgeting to meet future obligations.”
The good news is that, if you take action now, the situation may not be as intractable as you think - as long as it is approached realistically and addresses the full range of issues.
But what can you do?
1. Don’t ignore conflict – address it
It is inherent in pensions governance that there will be conflict. Trustees have different priorities to the corporate management team and, even within the boards of both, there will be different agendas.
By addressing these head-on and seeking compromise, progress can be made. After all, both have a common aim in the success of the business and achieving a well-funded pension scheme. Our Chairman, David Cheyne, who will be chairing the event, suggests that “If the company representative (generally the CFO) develops and maintains a good relationship with the Chair of Trustees, and if they both conduct themselves professionally and with integrity, then the appropriate solution can be reached without intervention from the Regulator or other third parties. To achieve this there will have been:
• Open, honest and effective communication
• Mutual respect and understanding of each others’ roles and duties
• A good dose of common sense and pragmatism
• Advisors who can balance the ever changing technical requirements with the softer aspects of a negotiation, whilst simultaneously protecting their respective clients from challenge
As discussions around solutions to pensions issues are not often 'black and white', when there are shades of grey, the professional integrity and values of the personalities involved will be tested."
2. Identify and calibrate your risks and then monitor them continuously
If you picture your pension commitments as a pipeline running 20-30 years into the future then, if you were to cut it at any point, you would find the same four risk quadrants:
• Employer Covenant
By examining each segment of each quadrant, and looking at all four together, you will get a much better understanding of your position.
Ian Harley, an Associate of Criticaleye, and Chairman of Rentokil Initial Pension Trustees says “The key to all of this is the trustees’ view of the employer's covenant, and the regulator's view of the same. Having a professionally, and independently validated view of the covenant's worth, and therefore its longevity, is an essential precursor to any debate about the funding position. If this view is shared with, and shared by, the employer, it makes for a much quicker and easier dialogue. The opposite, unfortunately, is equally true! Nonetheless, it is still a good idea to seek such a third party validation up front: it gives the trustees a firmer jumping off point in any negotiations; it inserts a buffer between the trustees and the employer if things get sticky; and it reassures the regulator that the trustees are taking their responsibilities seriously. Everyone wins."
3. Build a strategy and execute it at the right time
It may be better to act now, or it may be better to address problems over the next five or ten years. Either way, only by putting a clear strategy in place now can you address your risk and stop the pension scheme from taking control of your future.
Anthony Arter, London Senior Partner & Head of Pensions at Eversheds says, "From a legal perspective, the changes to the scheme funding regime in 2004 have required both employers and trustees to rethink their approach to managing scheme deficits in both financial and governance terms. In addition, the Regulator is taking an increasingly active role in dictating the issues which employers and trustees need to address in assessing scheme funding. The Regulator is also developing its own powers, including intervening where it feels scheme funding is not appropriate. This means there are considerable challenges for those involved with DB pension schemes which, when added to the changing economic landscape, means it is vital both for employers and trustees to keep scheme funding high on their agendas and under constant review."
To learn more about how to deal with your Gorilla in the Garden, please contact us about attending the upcoming event. Richard’s full article is also now available on the Criticaleye website under the same title.
Please get in touch if you have any comments about the issues raised in today’s update.
I hope to see you soon,