Captain Equity to the Rescue

Brian Spence

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Over recent months, we have seen the re-birth of the superhero, with Batman, Ironman, Hulk, the Fantastic Four and even the alternative superhero Hancock coming to the big screen to save us all from unspeakable peril. The level of blind confidence placed in these superheroes reminds me of a similar level of faith being demonstrated a bit closer to home, namely the ability of equities to deliver investment returns which are going to save our embattled final salary schemes from a fate worse than death. Actually, death is not such a bad thing for final salary schemes, particularly if it comes early and often.

A lot has been written and much has been said about final salary pension scheme deficits but, in reality, the options available to address them are relatively limited. In simple terms, schemes have only two sources of revenue. Trustees can either seek higher contributions from scheme sponsors or members, or both; or they must rely on achieving significant out-performance from their investment portfolio.

The requirement for this out-performance implies a relatively high risk investment strategy which, for most schemes, implies continued reliance to a greater or lesser extent on equity-based investments. Equity-based investments, as we all know, don’t always work out and, if they don’t, trustees are back to looking to even higher contributions from someone.

Of course the new actuarial orthodoxy is that pension liabilities are bond-like and best matched by bond-like investments. The implied lower returns from bond investments in turn imply higher contributions from somebody and takes us back to the starting point: that there are only two sources of money for the trustees – contributions or investment returns.

In reality, most schemes will opt for a middle course somewhere between higher contributions and an aggressive investment strategy. Where should the balance lie and how should the almost inevitable conflicts of interest between employer and scheme Trustees inherent in any discussion of this nature be addressed?

Considerable faith has been placed, in some quarters, on the ability of equity investments to “save the day”. This faith was severely tested from late 1999 through to early 2003 but began to be re-exert its sway from that point through to 2007, although we didn’t ever get to a point where we reached the heady levels seen at the end of the millennium. Developments over recent months have again led some to question the orthodoxy.

To some extent, the true impact of the falls in equities has been a little obscured for many companies in their FRS17 disclosures as a significant rise in bond values over the period has seen liabilities fall by an amount often in excess of the fall in the value of the assets. This scenario has seen many companies witness an “improved” FRS17 position.

As a result of this weakening of the FRS17 basis, it is now unlikely to be accepted by trustees as a suitable basis upon which to base future scheme funding plans. Without a dramatic turnaround in investment returns scheme sponsors, who have already witnessed significant rises in their contributions over recent years, may well be pursued again. Many will seek to control further rises, especially where a direct impact on the trading position of the business would result.

In the current market environment, it would not be unreasonable to expect employers to resist significant contribution increases and seek to pursue increased investment returns through a more aggressive investment strategy while the trustees seek to pursue an opposite course. How easy will it be for trustees to accept an aggressive investment proposal when viewed against the current investment background?

It will be increasingly important for trustees not only to act entirely independently of the company in such negotiations, but also to be able to demonstrate clearly that they have so acted. Given our cynical times, demonstrating a clear separation of the trustee and company roles may prove almost impossible where company directors perform the role of scheme trustees. This may leave room for claims from scheme members that trustees have not acted in their best interests. Even where the trustees have identified and managed any conflicts of interest, and acted entirely properly. This may not be the perception of the members. It is clear that the Pensions Regulator envisages trustees and employers becoming involved in robust negotiations on such matters.

Conflicts of interest also exist for such trustees in their capacity as directors of the company. Indeed, we believe it will be difficult for a director to act as a trustee without having the potential conflict authorised by his board in accordance with the requirements of the Companies Act 2006.

Many trustees are already beginning to commission accountants to research the company finances to ensure they are adequately prepared for negotiations with the employer. Furthermore, trustees will be able to judge an employer’s ability to pay higher contributions and risk of default using the risk-related levy basis applied to calculate the PPF levy.

The result of trustees’ investigations into the financial strength and security of the employer could see trustees seeking a move to lower-risk investments. All other things being equal, they will then need to seek higher contributions from employers and/or members. Alternatively, trustees may begin to require the provision of a form security in relation to the scheme deficit in return for funding any deficit over a longer period. However, this will only serve to reduce a company’s ability to raise finance to fund development.

Rule 1.01 for pension scheme trustees is that the best support a scheme can have is a thriving and profitable sponsor. The Pensions Regulator is asking trustees to make very difficult judgements about the correct balance between improving member security and killing off the Golden Goose which can provide the security.

The fortunes of sponsoring employers and their pension schemes are intrinsically linked. So, when they find themselves strapped together on the railway line with the last train to Disasterville roaring towards them, their blind faith in Captain Equity may well be severely tested.

Brian Spence

Post by Brian Spence

Fellow of the Institute and Faculty of Actuaries and Society of Actuaries in Ireland, scheme actuary, professional pension trustee