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Final salary pensions have been uniquely horrible for UK plc

Last week’s round of interest rate rises was bad news for anyone needing to refinance debt. But if you are a business with a defined benefit pension scheme, you may well be quietly pleased about the upward march of rates.

Most such schemes in the private sector, which pay out a pre-determined pension based on an employee’s salary while in work and their years of service, have long since closed to new members and further accruals of benefits. Many assume they are therefore no longer a big issue for companies.

Within a year or so, that should be true for many, as deficits are eliminated and more schemes transferred to insurers. But it should not detract from the deleterious impact they have had on UK plc. Over the past two decades, companies have paid more than £500bn into such schemes. They have held back wage growth, curtailed investment, distorted decision-making, scuppered takeovers and consumed incalculable amounts of management time — all for the benefit of a relatively small cohort of mostly older employees (including me).

Take Currys, a FTSE 250 electrical goods chain. It is saddled with the retirement obligations of Dixons, a forerunner company. The last actuarial review of that scheme showed a deficit of £645mn and to close that gap Currys agreed to pay in a total of £691mn between 2020 and 2029.

That was on top of the £259mn it had already shovelled into the scheme since it closed to accruals in 2010. Currys is not financially distressed as a result, but that is nevertheless real cash that could have been used for investment, cutting prices for customers or increasing wages for staff. For context, the company expects to make about £100mn in adjusted pre-tax profit this year and has a market capitalisation of £625mn.

At Treasury select committee hearings into last year’s liability-driven investment drama, the (unrelated) Dixon International Group described the heavy burden that legacy schemes placed on smaller companies.

Charles Malcolm-Brown, Dixon’s deputy chair and managing director, said that finding employees in a small company with the time and desire to serve as pension trustees was a constant challenge. One year the levy imposed by the UK’s Pension Protection Fund, which rescues pension funds when their sponsors become insolvent, rose by enough to wipe out the company’s profits.

Asked whether the company, which makes specialist construction products and has won various awards for innovation, had ever had to shelve investment plans because of its pension commitments, he replied: “How long have you got?”

Many explanations have been offered as to why companies have ended up virtual slaves to pensions schemes: changes to accounting rules, Gordon Brown’s 1997 pension tax raid, regulation, misguided notions of risk and volatility, bad and expensive advice from consultants and unrealistic estimates of investment growth.

But by far the most significant factor is surely the tyranny of the discount rate, which is used to calculate the net present value of a scheme’s future payouts to members. In the triennial valuations that determine employer contribution, this figure is derived from gilt yields, which in nominal terms fell from 10 per cent in 1989 to 0.2 per cent at the end of 2020.

Lower yields mean a lower discount rate and, according to pension consultant John Ralfe, every 0.25 percentage point fall in the discount rate (calculated using inflation-adjusted gilt yields) adds 3-4 per cent to liabilities. Malcolm-Brown estimates that his scheme’s on-paper actuarial liabilities are about three times what it would actually have to pay out.

But that merciless maths is now working in reverse. Ten-year UK government bonds now yield more than 3 per cent. Pension Protection Fund data showed that 672 defined benefit schemes were in deficit in February; in the same month last year the number was 3,149. More and more schemes are heading for a level of surplus that allows them to be transferred to an insurer, relieving the sponsoring company of responsibility.

John Lewis, another retailer with a troublesome pension deficit, said recently that a pending actuarial review “may mean that no deficit contributions will be required” between now and the next revaluation in 2025. Many other companies will be quietly harbouring similar hopes.