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Once seen as a hallmark of good corporate citizenship, final salary pension schemes have saddled UK and US businesses in particular with enormous financial obligations

This article was first published in the September 2013 International edition of Accounting and Business magazine.

Paternalism can carry a heavy price tag, as many older companies in the US and Britain are discovering. Many that set up pension schemes years ago as a perk for loyal employees are now facing huge financial obligations. Former workers are living far longer than expected and investment returns have been decimated by ultra-low interest rates. As a result the 100 largest US companies have a US$400bn pension gap, up about a fifth since last year, according to a study by consulting firm Milliman.

The situation is even worse in the UK. The roughly £1 trillion in assets held by pension funds there is up to £400bn short of expected future payments. To fully hand over their obligations to insurers would cost British companies around £600bn, according to the Pension Insurance Corporation. 

‘These old pension funds are going to be a burden for decades to come,’ says David Collinson, the co-head of origination at the UK’s Pension Insurance Corporation. ‘In extreme cases it can wipe out shareholders; in others it can drain cash for investment as well as distract management from the task of running the business.’ 

The corporate pension curse is not truly global. Only in a handful of countries did companies start to offer defined benefit retirement schemes that assumed all the risks of supporting former staff. Such schemes failed to take off in much of continental Europe. Australia embraced them but also phased them out over a decade ago. The biggest burdens are in the US, the Netherlands and the UK. 

The UK’s problem is worst of all, say experts. ‘We have made life so much harder for ourselves over here,’ says Kevin Wesbroom, a partner at Aon Hewitt. Unlike in the US, regulations in the UK force schemes to raise pension payouts to keep pace with inflation, radically increasing the cost over the long term. 

Harder to walk away

‘It is also far harder to walk away from pension obligations in Britain,’ Wesbroom says. ‘In Ireland a company can close a plan and divvy up the proceeds among members. Before British funds can close up in this way they need to be topped up so they can cover all future payments.’ 

The plight of British companies also looks worse because regulators have given them more time to clear pension shortfalls. Companies in the Netherlands have also suffered but because regulators there refused to allow companies to fall too far behind the current problem is less acute. ‘Although businesses have had to stump up lots of extra cash, which has been painful, the problem has 

not been allowed to fester so much,’ says Pablo Antolin, a pensions expert at the Organisation for Economic Cooperation and Development. 

The pensions crisis affects mainly older industries such as engineering, transportation and manufacturing. Only schemes set up before the 1970s, when it was considered good corporate citizenship, tend to have this problem now. ‘This is not an issue for young, hi-tech companies,’ points out Collinson. 

In many cases the size of pension obligations now dwarves the market capitalisation of companies – British Airways’ £15bn pension fund is far greater than the value of the company. ‘There is a lot of truth to the joke that BA is a pension fund that also flies planes,’ says Wesbroom. ‘Sadly they are not alone.’ 

A pension shortfall proved fatal for shareholders in Uniq, the food company formerly known as Unigate. With a workforce of just 500 and obligations to 20,000 former workers, the company ended up ceding 90% of its shares to the company pension fund in 2011. 

Even where pensioners don’t end up taking over the company, obligations to former staff can seriously undermine competitiveness. British businesses have had to funnel in around £135bn over the past four years or so, according to the Pension Protection Fund, a British institution that protects the pensioners of companies that become insolvent. 

Long-term outlook damaged

‘Such huge transfers can damage the long-term outlook for the business, starving it of the cash to invest and hire. For many companies this is their single largest liability,’ says Collinson. 

This tension creates a delicate balancing act for regulators and pension trustees, both charged with extracting the maximum for retirees. ‘Neither has an interest in killing off or crippling the business,’ says Antolin. ‘Still, they need to get as much as they can out of the company.’ 

This raises the question of what companies can do to extricate themselves from the mess. Some aspects are particularly hard to solve; rising life expectancy is one. ‘Over the past 40 years people have been living an extra two and a half years more into retirement each decade,’ says Antolin. ‘That was more than twice as fast as actuaries had been expecting.’ 

In response, companies have ditched defined benefit schemes and shifted to defined contribution alternatives. Companies can also try to negotiate with workers, individually or collectively, to reduce liabilities. ‘This is harder in some countries than in others,’ says Wesbroom. ‘In Britain government rules make this particularly tough and you need to find some way of offering to buy employees out to cap future liabilities.’ 

Companies can also offload their obligations on to an insurer. Shares in manufacturer Delta jumped by 10% on the day it announced a £453m deal to offload some of its commitments to the Pension Insurance Corporation in 2008. ‘Exiting the pension business altogether not only reassures shareholders that potential losses are capped,’ says Collinson, ‘it also removes a major distraction for executives. After all, it is not ideal for a manufacturer, for example, also to run a mini-financial services company.’ But with insurers understandably demanding compensation for taking on these risks, the cost to companies of this exit strategy can be high. 

Bolder companies can try to solve the problem by ‘sweating’ assets, says Wesbroom. ‘One major component of the problem has been falling returns on investment as interest rates have plunged. So companies can try to shift towards riskier assets, including foreign equities, private equity or hedge funds, commodities and high-yield bonds.’ The downside is that along with higher returns comes the greater chance of capital loss. ‘As a result, there is a limit to how far this strategy can work,’ says Wesbroom. 

It is possible that an economic shift will rescue pension funds. A recovery in interest rates and a bull market in equities would help. Sadly, companies cannot count on getting this lucky and many face many gruelling years in which pension funds drain cash, reduce the funds available for investment and sometimes even threaten to overwhelm shareholders altogether. 

Christopher Alkan, journalist based in New York


Last updated: 4 Apr 2014