People have nostalgia for the way things used to be. Though we’ve spent years moving forward in the name of progress, the haziness of time can create a past that forgets the bad and remembers the good. So much so, it starts to sound like going backward is a reasonable goal. We’re seeing the effect of this thinking around the world, “Make America Great Again,” in the US and Brexit right here at home. There’s a belief that a return to the good-old-days is just the prescription we need to make things better. But just as a placebo may temporarily fool a patient into believing medicine is working, this belief that going back to an ideal may pacify people in the short-term, but have negative effects in the long-term.
Take pension schemes for example. Defined benefit plans were once the de-facto way of helping employees prepare for retirement. It was taken for granted that plan growth would continue, regardless of economic changes, political changes, cultural changes, or changes in plan governance. Based on current trends, it’s safe to say that this view of the future, through the lens of the past was rather misguided.
We recently completed the Conduent Mid-Market UK Pension Review for 2017, and while I share the sentiment that pension schemes were better “back in the day,” no amount of wishing will solve the funding problems the plans are currently experiencing. At a summary level, pension schemes are in the same condition they have been in recent memory. UK pension deficits have risen by c. £100 billion over the past year, with four in every five schemes now in deficit.
Much press commentary in recent months has focused on the financial impact of Brexit not being as bad as feared. After some initial volatility, the impact of the referendum result has not been felt too hard by pension schemes, with investment returns actually picking up around the turn of the year. The real question is how long will this upturn in returns last? Based on our research, we have to take a skeptical, if not pessimistic position on that question.
The financial health of a defined benefit pension scheme depends heavily on the bond market, and bond yields show no significant signs of shifting from their historic low levels. That, coupled with the near-certainty of a “Hard Brexit” is expected to hit pension schemes hard. Should Brexit play out as we expect, pension deficits are expected to rise by c. £225 billion. This continued trend in the wrong direction may cause increased annual company cash demands of c. £25 billion. So while it is good news that pension schemes in the UK have taken an uptick in recent months, the long-term prognosis is not so positive.
So where does that leave us? Companies are becoming increasingly frustrated that they are paying in significant levels of contributions – c. £40 billion across the UK per year – but the deficits just don’t go away. Indeed they are set to get worse. On top of that, many defined benefit schemes face a potential cash flow crisis – two-thirds of schemes are now paying out more money than they are receiving in contributions. This puts increasing pressure on scheme investments to deliver sufficient and timely income to meet promised benefit payments.
Advances in increased life expectancy have also contributed to the problem – though there is some evidence of a slowing in the rate of increase in recent years. However it’s always worth remembering that further medical developments will have a big impact – e.g. it is estimated that a cure for cancer would increase average life expectancy by 3 years, and pensions liabilities by c. 10%.
What does that mean for finance directors and pensions managers today? If necessity is the mother of invention, there is no doubt that the pension needs of today are driving new and unique solutions for the future. Some solutions, once the preserve of only the larger schemes, are helping Mid-Market companies gain increased efficiencies and reduce scheme risks and costs.
As an example, by using insurance solutions and transfer exercises companies can take pension liability off the table entirely. Other solutions, including a range of innovative funding approaches, aim to reduce contributions and kick-the-can further down the road, hopefully to a future time where everything looks a bit rosier!
For all the looking backward, pension commitments are not going to disappear. The smart managers are working with forward-thinking partners to find the right strategy to help schemes achieve both a stronger financial position today and dampen the impact of future events – including “Hard Brexit” or a cure for cancer. That way defined benefit schemes can still be sustainable and effective, rather than merely a financial headache that is destined for the scrap heap. In all, a more practical approach than building a time machine.
The Conduent Mid-Market Pensions Review 2017 covers around 1,900 defined benefit pension schemes in the range £10m to £1bn in asset size, sponsored by UK companies. Click the image below for the review.