The Lex Newsletter: finally, final salary pensions weaken their grip

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Dear reader,

There is a Pollyanna-ish ring to the adage about an ill wind blowing no good. But the latest twist in Britain’s corporate pensions saga seems to bear it out. Trends in interest rates, inflation and mortality rates are propelling more schemes into surplus. For the first time in decades, finance directors have stopped losing sleep over retirement promises, according to pensions expert John Ralfe. 

The funding position of defined benefit (DB) pension schemes caused endless problems in the era of low interest rates. In the private sector, these schemes, which promise to pay benefits based on salary and length of service, are now largely closed to new members. But more than 5,000 such schemes remain with about £1.4tn in assets.

Their health has an important bearing on the companies that back them and the wider economy. Shrinking pension deficits reduce or eliminate the need for top-up contributions. That improves creditworthiness, valuations and investment capability and lifts restrictions on dividends and buybacks.

Shares in logistics group Wincanton jumped 15 per cent after it announced its pension fund had moved into surplus earlier this month. The scheme requires no further contributions for the next three years at least. The £65mn cash saving gives the company the firepower to invest in robotics and automation, reward shareholders or make deals, says Numis.

Companies should produce more positive surprises as they announce the results of deep-dive valuations they undertake every three years. These are more likely at mid-cap businesses than at large corporates that are closely watched by analysts.

To be sure, predicting the outcome of valuations is more art than science for outsiders. Negotiations between fund and sponsor can affect the result. There are many other variables. One is the recent reversal of the long-running trend for rising longevity expectations. Recent falls in life expectancy of about six months will reduce DB pension scheme liabilities by about 2 per cent. 

Another factor is the degree of inflation-proofing. Caps on inflation protection vary but the statutory minimum for pensions earned from 2005 is 2.5 per cent, far below the rate of recent price increases. That eases pressure on the schemes, though not for pensioners whose living standards will be squeezed.

Rising bond yields are the biggest driver of deficit reductions via discount rates. The 2 per cent rise in long-term government bond yields in the year to May reduced DB schemes’ liabilities by about 30 per cent on average, according to professional services consultancy Barnett Waddingham. Yet many were hedged. For about 12 per cent of the FTSE 350 DB schemes, the buyout funding position was unchanged or worsened.

Take telecoms group BT. It has the biggest corporate DB scheme of all. Its pension liabilities of £41.6bn are more than three times the size of its market capitalisation. Over the year to March, its assets and liabilities both fell by about a third. Higher interest rates hit bond prices. Steeper discount rates reduced future liabilities.

The scheme had a deficit of £4.4bn, as of June 2022, but a more thorough review is under way. The outcome will be closely watched by potential acquirers, who may or may not include stakebuilding French tycoon Patrick Drahi. Trustees have the power to block takeover bids over pension concerns. 

Many other companies will celebrate the complete disappearance of their deficits. The aggregate surplus of the 5,000-odd schemes monitored by the Pension Protection Fund was £441.1bn at the end of August. That compares with a collective deficit of £132bn in 2020. An increasing number of schemes are strong enough for sponsors to transfer them to an insurer. On average, FTSE 350 DB pension schemes are five years away from a buyout, estimates Barnett Waddingham. That is at least three years less than in May 2022. 

The end of a costly, protracted struggle is in sight for many schemes. The total bill for the extra pension contributions demanded by the regulator since 2004 came to £300bn, according to the Tony Blair Institute for Global Change. That is a lot of money to divert from other, potentially more productive uses. Escape will not come a moment too soon, however painful the exit from low rates that enables it.

Other things I enjoyed this week

The UK once had thriving provincial stock exchanges that lost out to London’s deep pool of capital. Philip Augar argues something similar could be happening today as the US becomes the world’s stock exchange.

Anjana Ahuja explains why the development of “inverse vaccines” is a shot in the arm for immunotherapy. 

Enjoy the rest of your week,

Vanessa Houlder
Lex writer

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