Pension deficits vs company dividends
Nearly a decade of ultra-loose monetary policy has left companies nursing big pension scheme deficits
Pension deficits hit the headlines again this week with Tesco’s results overshadowed by news the hole in its pension fund has almost double in six months.
Here’s what you need to know about the growing crisis in UK company pensions.
What is a pension deficit?
There are two types of pension scheme in the UK, defined benefit and defined contribution.
With the latter, often referred to as "money purchase" schemes, employees pay into a pension scheme alongside their employer. Whatever is saved is then used to "buy" an annual income when the worker retires.
Defined benefit schemes are the type that pay you an income when you retire either based on your final salary, a portion of your final salary or your average salary over your career. This type need to have a lot of money a decent investment plan in place to cover future payments to those who have retired.
A pension deficit occurs when a company doesn’t have enough money to meet its entire assumed future pension bill.
For example, this week Tesco revealed that its pension deficit is £5.9bn. It isn’t alone, John Lewis, the AA, BT, BAE and Thomas Cook all have sizeable holes in their pension scheme funding.
Why are they soaring?
In August defined benefit pension schemes hit a record deficit of £1trn, according to consultant Hymans Robertson. A decade ago the deficit was just £250m.
In large part the current problems stem from nearly a decade of loose monetary policy, such as ultra-low interest rates and central bank bond-buying, or quantitative easing.
Along with a general surge in demand for "safe haven" assets like bonds, this has had the effect of pushing down the yields on the likes of government gilts. These investments are used by pension scheme trustees to provide the steady, long-term returns needed to cover future payout liabilities.
“A rush for safe-haven bonds around the world has sent the yields on sovereign bonds through the floor – meaning a fall in the regular income that pension funds use to pay their retirees their defined benefits,” says Marion Dakers in The Telegraph.
There is also criticism of companies that for years they have been more concerned with paying shareholders than their own pensioners.
UK companies threw five times as much cash at their shareholders as they did their pension deficits last year,” points out Ben Wright in The Telegraph.
What does it mean for pensioners?
“Defined benefit schemes are slowly dying out, but there are still about 6,000 in the private sector,” says Ruth Emery in The Sunday Times.
The concern is that more and more of those firms are going to fail to meet their pension obligations. When this happens the Pension Protection Fund steps in, but it doesn’t pay out the full amount members will be expecting. This means thousands of pensioners and people approaching retirement could find their retirement income slashed unexpectedly.
What does it mean for investors?
Companies are going to have to take “drastic action,” says Emery. Businesses could be forced to slash dividend payments in order to plug the gaps in their deficits - especially if new Prime Minister Theresa May follows up her tough rhetoric with legislative action.
Investors starved of income from other sources have been increasingly focused on dividend yields in recent years, but the pension deficit crisis could snub out another income stream for them.
Emery warns in The Sunday Times that we could see dividend cuts at Carillion, Thomas Cook, BT, BAE, the AA, Dixons Carphone, Tui, Stagecoach and G4S.
What is being done about this?
The Commons work and pensions committee is investigating how companies can repair their pension holes.
One idea is to allow schemes to change the inflation rate on which annual rises in payouts are based, “from the retail price index to the less generous consumer prices index,” says Emery.
But, rather than making the pensioners suffer in order to deal with the deficit some are arguing that companies need to shift their focus from pleasing shareholders at all costs to looking after their former employees.
“It is time for management teams to realise, and explain to their investors, that sorting out their pension deficits is a much better sign of strength than senselessly spewing out dividends,” says Wright.
FTSE 100 firms paying five times more to investors than into pensions
The biggest listed companies in the UK paid around five times more in dividends to investors last year than into their pension schemes to plug a growing black hole, new research reveals.
Actuarial consultants Lane Clark & Peacock (LCP), analysing the annual reports of firms in the FTSE 100 index, found a collective £71.8bn was paid to shareholders compared to pension-scheme contributions of £13.3bn.
Among these, 56 reported a deficit in their pension scheme funding of a collective £42.3bn. These same firms paid out £53bn worth of income to investors, says the Financial Times.
LCP added that in the case of 29 firms, the dividends were more than double what was paid into the pension fund, "suggesting that these companies could pay off their pension scheme deficit relatively easily if they wanted to".
The figures will increase pressure on firms over their dividend policies.
BT Group, for example, has the biggest deficit of £7.6bn. According to a Daily Mail report in May, it paid £880m into its pension last year compared to a £1.1bn dividend.
Pension consultant John Ralfe told the Daily Telegraph that any proposal to close the UK's massive near-£1trn final-salary pension black hole should include dividends being "stopped" until all obligations to pensioners are met.
Companies would argue that the income paid to shareholders is essential to maintain the flow of investor cash – and of course, dividends are critical to the money-purchase pension schemes that rely on the income to meet their own payout obligations.
Final salary pension deficits are negatively affected by the Bank of England's cut to interest rates and its massive bond-buying programme, which reduces the yield on their fixed-income investments.
This means that in the longer term – assuming rates eventually improve – pension deficits will close considerably from their current level without requiring a huge investment from the sponsoring firms.