Impact of pension schemes on UK business. Reviewing the effect of DB pensions on companies within the FTSE350 RISK PENSIONS INVESTMENT INSURANCE

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1 RISK PENSIONS INVESTMENT INSURANCE Impact of pension schemes on UK business Reviewing the effect of DB pensions on companies within the FTSE350 1 Impact of pension schemes on UK business

2 It has been a turbulent few years and our 7th annual report on the pension provision of the FTSE350 shows that 2016 was a particularly volatile year for the defined benefit (DB) pension schemes of the UK s largest public companies. The EU referendum in June neatly split the year in two, with companies reporting in the second half of the year seeing a material increase in their DB pension scheme deficit, in contrast to the generally positive start to the year. 2 Impact of Pension Schemes on UK Business 2 Impact of pension schemes on UK business

3 Overall, the aggregate IAS19 deficit for companies in the FTSE350 increased from 50bn to 62bn in However, it was not all bad news for these companies, with various reasons to remain optimistic, including: Deficit contributions as a proportion of free cashflow reduced significantly for FTSE350 companies (from 9% in 2015 to 5% in 2016), with a number of companies with overseas operations benefitting from the post-referendum fall in the value of sterling. Recent data suggests that, across the UK population as a whole, longevity has not improved over the past five years. From a DB pension scheme funding perspective this may provide some welcome respite for companies from the huge improvements in mortality seen over recent decades. Data confirming this was only released in the last few months, but if this trend had been recognised in the 2016 financial statements of the FTSE350 companies, this would have reduced the aggregate deficit by around 10bn. Contents Report highlights 4 Background 5 Impact on Balance Sheet 9 Impact on Shareholders 11 Impact on Risk 14 Impact on Free Cashflow 21 Impact on Profit & Loss Account 24 Appendix 27 Benefit payments from FTSE350 companies increased by around 15% in This is almost certainly due to an increase in transfer value payments to defined contribution (DC) schemes following the introduction of the pension flexibilities in 2015, and will have helped to reduce the pension-related risk faced by the FTSE350 companies. Our report summarises the data collected from over 200 companies within the FTSE350 that sponsor DB pension arrangements. Separate analyses have been carried out for FTSE250 companies, as well as companies within different industry sectors. Nick Griggs Head of Corporate Consulting nick.griggs@barnett-waddingham.co.uk I would like to thank Michal Bobula, John O Malley, Lewys Curteis and Joseph Edwards from Barnett Waddingham for their work in helping prepare this report.

4 Report highlights Deficit contributions stable Excluding a large one-off contribution made by one of the banks, the amount of cash that sponsors committed to pay down deficits remained stable in It will be interesting, however, to see whether this trend continues next year. We expect increased deficits for schemes with valuation dates in 2017, so it would not be unexpected for companies to be under pressure to increase contributions to their DB schemes. Our analysis compares deficit contributions with the dividends paid by companies. The Pensions Regulator (TPR) again raised this issue in its annual funding statement, commenting that it will investigate cases where the level of payments to shareholders implies that the company has greater affordability than its current level of deficit contributions would suggest. Increase in contributions to DC schemes Around 150 of the companies surveyed continue to offer current employees the benefits of a DB pension somewhere within their global operations at the time of reporting their 2016 financials. However, the closure of these schemes continue apace, with some high-profile companies terminating DB pension accrual over the year. With auto-enrolment fully underway, it is unsurprising to see that DC schemes now account for nearly 40% of total pension costs for firms in our survey, and that the median increase in employer contributions to DC schemes was 9%. The relative generosity of DB and DC will continue to be debated, but with the minimum auto-enrolment contribution rate set to step up, it is certain that this trend will continue over the coming years. Other highlights Our analysis shows that deficits increased as a proportion of market capitalisation over 2016, despite strong equity market performance. Interest rate and inflation rate changes continue to be the greatest source of pension scheme volatility for FTSE350 companies. 4 Impact of pension schemes on UK business

5 Background DB scheme deficits worsen in 2016 The average discount rate was around 1% p.a. lower for the 70% of companies reporting in the period after the EU referendum. In 2016, the aggregate IAS19 deficit 1 for companies in the FTSE350 increased from 50bn to 62bn. The increase in the reported shortfall can be attributed to a significant increase in accounting deficits for companies reporting in the period after the EU referendum. The material difference in market conditions before and after the EU referendum highlights the difficult environment facing pension schemes. Changes in market conditions over the year saw FTSE350 funded defined benefit obligations increase by around 17bn for companies reporting at the end of December. More details on market conditions driving this increase can be found in our detailed accounting assumptions note 2. It was not all bad news for those producing their 2016 accounts, as most companies reporting earlier in the calendar year saw deficits improve. However, with the average discount rate being around 1% p.a. lower for the 70% of companies reporting in the period after the EU referendum, the overall picture was worse than the previous year. Pension deficits remain an issue across a wide range of industries. The chart below shows how the aggregate deficit was split between the different sectors, with the more mature industries continuing to share the bulk of DB shortfalls. 1. FTSE350 AGGREGATE DEFICIT BY SECTOR Industrials Consumer staples Assets: 718bn AGGREGATE DEFICIT 62bn Telecom services Consumer discretionary Energy Materials Healthcare Utilities Financials IT Impact of pension schemes on UK business 5

6 A more detailed analysis of the increase in the aggregate deficit over the last year is shown in the graph below. It shows that while scheme assets have performed strongly over the period, this has been more than offset by falling bond yields in the period after the EU referendum. However, it was a year of two halves, with schemes positions being largely dependent on the month of reporting. Many of those reporting in the first half of the year saw their assets keep pace with (and often exceed) the growth in liabilities. 2. ANALYSIS OF CHANGE IN AGGREGATE DEFICIT IN DEFICIT ( bn) Aggregate deficit 2015 Interest on deficit Deficit contributions Actuarial gains on assets Actuarial losses on liabilities Other losses and charges Aggregate deficit Impact of pension schemes on UK business

7 Deficit contributions relatively stable (with one large outlier) In 2016, nearly 12bn was paid by FTSE350 companies to reduce DB deficits. This was significantly higher than the previous year, but this can be attributed to the 4.2bn deficit contribution paid by Royal Bank of Scotland. If this contribution is ignored, deficit contributions 3 have been relatively stable over the last two years. The chart below shows the total deficit contributions paid in each year since In the earlier years, there were a greater proportion of substantial, one-off contributions of over 500m being made to the very largest schemes. In 2016 only three companies made contributions of greater than 500m to reduce funding shortfalls, compared with four in 2012 and eight in However, we are expecting increased Scheme Funding deficits in 2017, and with future deficit contributions continuing to place a strain on certain companies, it will be interesting to see whether we see a return to larger contributions in our FTSE350 survey in future years. 3. DEFICIT CONTRIBUTIONS BY SIZE DEFICIT CONTRIBUTIONS ( bn) Less than 100m 100m to 500m 500m to 1bn Over 1bn Impact of pension schemes on UK business 7

8 Funding level expectations not materialised Based on the substantial amount of deficit contributions paid by FTSE350 companies since 2009, an aggregate surplus was expected to have materialised by this point. In the chart below, the orange bars show the expected reduction in deficits since 2009, given the nearly 70bn of deficit contributions that have been paid since that year. However, rather than seeing shortfalls removed, net actuarial losses, shown by the green bars, have offset a large proportion of the benefit of these contributions amidst falling bond yields. Since 2009 cumulative actuarial losses have totalled around 63bn. Based on the substantial amount of deficit contributions paid by FTSE350 companies since 2009, an aggregate surplus was expected to have materialised by this point. However, the sharp fall in corporate bond yields since 2009 (and the corresponding drop in IAS19 discount rates) has put paid to these expectations. In 2016, companies in the FTSE350 adopted discount rates that were on average approximately 3% p.a. below those used in their 2009 accounts. For a typical scheme this equates to an increase of over 70% in the expected cost of providing DB obligations. The other key financial assumption is future inflation expectations. The typical RPI inflation assumption shows a modest drop of around 0.2% p.a. between 2009 and 2016, albeit with some volatility in the intervening period. 4. PROGRESSION OF AGGREGATE PENSION DEFICIT SINCE AGGREGATE DEFICIT ( bn) Expected deficit Increase due to cumulative actuarial losses 8 Impact of pension schemes on UK business

9 Impact on Balance Sheet Despite strong market performance over 2016, pension deficits increased as a proportion of market capitalisation for many FTSE350 firms. CASE STUDY The recent contribution paid by the Royal Bank of Scotland (RBS) highlights the real impact that pension schemes can have on the balance sheet of a company. In January 2016, RBS announced that they were accelerating deficit payments of 4.2bn, which had previously been scheduled to be paid over a period of 10 years. This was prompted by an amendment to the accounting standards, which would have required RBS to recognise its deficit payments as an additional liability in its year-end balance sheet. DB pension schemes can have a material impact on the balance sheet of a company. This can have tangible consequences for companies, particularly for regulated entities such as banks and insurance companies. Even non-financial entities can be adversely affected by large pension deficits, with the cancellation of Carclo s 2016 interim dividend 4 being a recent example of this. Market capitalisation A straightforward way to compare the relative impact of DB deficits on the financial strength of sponsoring employers is to examine the size of the deficit against its market value. Despite strong market performance over 2016, pension deficits increased as a proportion of market capitalisation for many FTSE350 firms. This ratio increased to 6.3% in 2016 (2015: 5.7%), and was higher for the FTSE250 than the FTSE100 (7.6% versus 4.1%), suggesting that larger 5. DEFICIT AS % OF MARKET CAPITALISATION BY SECTOR (and % change from 2015) PENSION DEFICIT AS % OF MARKET CAPITALISATION % Energy -2.4% Materials 1.9% Industrials 2.2% companies are burdened by DB plans to a slightly less extent than the smaller FTSE250 firms (despite the FTSE100 being responsible for around 85% of the aggregate deficit). This also reflects the relative performance of the FTSE250 and the FTSE100 in the face of a weakening pound. With a large proportion of FTSE100 companies income being earned overseas (compared to the more domestically-focused FTSE250), UK DB liabilities appear to be less of a concern to global profitability for these companies. The chart below highlights differences across the individual sectors. 0.7% -0.9% Consumer discretionary Consumer staples Healthcare 1.4% Financials 0.2% IT -1.8% 0.1% Telecom services Utilities Impact of pension schemes on UK business 9

10 For 21 companies, the deficit exceeds 10% of the market capitalisation of the company (2015: 18 companies). With many DB schemes targeting a level in excess of the IAS19 liabilities, where a very low risk investment strategy or insurance buy-out is the objective, the issue of a trapped surplus will become an increasing concern for DB scheme sponsoring employers. It will likely be on the agenda for the five companies with a surplus that exceeded 10% of their market capitalisation. 6. Year Deficit as % of the Market Cap (if the DB scheme is ignored) 5.8% 5.4% 4.5% 4.2% 4.7% 5.1% TIP FOR FINANCE DIRECTORS As DB scheme deficits have continued to persist, greater attention has been paid to the choice of assumptions at the year end and in particular, the demographic assumptions that have historically been set in line with the trustees triennial valuation. The assumptions are ultimately the responsibility of the company and small changes can make a large difference to the deficit disclosed on your balance sheet. Based on our analysis, around... of the FTSE350 companies with a year % end at 31 December 2016 may have 40 been able to increase their discount rate assumption by 0.2% p.a. or more. 10 Impact of pension schemes on UK business

11 Impact on Shareholders Deficit contributions versus dividends Deficit contributions as a proportion of net dividend payments remained relatively steady at 12%. The presence of a DB deficit is an interesting issue for shareholders and there is evidence that certain events related to DB schemes can have an impact on a company s share price 5. In theory, companies with pension deficits face a trade-off and must balance the payment of deficit contributions with requirements to make investments for the future growth of the company, reduce any non-pension-related debt or pay dividends. Over the last eight years the net dividends paid by FTSE350 companies which sponsor DB schemes was around 400bn. By comparison, there has been just over 80bn paid into DB schemes to reduce funding deficits. The chart below shows deficit contributions as a proportion of dividends for the FTSE350 including the median and the upper and lower quartiles. While the relative amounts paid vary significantly across the FTSE350, our research shows that, in 2016, deficit contributions as a proportion of net dividend payments remained relatively steady at 12% compared with the previous year (2015: 13%). Despite the significant amounts being committed towards securing historical pension benefits, TPR still felt the need to draw attention to the fair treatment between schemes and shareholders in its annual statement on funding DB pensions. This is unsurprising following recent high-profile corporate failures, and the comparative fall in deficit contributions as a proportion of dividends for FTSE350 companies since 2010 highlighted in previous annual statements from TPR. This is a legitimate point and it may well provide trustees with a useful benchmark to consider when undertaking valuation discussions regarding the affordability of deficit contributions. Nevertheless, the reduction in deficit contributions relative to dividends has to be considered in a wider context to understand the trade-off facing Finance Directors. There are a wide range of factors affecting how companies look to reward shareholders and the interaction between this and the commitment to reduce DB deficits is rarely straightforward. 7. DEFICIT CONTRIBUTIONS AS % OF DIVIDENDS 60% 50% 40% 30% 75 th percentile 25 th percentile Median 20% 10% 0% Impact of pension schemes on UK business 11

12 In 2016, 45 companies increased payouts to shareholders and at the same time reduced deficit contributions. Total shareholder return Our analysis shows that total returns to shareholders (measured as net dividends plus share repurchases) are considerable. In the past five years, aggregate payments were around 75bn a year for FTSE350 firms sponsoring DB schemes. On an aggregate level it could be suggested that companies have enough cash to reduce pension deficits further by increasing contributions, and this appears to be one of the conclusions of TPR s research. However, it is very important to understand that there are significant differences between individual companies. We have analysed changes to shareholder payouts and changes to deficit contributions for FTSE350 companies. In 2016, 45 companies increased payouts to shareholders and at the same time reduced deficit contributions. The equivalent number of companies for 2014 and 2015 was 79 and 61 respectively. This represents a significant decrease, and could be a direct result of regulatory pressure. For example, TPR may have argued in 2016 that these 45 companies had enough cash resources to increase deficit contributions. It is perhaps unsurprising that companies that have increased shareholder returns and decreased deficit contributions have seen the average implied period for clearing the pension deficit given current contribution levels increase by over three years between 2015 and Given TPR s comments on fair treatment between schemes and shareholders, these companies are likely to come under increased scrutiny from TPR. Further analysis shows that 53 companies (2015: 51) were able to increase both shareholder payouts and contributions. However a number of FTSE350 companies seem to be facing greater financial constraints and financial pressure in relation to their DB scheme, as 29 companies (2015: 28) reduced distributions to shareholders but increased or maintained deficit contributions, showing a commitment to pension deficit recovery plans. 12 Impact of pension schemes on UK business

13 The bulk annuity market 2016 was another strong year for the UK bulk annuity insurers, with total transaction volumes with UK pension schemes exceeding 10bn for the third consecutive year. This figure was slightly below the business achieved in 2014 and 2015, which were both over 12bn. However, 2016 saw the introduction of Solvency II, the new regulatory regime for insurers, and it took time for some of the insurers to adjust to the new regime and to judge the level of pricing that was competitive. In addition to the deals with pension schemes, Rothesay Life and Legal & General completed transactions for Aegon s annuity book worth a combined 9bn during Prudential made the decision to withdraw from the bulk annuity market during As a result, there are currently seven insurers in the market who are quoting for pension schemes but some other insurers are preparing to join. Pensioner pricing over the first half of 2017 has been very attractive with plenty of schemes being able to purchase a pensioner buy-in without worsening their funding level. This is often achieved by selling low-yielding assets such as gilts to fund the purchase. Nearly 7bn of the transactions completed in 2016 were for buy-in transactions over 100m, so this option has been very attractive for larger schemes. Some insurers provide regular price tracking mechanisms for larger schemes with pre-agreed contracts arranged so that a buy-in transaction can occur as soon as pricing becomes affordable. The medically underwritten bulk annuity market has slowed around 5% of transactions completed in 2016 were medically underwritten, compared to 12% in The two main players, Just Retirement and Partnership, merged in early 2016 and this has reduced the competition in this area of the market. In our survey, 86 of the companies analysed would be able to achieve a full buy-out of their funded DB liabilities from their cash holdings alone, although for 31 of these companies it would have involved committing over 50% of their total cash holdings. Meanwhile, there were 27 companies in our survey that would have been able to fund a full pension scheme buy-out using the increase in their cash holdings between 2015 and Impact of pension schemes on UK business

14 With many DB pension schemes now closed to future accrual, the investment timeframe is now far shorter than it has historically been. Impact on Risk Impact of DB pensions risk In 2016, the total DB scheme assets for FTSE350 companies totalled 718bn. DB pension schemes can expose companies to a significant level of investment risk, which can often go unnoticed. While the allocation of DB pension scheme assets to equities has declined in recent years, equity risk remains substantial for some companies. Of the companies analysed, there were 11 with an equity holding in their scheme which was more than 50% of the market capitalisation of the company (2015: 9 companies), whilst 27 companies have total pension obligations that exceeded their market capitalisation (2015: 26 companies). Historically, the allocation to equities has been regarded as a good indicator of the level of risk within a DB pension scheme. However, over the last few years, it is the change in the discount rate and inflation rate assumptions that have caused the greatest volatility in IAS19 funding levels. This is illustrated in the graph below, which shows the volatility caused by changes in yields over the past 5 years against other sources of actuarial gains and losses (for example, movements in equity markets and changes to demographic assumptions). The graph shows that for the vast majority of companies the greatest volatility has come from an investment strategy that is only partially hedged against movements in real and nominal yields. Even where the pension scheme has significant bond or swap holdings, there is still considerable volatility where a scheme is significantly underfunded or where liabilities have a longer duration than the matching assets held. With many DB pension schemes now closed to future accrual, the investment timeframe is now far shorter than it has historically been. Many companies are therefore taking steps to reduce their DB investment risk (and, in particular, the exposure to interest rate and inflation risk) through using a variety of investment strategies. 8. IMPACT OF NOMINAL AND REAL YIELD RISK ON IAS19 FUNDING LEVEL OTHER ACTUARIAL GAIN/LOSSES AS % OF IAS19 LIABILITIES (5 YEAR AVERAGE) 20% 16% 12% 8% 4% 0% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% ACTUARIAL GAIN/LOSSES FROM CHANGES IN NOMINAL AND REAL YIELDS AS % OF IAS19 LIABILITIES (5 YEAR AVERAGE) 14 Impact of pension schemes on UK business

15 Actuarial gains and losses, although not reported in a company s Profit & Loss account, are the main cause of change in the pension scheme liability disclosed on the balance sheet. In 2016, actuarial gains and losses on assets and liabilities on average resulted in a 6% movement in the equity position of FTSE350 companies (2015: 5%). This shows the significant volatility that the pension scheme brings to a business. For some companies the movements have been even more severe, with 13 companies seeing actuarial gains and losses leading to changes in equity of more than 25% (2015: 8). We would recommend that companies be proactive in relation to the investment strategy company directors should ensure that they are comfortable with the level and type of risk being taken by the DB scheme assets. If your global DB pension obligations are a significant risk to the company and you cannot answer the following questions then we would suggest that you should be engaging more actively on these issues: TIP FOR FINANCE DIRECTORS What is the level of interest rate and inflation hedging in your DB pension scheme? When you have scenario-tested the robustness of your business to various economic scenarios, did you take into account the impact of the pension scheme on the balance sheet and cashflow? What is the ultimate objective for your pension scheme, and how is the scheme s investment strategy intended to help support this objective? Do you have a plan for managing cashflow in your DB scheme, particularly as your scheme matures? 15 Impact of pension schemes on UK business

16 If this slowing in mortality improvement had been recognised in the financial statements of the FTSE350 companies last year this would have reduced the aggregate deficit by around 10bn. Longevity risk One of the risks to which pension schemes are exposed is the longevity of its pension scheme members. The past decade has seen longevity expectations increasing consistently which, when coupled with the low interest rate environment, has been a key factor in the increasing DB obligations of sponsors. However, contrary to the expectations of many in the industry, across the UK population as a whole longevity has not improved over the past five years. The data confirming this was released earlier this year, but if this slowing in mortality improvement had been recognised in the financial statements of the FTSE350 companies last year, we expect that this would have reduced the aggregate deficit by around 10bn. While the risk posed by longevity is not as immediate as, say, large falls in equity values or falling interest rates, it has proved to be an expensive risk to have taken over the long term. For some schemes, longevity risk is now or will shortly be the single largest risk being taken - 4% of the liabilities is considered a general guide to the cost of removing this risk, but it can be even higher for the most mature schemes. Many schemes have directed their governance efforts and budgets over the past decade to the management of interest rate and inflation risk through Liability Driven Investment (LDI) portfolios and fiduciary solutions. However, in general, other than those schemes that have entered into a buyin contract with an insurer, schemes have not tended to manage longevity risk to date. Whilst historically it had only been possible to hedge longevity risk on liabilities of 0.5bn and upwards, insurers are now willing to structure uncollateralised transactions which make longevity management available at a much smaller scale in theory as small as 50m these are also more cost effective in terms of legal fees and the costs of posting collateral. For companies in the finance sector, the advent of Solvency II has encouraged more hedging of longevity risk with the Prudential Regulatory Authority (PRA) recognising 6 the regime provides firms with an additional incentive to undertake transactions to transfer longevity risk by way of reinsurance. 16 Impact of pension schemes on UK business

17 CASE STUDY We provide ongoing consultancy including investment strategy advice to a company that sponsors DB schemes with assets of around 4 bn and have done considerable work to date on long-term de-risking and liability management plans. The main scheme s assets have performed well in recent years, benefiting from strong performance from both return-seeking assets and liability hedging. The scheme had a Technical Provisions surplus and a key objective was to reduce the likelihood of future contributions given this position. We advised the Company of an opportunity to both improve the hedging and also reduce the growth asset exposure in a manner which reduced risk materially without significant impact on the expected timescales for achieving longer term objectives. This was done in a manner which reduced downside risk, but still left some potential benefit if gilt yields do ultimately rise more quickly than the market expects. We worked with the employer and the Trustees investment advisers to agree common objectives and the desired de-risking was able to be implemented within a few weeks of the topic being originally raised with the employer. 17 Impact of pension schemes on UK business

18 Risk removal With many DB schemes now closed to future accrual, a number of companies are putting in place plans to settle their DB liabilities. Ultimately, over the long term, most schemes will be seeking to transfer their DB pension scheme liabilities to an insurer via the bulk annuity market. In the short term, liability management exercises have continued to increase in popularity. These provide companies with an opportunity to reduce cost and risk, as well as the chance to settle benefits at a cost below that of purchasing annuities. Liability management exercises The introduction of the pension flexibilities in the 2014 Budget significantly changed the opportunities available for companies to settle DB pension liablities. These changes provided members of DC schemes with complete flexibility in terms of how they could access their pension benefits. For members of DB schemes these flexibilities are not available, but members are able to transfer their DB benefits to a DC scheme to access the flexibilities. From a company perspective, members transferring their benefits from DB to DC can lead to an improvement in the funding level of the DB scheme, and the risk associated with providing these DB benefits is entirely removed. The graph below shows the total benefit payments made by FTSE350 companies over the last six years. 9. TOTAL BENEFIT PAYMENTS MADE BY FTSE350 COMPANIES OVER LAST SIX YEARS BENEFIT PAYMENTS ( bn) Impact of pension schemes on UK business

19 Benefit payments from FTSE350 companies increased by around 15% in While we would expect benefit payments from DB schemes to increase over time as the DB scheme population matures, there was a marked increase in benefit payments over 2015 and The DC pension flexibilities were introduced in April 2015, so it is almost certain that the material increase in benefit payments is mainly due to the increase in members transferring from DB to DC. The percentage increase in benefit payments from the FTSE350 companies is shown below: 10. Year % increase in benefit payments compared to previous year 0.8% 0.1% 4.7% 12.5% 15.2% To give an indication of the impact that an increase in transfer values from DB to DC could have on the future cashflows from FTSE350 DB schemes, the chart below shows the difference in projected payments if 10% of the non-retired population transferred out at retirement (compared to the payments assuming no transfers at retirement). If 10% of non-retired members transfer out at retirement, this would result in around 40bn additional benefit payments being made in the next 20 years from FTSE350 DB schemes than currently expected (with a corresponding reduction in the level of benefit payments expected from 2037 onwards). This expected acceleration of payments will have implications for scheme cashflow, with schemes needing to focus more on their investment time horizon and ensure that they are not forced to disinvest from assets where the values are depressed to meet payments as they fall due (if these are not covered by companies deficit contributions) 7. TPR emphasised the importance of cashflow management in its recent funding statement. For companies, transfers out can result in a significant reduction to the level of risk in their DB scheme, and can also reduce the timeframe to securing member benefits with an insurance company. 11. EXPECTED CASHFLOW CHANGE IF 10% OF NON-RETIRED MEMBERS TRANSFER OUT AT RETIREMENT 4 2 Actives bn Deferreds -2-4 Impact of pension schemes on UK business 19

20 CASE STUDY We provided support on a Flexible Retirement Offer (FRO) exercise for a 500 million DB scheme. This exercise gave around 725 nonretired members the option of taking free independent financial advice on various ways in which they could draw their benefits either within the scheme or externally (transfer out, trivial commutation or early retirement). We were appointed directly by the sponsoring employer to carry out the TVAS analysis for this exercise. Our actuarial expertise and clientfocused approach meant that we were able to deliver the tailored information that the IFA wanted and work flexibly to ensure that the client s deadline for the project was met. 20 Impact of pension schemes on UK business

21 Impact on Free Cashflow The number of companies paying deficit contributions at a level which is higher than their free cashflow fell back significantly in Free cashflow is cash generated by a company over and above that required to maintain or expand its asset base. It is an important measure of the affordability of deficit contributions. In this section, we consider the impact that DB schemes are having on financial flexibility for FTSE350 companies. Whether measured against the ability of companies to generate cash or, alternatively, against profit and loss measures, the contributions required to reduce DB scheme deficits must compete with many other financial commitments. TPR s Code of Practice for funding DB schemes was released in 2014 and shifted the focus of trustees and employers to the new statutory objective to minimise any adverse impact on the sustainable growth of an employer. The Code is intended to provide more freedom for employers whose DB commitments are affecting their ability to invest for sustainable growth in the business, but the recent failure of BHS and other highprofile insolvencies have prompted TPR to again review its approach and strengthen its advice to trustees and employers on scheme funding matters. The latest Annual Funding Statement from TPR includes a new section on fair treatment between schemes and shareholders. TPR states that it is likely to intervene where it believes that schemes are not being treated fairly. In particular it highlights the situation where companies are paying higher distributions to shareholders than the level of deficit reduction contributions they are making (which was discussed earlier in this report) and where recovery plans are not relatively short or rely excessively on investment outperformance. Ability to generate cash One measure of a company s performance is its ability to generate cash, which may in turn be utilised to provide the financial resources to make additional investments, repay debt, build reserves or return cash to the shareholders (i.e. their free cashflow). Our analysis shows that the number of companies paying deficit contributions at a level which is higher than their free cashflow 8 fell back significantly in 2016 following a spike in In 2016, total deficit contributions represented 9% of total free cashflow for the FTSE350, which is the same as the equivalent figure in 2015 (9%). However, this figure is skewed by the significant contribution made to Royal Bank of Scotland s pension scheme. Disregarding this contribution, total deficit contributions represented 5% of total free cashflow for the FTSE350 a material reduction from the 2015 figures. Impact of pension schemes on UK business 21

22 However, there is potential for these statistics to mask the strain that deficit contributions are putting on certain companies: there are still a significant number of companies paying deficit contributions at a level above their free cashflow. The graph below shows the number of companies whose deficit contributions exceeded free cashflow in 2016, compared with previous financial years. The figure of 38 in 2016 was the smallest since 2010 and is in contrast to the figure of 64 in 2015, the highest since our research began. This indicates the inherent volatility of cashflows for many firms and the relative inflexibility of deficit contributions following changes in a company s financial position. Past analysis from TPR focused on the affordability of contributions in the context of profitability 9. However it is likely that many finance directors will also have been concerned with the cash available when in negotiation with pension trustees, particularly as recovery plans are lengthy commitments. Our data shows that the improvement in the figures shown in the graphic below is largely due to an increase in the cash generated from day-to-day business activities of FTSE350 companies sponsoring DB schemes. For the many companies with overseas operations, free cashflow is likely to have been boosted by the fall in the value of sterling following the result of the EU referendum. 12. DEFICIT CONTRIBUTIONS GREATER THAN FREE CASHFLOW Impact of pension schemes on UK business

23 Indeed, recent research has shown that the payment of deficit contributions has directly resulted in a lowering of employee pay of between 0.2% p.a. and 0.3% p.a. Deficit contributions versus wages The regulatory environment in which in each year would have been around 5% schemes are forced to operate and the higher. In reality, some of this cash would continued squeeze on bond yields has have been reinvested in the business or resulted in an increase in deficit reduction paid out to shareholders. This highlights the payments for many companies cash that difficult position for companies wanting to otherwise may have been used to increase reward current employees, but at the same salaries and possibly part of the reason that time having to pay significant contributions in earnings have lagged behind inflation in the respect of the benefits of former employees. UK for several years. For those companies in the FTSE350 with Indeed, recent research 10 has shown that the DB schemes, and excluding the Royal Bank payment of deficit contributions has directly of Scotland contribution, the aggregate resulted in a lowering of employee pay of amount paid towards reducing DB deficits in between 0.2% p.a. and 0.3% p.a represented around 30% of the total contributions paid towards pension provision. The chart below shows how deficit While this is a reduction compared to last contributions per employee and wages year s figure, it is still a significant amount per employee have progressed since that UK businesses are having to commit Evidently, there was a stagnation in wages towards legacy benefits, a substantial portion between 2012 and 2015, with wages of which will relate to beneficiaries who are only starting to pick up again in no longer in their employment. Companies have many different conflicting obligations, but it is not unreasonable to At least 45% of the companies in the suggest that the wage stagnation seen in Consumer Discretionary, Utilities and Telecom recent years may have been partly due to Services sectors are paying more in deficit companies commitment to pay contributions contributions than they are for future pension in respect of benefits awarded in the past. provision for current employees. Conversely, all of the companies in the Energy sector are If all deficit contributions paid since 2009 had paying more towards future pension provision instead been allocated to employee wages, than towards plugging deficits. on average the median employee wage 13. WAGES/DEFICIT CONTRIBUTIONS PER EMPLOYEE 40,000 1,400 38,000 36,000 1,200 1, , , Median - wages per employee Median - DRCs per employee Impact of pension schemes on UK business 23

24 Between 2015 and 2016, the median increase in employer contributions to DC schemes was 9%. Impact on Profit & Loss Account Service costs The cost associated with providing future and now accounts for nearly 40% of total pension provision remains an increasing pension costs for firms in our survey. pressure for many companies in the FTSE350. On the face of it, the increase in The average annual cost of pension provision contributions to DC schemes is good news (including DC schemes) earned by employees for the employees of FTSE350 companies, averaged around 3,100 per employee in particularly given the concerns in relation 2016 (2015: 2,800). to retirement provision for the younger The graph below shows how FTSE350 generation. However, part of this increase pension costs have been split over the past can be attributed to the continued closure 8 years (excluding the one-off contribution of DB schemes, with some significant of 4.2 bn paid by Royal Bank of Scotland companies terminating DB pension accrual in 2016). The amount paid into DC over the period. arrangements has increased each year, 14. TOTAL PENSION CONTRIBUTIONS - FTSE DB - future service DB - deficit contributions DC 24 Impact of pension schemes on UK business

25 The trend of DC replacing DB, both in terms of being the main workplace pension scheme and in terms of the allocation of employer resources, is likely to continue into the future. Between 2015 and 2016, the median increase in employer contributions to DC schemes was 9%. When viewed by company size, the below graph shows that this increase was distributed relatively evenly between the different companies. The trend of DC replacing DB, both in terms of being the main workplace pension scheme and in terms of the allocation of employer resources, is likely to continue into the future. Median DC costs as a proportion of total staff costs increased once more in 2016 to 3.2% (2015: 2.9%; 2014: 2.8%). With the minimum auto-enrolment contribution rate stepping up over the next few years, this figure is expected to continue to increase. Whether this increase in the auto-enrolment contribution rate will be sufficient to provide an adequate retirement income for current employees is a subject of intense discussion at present. While employee contributions are being paid in addition to those DC costs highlighted above, the Pensions and Lifetime Savings Association believes that the minimum auto-enrolment contribution rate needs to increase to at least 12% to provide an adequate income for retirees 11. This compares to the current statutory minimum contribution rate of 2% (increasing to 5% from 6 April 2018 and 8% from 6 April 2019 onwards). The commentary earlier in this report in relation to the impact of DB deficit contributions on the level of wage increases could equally be applied to the level of DC contributions. Once again, this highlights the difficult balance that companies face in the allocation of limited resources, as well as the much-discussed topic of intergenerational fairness. 15. ANNUAL INCREASE IN EMPLOYER DC CONTRIBUTIONS 0 % <1000 employees 11 % employees 5 % employees 6 % 5,000-10,000 employees 14 % 10,000-20,000 employees 12 % 20,000-30,000 employees 8 % 30,000-50,000 employees 14 % 50, ,000 employees 6 % 100,000+ employees Impact of pension schemes on UK business 25

26 Big Schemes Survey 2017 The largest occupational pension schemes are an integral part of the UK economy. These schemes invest substantial amounts of capital in the wider economy and are responsible for the retirement wellbeing of a large proportion of the population. They also strongly influence the behaviour of smaller schemes, for example with respect to developing innovative methods of sponsor support and risk mitigation. Our latest analysis continues to highlight the closure of DB schemes, both to new members and to future pension accrual. Given the focus on transferring risk from sponsoring employers, we also see some evidence of increased transfer activity in the new freedom and choice landscape. Key highlights: 97% of final salary schemes in our survey are either closed to new members or to future accrual 57% of schemes have a deficit on their company accounting basis 60m of average annual employer deficit contribution 80% median annual increase in transfer values paid out for some of the very largest schemes Read the Big Scheme Survey in further detail: European companies with UK DB schemes This report relates to constituent companies of the Dutch AEX, French CAC40, German DAX, Spanish IBEX, Italian FTSE MIB and Scandinavian OMX share indices that have UK subsidiary companies with DB pension schemes. The survey covers 79 European companies with around 107bn of UK pension liabilities between them. The costs and risks associated with DB pension schemes are well known within the industry. In most cases the parent companies in our survey are leading players in their industries and are able to absorb reasonably substantial pension costs. However, the impact upon performance and return on investments of the UK subsidiary companies can be more pronounced. We publish annual European company surveys that aim to provide parent companies with a useful benchmark of the UK pension exposure against other European-owned companies. Our reports analyse the contributions paid, levels of deficit and levels of risk within the schemes. Find out more: 26 Impact of pension schemes on UK business

27 Notes 1 As published in the latest set of published accounts up to and including 31 December 2016 and ignoring 47 companies with an IAS19 surplus or neutral position. 2 Accounting for pension costs by FTSE100 companies - Survey of assumptions used at 31 December Deficit contributions approximated by subtracting disclosed service costs (in respect of future pension provision) from the amount of contributions paid by companies into the DB scheme Impact on a company s share price of its final salary pension scheme Barnett Waddingham research 6 Prudential Regulation Authority letter on longevity risk transfers insdirectorsletter pdf Free cashflow is cash generated by a company over and above that required to maintain or expand its asset base. Adjustment has been made for treatment of interest paid which has been included in the operating cashflows throughout the sample. 9 Under IAS19, the cost of a pension scheme included in the Income Statement is based on the cost of benefits accrued over the accounting period (the current service cost) and the interest on an accrued DB deficit. The level of contributions actually paid (regular and deficit contributions) are included in the Cash Flow Statement Appendix Fig. 1, 2, 4: Aggregate deficit calculations include unfunded liabilities and exclude surpluses. Fig. 3, 4, 7, 12, 13, 14: Deficit contributions approximated by subtracting disclosed service costs (in respect of future pension provision) from the amount of contributions paid by companies into the DB scheme. Fig. 5, 6: Market capitalisation recorded at earnings publication date for each company. Fig. 7: Dividends paid calculated as the net dividends paid (dividends paid less dividends received). Fig. 8: Increase in IAS19 deficit from change in longevity assumption is taken from IAS19 sensitivity information for the bulk of companies in our survey. Where these sensitivities not disclosed, this has been estimated from other information disclosed relating to financial and demographic assumptions. Fig. 11: Nominal projected payments for current and future pensioners have been approximated using disclosed obligations and benefit payments for DB schemes in the FTSE350. Fig. 12: Free cashflow measured as adjusted free cashflow. Impact of pension schemes on UK business 27

28 For further information please contact your usual Barnett Waddingham consultant or Nick Griggs, Head of Corporate Consulting via the following: Although we try to ensure its accuracy, Barnett Waddingham LLP and the University of the West of England accepts no liability for any errors or omissions this report may contain. Readers should take professional advice in relation to their own circumstances and/ or refer to the original source material as appropriate. The data has been collected from published accounts and the firms concerned have not been contacted to provide additional information. The analysis included in this report can be reproduced without our permission provided prominent acknowledgment is provided to Barnett Waddingham LLP. Barnett Waddingham LLP is a body corporate with members to whom we refer as partners. A list of members can be inspected at the registered office. Barnett Waddingham LLP (OC307678), BW SIPP LLP (OC322417)), and Barnett Waddingham Actuaries and Consultants Limited ( ) are registered in England and Wales with their registered office at Cheapside House, 138 Cheapside, London EC2V 6BW. Barnett Waddingham LLP is authorised and regulated by the Financial Conduct Authority and is licensed by the Institute and Faculty of Actuaries for a range of investment business activities. BBW SIPP LLP is authorised and regulated by the Financial Conduct Authority. Barnett Waddingham Actuaries and Consultants Limited is licensed by the Institute and Faculty of Actuaries in respect of a range of investment business activities.