a true partnership approach Impact of pension schemes on UK business

Transcription

1 August 2014

2 RESEARCH Introduction Finally, things are looking up for employers funding defined benefit pension schemes Nick Griggs Head of Corporate Consulting, Barnett Waddingham For many years we have read about the ever increasing pain that defined benefit (DB) pension schemes have piled onto employers, be it additional funding requirements or unwelcome volatility on the. However, Barnett Waddingham s 4th annual report on the FTSE350 shows more positive signs than previous editions and the past year seems to have been a good one. With unprecedented changes to occupational pensions in the UK and with further revolutionary changes in the regulatory pipeline there may be further opportunities to tackle your legacy DB liabilities and ensure your current pension arrangements are set to deliver what you need from them. Our report summarises the data collected from the 220 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. In carrying out our research we have received valuable input from the Centre for Global Finance at the University of the West of England. 2

3 RESEARCH Introduction Some of the highlights in our report are: This change could have a significant impact on the run-off period for DB schemes and for those targeting the end-game this may have moved it a few years closer. Boost to de-risking initiatives Whilst George Osborne s decision to liberalise defined contribution (DC) drawdown may have captured the hearts of savers following his annuity-killer Budget, finance directors will have taken note of the potential impact that this could have on de-risking their company s DB scheme. Our report analyses how companies could take opportunities in the bulk annuity market based on their 2013 financials and the amount of de-risking we are seeing with reduced pensions volatility on the. Easement of funding requirements The Pensions Regulator (TPR) has delivered a new funding Code of Practice for DB pension schemes based around the requirement to look after the sustainable growth of the employer. Our first impressions are that this will give employers more breathing space in future. Encouragingly our report already notes a slight improvement in the scale of deficit contributions being ploughed into DB schemes and there has been a welcome reduction in deficit contributions relative to dividends paid to. Improvement in funding positions The overall picture for DB funding in 2013 was better than in previous years. Whilst there was variation throughout the year, the aggregate level of DB deficits reduced from 63bn to 56bn thanks in part to good asset performance as well as rising bond yields in 2013, particularly at the December year-end. Encouragingly in 2013 we have also seen a levelling out, both with respect to the number and significance, of the outliers present in our metrics. The cross-sector differences, which have been a feature of previous reports, are also becoming less marked. This is hopefully a reflection of the success of many companies in tackling the problems associated with their DB schemes. 3

4 RESEARCH Introduction A time of further change In 2013 the largest UK businesses were busy enrolling some staff into workplace pensions for the first time. Our research shows that for those among the first tranches of businesses having to comply with the new auto-enrolment regime, defined contribution (DC) service costs increased markedly - on average, an increase in DC costs of around 16% in Whilst extra cost is never welcomed by employers this must put the country in a better position to tackle the problems associated with an ageing population. There were 180 FTSE350 companies offering current employees access to a DB pension at the time of reporting their 2013 financials. With the end of contracting-out for DB schemes on the horizon and with the Pensions Minister s crusade to introduce a legal framework that will allow companies to offer some form of risk sharing pension arrangement, it will be interesting to see how pensions or, perhaps more accurately in future retirement savings, will change over the next few years. I would like to thank Michal Bobula and John O Malley from Barnett Waddingham and Ismail Ufuk Misirlioglu and Jon Tucker from the University of the West of England for their work in helping prepare this report. Please contact me for further information on the results of this research or if you would like a personalised report benchmarking your company against those included in the data. Nick Griggs Head of Corporate Consulting nick.griggs@barnett-waddingham.co.uk

5 DB scheme deficits and contributions In 2013, the aggregate IAS19 deficit 1 for companies in the FTSE350 decreased from 63.2bn to 55.6bn. Whilst there were some notable exceptions, some companies would have benefited from the trend of increasing corporate bond yields in 2013 as well as strong asset returns which helped to bring about a modest degree of respite to company s. For those companies reporting at the end of the calendar year, 2013 represented the first year since 2009 where the average discount rate increased for FTSE100 companies 2. The chart below shows how the aggregate deficit was split between the different sectors. Unsurprisingly, it is the more mature industries which contain the companies with the most substantial DB liabilities. There were three sectors (IT, Telecoms, and Utilities) which actually saw aggregate deficits increase compared with 2012, though this appears to be a function of constituent companies within these sectors reporting with March year-ends. FTSE350 aggregate deficit by sector Assets 566bn Aggregate deficit 55.6bn 8.5bn 5.1bn 9.8bn 5.8bn 7.3bn 2.2bn 7.2bn 0.2bn 6.5bn 2.9bn Energy Materials Industrials Consumer Discretionary Consumer Staples Healthcare Financials IT Telecom Services Utilities Fig. 1 1 As disclosed in the latest set of published accounts up to and including 31 December 2013 and ignoring the 54 companies with an IAS19 surplus or neutral position. 2 Accounting for pension costs FTSE100 - Barnett Waddingham s survey of assumptions used at 31 December

6 Nonetheless, DB deficits continue to warrant large injections of cash being set aside as part of scheme funding recovery plans. In the graphic below, the red bars show the expected reduction in deficits since 2009, given the 44bn of deficit contributions 3 being paid in the past 4 years. However, net actuarial losses 4, shown by the green bars, have largely offset the benefit of these contributions and finance directors, who had been hoping to see deficits fall significantly, will have been disappointed with the outcome over the last few years. 68.5bn Progression of aggregate pension deficit since bn 63.2bn 55.2bn 55.6bn Fig The extensive actuarial losses seen since 2009 have predominantly been caused by falling corporate bond yields, which has resulted in a sharp drop in IAS19 discount rates over the period. In 2013, companies in the FTSE350 adopted discount rates that were on average 1.5% below those used in their 2009 accounts. Companies with a December year-end benefited from a more positive trend seen during the last 9 months of 2013, although there is still some way to go to reclaim the losses brought about since The other key financial assumption is they still have future inflation expectations. Over the period since 2009, the inflation assumption has been more steady, with a negligible difference between the assumptions for RPI inflation in 2009 and 2013 (though there was an average increase of 0.4% between 2012 to 2013). However, this does not take into account the government s switch to CPI for statutory increases, which afforded many schemes the opportunity to alter their pension increase assumption. A more detailed analysis of the increase in aggregate deficit over the last year is shown in the graph below. It shows the extent to which greater than assumed asset returns contributed to the overall reduction in deficits. Part of this was related to the strong performance in equities, with the returns for the calendar year on the FTSE All Share and All World indices totalling 16.7% and 17.9%, respectively. At the aggregate level liability values increased, although rising corporate bond yields towards the end of 2013 was another driver in reducing the aggregate deficit. Analysis of change in aggregate deficit in Actuarial gains on assets Deficit contributions Fig. 3 Aggregate deficit 2012 Interest on deficit Actuarial losses on liabilities Other losses and charges Aggregate deficit

7 The good news is that deficit contributions seem to be heading in the right direction from an employer perspective. In 2013 they had fallen to around 8.5bn, which represents a significant improvement on the 12.5bn spent on reducing scheme deficits in the first year of our research, Deficit reduction contributions 12.5bn 12.3bn 12.2bn 11.0bn 8.5bn Fig. 4 Free In this section, we consider the impact that DB schemes are having upon financial flexibility for FTSE350 companies. Whether measured against the ability of companies to generate cash or profit and loss measures, the contributions required to pay down DB scheme deficits must compete with many other financial commitments. TPR s new Code of Practice for funding DB schemes is intended to be more forgiving for those employers whose DB commitments are affecting sustainable growth. One measure of a company s performance is its ability to generate cash which may be utilised in turn to provide the financial resources to make additional investments, repay debt, build reserves or return cash to the. The analysis below shows that there are a significant number of companies paying deficit contributions higher than their free 5 ; the unfortunate consequence for these companies is the consequent need to rely upon external sources of finance or to draw upon their cash reserves. This in effect represents the hidden cost of pension provision, potentially having more widespread implications on the business. Deficit contributions exceeded free for nearly a quarter of companies that provide DB schemes in the FTSE350. Deficit contributions greater than free companies companies Fig companies 56 companies 52 companies 3 Deficit contributions approximated by subtracting disclosed service cost (in respect of future pension provision) from the amount of contributions being made into the DB pension scheme. 4 Primarily due to falling corporate bond yields which have increased IAS19 liability values. 5 Free is defined as 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 s throughout the sample. 7

8 In 2013, deficit contributions represented 8.2% (2012: 9.5%) of total free. As with a number of metrics in this year s report, the trend appears positive. In light of the new Code of Practice, it will be interesting to see in coming years how many companies continue to commit to onerous deficit clearing plans and in cases where resources are particularly limited, whether companies will be allowed to push for a more favourable compromise. Such companies may well include those who are paying deficit contributions despite being cash poor. In 2009, 32 companies had negative s and paid deficit contributions; this actually increased to 44 in Deficit clearing periods In general we would expect companies with high levels of free cash to be required, after negotiations with the pension scheme trustees, to clear pension scheme deficits more quickly. We have analysed the deficit clearing period 6 against the proportion of free being paid into the pension scheme as deficit contributions. Deficit clearing periods in relation to FCF (free ) 15 companies Deficit clearing period 19 over 15 years despite deficit contributions being less than 25% FCF companies Deficit clearing period less than 5 years despite deficit contributions being over 50% FCF Fig. 6 This graphic highlights some significant variations within the FTSE350. There are a handful of companies who have a comparatively short recovery period and are paying a substantial proportion of free in deficit contributions. The opposite is also true for others in the FTSE350. For a number of firms deficit contributions have become, and remain, substantial. In a quarter of cases they now surpass the disclosed free figure. For such firms, it is widely suggested that deficit contributions are impacting upon investment elsewhere in the business, crowding out potentially profitable investment project opportunities and/or other priorities such as dividend payments to investors. With TPR s aforementioned new Funding Code of Practice for DB schemes, the emphasis on affordability of employer contributions has been reviewed. TPR has stressed that trustees should consider the risks to the scheme and the impact on the employer when assessing the appropriateness of a deficit recovery plan rather than requiring deficits to be paid as quickly as reasonably affordable. Whilst this flexibility is to be welcomed from the point of view of scheme sponsors, the regulations do state that trustees may challenge the employer where they believe that the employer covenant is weak (or where unusually large dividends are to be paid). Therefore, there will be greater need for employers to engage with their scheme s trustees. It is interesting to consider the correlation between how a company is rated as a going concern (as a proxy for the strength of the employer covenant) and the period over which trustees have agreed to clear DB scheme deficits. 6 Calculated as the 2013 IAS19 deficit divided by the average deficit contributions paid over the last three years. 8

9 The chart below shows the deficit clearing periods for those FTSE350 companies which have at least a BB-rating from one of the 3 main credit rating agencies (Standard & Poor s, Moody s and Fitch). Credit ratings and deficit clearing period Deficit clearing period years Deficit as percentage of market capitalisation increases Fig. 7 AA/A BBB/BB As you might expect the results are mixed. However, it is interesting to note that those companies with comparatively poorer ratings generally have longer deficit recovery periods, suggesting some allowance has been made based on affordability. In some cases contingent security may have been provided that has allowed a longer deficit clearing period to be agreed. Our chart above has excluded three companies with deficit clearing periods greater than 50 years. As it is very unlikely that these extreme cases will reflect agreed recovery plans, they have been removed. In such instances, we would expect a new contribution schedule will be put in place shortly to reflect the increased deficit. From October 2014, DB scheme sponsors will be assessed by a new model for the purposes of determining insolvency risk for the Pension Protection Fund (PPF) levy. The new model, which has been developed by the PPF and Experian, primarily uses financial metrics to determine insolvency risk. 9

10 Our analysis has shown that in 2013 there were just 10 companies for whom the size of the DB deficit was having a significant impact on the assessed insolvency risk under the PPF model. If we consider the deficit recovery period as another measure of insolvency risk (viz. the employer covenant), it is interesting to note that there is no apparent correlation with how insolvency risk is determined under the PPF model 7. Based on the associated probabilities of insolvency, the PPF might expect to take on deficits 8 of 124m per annum from FTSE350 companies. Given the level of cross-subsidy that is in place with levy payments, it is to be expected that the quantum of PPF levies being paid by these same companies per annum will be more than enough to cover this amount. Operating profit When compared against a profitability measure, deficit contributions again represent a significant cost for the majority of companies. Despite making an operating loss, 6 companies still paid deficit contributions in On average deficit contributions now represent 11% of operating profit for the FTSE350. Despite making an operating loss, 6 companies still paid deficit contributions in This clearly has a marked negative and exacerbating impact on the ultimate bottom line. 7 Note that only two of the seven metrics could be described as being directly affected by DB schemes: Capital Employed (defined as total assets less current liabilities - equivalent to long-term liabilities, inclusive of any deficit, plus total equity) and Return on Assets (defined as pre-tax profit, net of pension finance costs, divided by total assets). 8 Deficit measured on an IAS19 basis. 10

11 As a function of earnings, deficit contribution levels will have been fairly consistent over the past 5 years. However, the range has narrowed and a number of the extreme cases observed in previous years have been brought under greater control. The chart below shows deficit contribution levels as a proportion of operating profit (i.e. earnings before interest and taxes, or EBIT) since To illustrate the change in variability since 2009, the boxplots show the interquartile range and 10th/90th percentiles in each year. Deficit contributions as % of operating profit 30% 25% 20% 15% 10% 90th percentile - top of the red line 75th percentile - top of the blue box 5% 0% th percentile - the green dot in the middle is the median 25th percentile - bottom of the blue box 10th percentile - bottom of the red line Fig. 8 Some industry sectors remained more affected than others. In 2013, deficit contributions represented a particularly significant proportion of average free and/or average revenue amongst companies operating within the Industrials, Consumer Discretionary, Telecommunication Services and Utilities sectors (see Appendix). Some of these sectors might be considered better able to absorb greater contributions given the more predictable nature of their cash generation. In 2013, deficit contributions represented over 50% of average free in the Utilities sector and over 1% of average revenues for companies in the Industrials sector. 9 9 Average free and revenue is calculated over the 5 year period to

12 Future service contributions To put these deficit contributions in the context of the total expenditure on pensions, the average contribution per employee being paid to clear the DB deficit was 3,000 in Though this includes a handful of extreme cases of companies with small employee numbers and substantial deficits, it still represented a decrease of around 700 on the per capita contribution in By comparison, the cost of providing future pension provision for current employees, including DC arrangements, was 2,700 per employee in 2013 representing an increase of around 100 from the previous year. The graphic below compares deficit contributions against future service contributions in These now represent 4.5% and 4.6% of total staff costs, respectively. Whilst this is a relatively small proportion of the staff costs it varies greatly between companies and for 18 companies deficit contributions exceeded 10% of total staff costs. Interestingly 17 companies with a surplus on an IAS19 basis continue to pay more in the form of deficit contributions than they pay for future service provisions. These companies are presumably targeting a low risk investment strategy or buy-out within a fairly short timeframe. Deficit contributions vs future service contributions 12,000 Deficit contributions per employee ( ) 10,000 8,000 6,000 4,000 2, ,000 4,000 6,000 8,000 10,000 12,000 Fig. 9 Future service contributions per employee ( ) The analysis shows that there were 64 companies in the FTSE350 paying higher deficit contributions per employee than the contributions for future pension provision (represented by those above the red line) 10. These companies had an average deficit per employee of 17,000, which was significantly higher than the FTSE350 average of 12, In 2013, 64 companies were above the red line; in 2012, it was

13 For those companies in the FTSE350 with DB schemes, the total amount paid towards reducing DB deficits in 2013 represented 37% of the total contributions paid towards pension provision. With the advent of auto-enrolment and the acknowledged goal of nudging younger generations towards saving for retirement, it is remarkable to consider the level of resources that UK businesses are still having to commit towards legacy benefits, a substantial portion of which will relate to beneficiaries who are no longer in their employment. Over 40% of companies operating in the Consumer Staples, Consumer Discretionary and Utilities sectors are paying more in deficit contributions than they are for future pension provision for current employees. In the Energy sector no company pays deficit contributions higher than the cost of future service provision. This is despite 5 out of the 8 companies having underfunded pension plans. 13

14 The presence of a DB deficit is an interesting issue for and there is evidence that certain events related to DB schemes can have a negative impact on a company s share price 11. Research conducted by Liu and Tonks (2013) 12 shows that the effects of FTSE350 company pension contributions can be observed more through the financial channel (i.e. with a negative impact on dividends) than the real channel (i.e. with a negative effect on real investment projects). We have considered below the interaction between commitments to reduce DB deficits and how they are prioritised against shareholder interests. Over the last 5 years the total dividends paid by FTSE350 companies which sponsor DB schemes was just under a quarter of a trillion pounds ( 249bn). Over the same period cash paid into DB schemes to reduce funding deficits equalled 57bn. Therefore, DB deficit contributions are not only of a sufficient scale to materially impact on potential investment opportunities but also to reduce the visible rewards to equity investors. While the amounts paid vary significantly across the FTSE350, deficit contributions as a proportion of net dividend payments were lower in 2013 compared to previous years. The graph overleaf shows how deficit contributions and dividend payments compared in 2013 and on average over the previous 4 years. There are a significant number of cases where the deficit contributions paid over the period are greater than dividends paid over the same period (i.e. blue dots above the red line). In 2013, this situation is less common (i.e. less red dots above the red line). In 2013, FTSE350 companies paid 33p of deficit contributions for every 1 returned to (37p in 2012 and 41p in 2011). 11 a company s share price of its final salary pension scheme Barnett Waddingham research. 12 Liu, W. and Tonks, I., Pension funding constraints and corporate expenditures. Oxford Bulletin of Economics and Statistics, 75 (2), pp

15 Deficit contributions vs net dividends paid 300 Average Deficit contributions ( m) Net dividends paid ( m) Fig. 10 In 2011, 44 companies paid more in deficit contributions than they paid to in the form of dividends. In 2012, there were 32 companies in this position; in 2013, this fell further to 25 companies. Of the 25 companies, 15 companies paid no dividend whilst paying deficit contributions to an affiliated DB scheme. Thus, while the issue of the pension contributions limiting dividend payments to equity investors has abated somewhat, such contributions remain an impediment to attracting investors in an equity market environment where cash rewards are considered ever more important, particularly in a sideways or trading market going forward. The same trade-off applies in terms of limiting share buybacks which are currently seen as an important strategy for equity value maintenance in an uncertain capital investment landscape. 15

16 Many companies continue to face difficulties in generating cash reserves, with the DB scheme consuming a significant proportion of the cash that is generated from core operations. Since 2009, the total deficit contributions paid into DB schemes were equivalent to around 4 ¾ months of all cash generated in 2013 through core business activities 13. Looking at the 2013 financials, we estimate it would take companies on average over 5 ½ months 14 to clear their IAS19 deficit using net cash 15 generated from their core activities. This compares with an average of over 7 ½ months in The distribution of periods required by FTSE350 companies in 2013 is shown in the graph below. Time needed to clear current IAS19 deficit using net cash generated from businesses core activities 80 companies 33 companies Fig companies 7 companies 8 companies Less than 3 months 3-6 months 6-9 months 9-12 months months 14 companies Over 18 months For 22 companies, it would take over one year to repay the IAS19 deficit using the net cash generated from core activities. This demonstrates that companies continue to divert a significant proportion of the cash they generate towards their DB schemes and this looks unlikely to change markedly in the short-term. If companies are aiming for a full buy-out, we have estimated that on average nearly 20 months of cash generated from core operations would be needed to achieve this, based on market conditions at the time of the company s 2013 accounts. 13 Operating is a measure of net cash generated each year from core activities. 14 This ignores 2 outliers as well as companies with negative net operating s. 15 Net cash refers to the cash generated from operations after paying for the costs of those operations. 16

17 Whilst trading conditions in many sectors remain tough, the level of cash being held by many large companies has triggered much comment over the past couple of years, with some quite marked examples of cash hoarding. In total, the 220 companies analysed were holding 123bn in cash at their 2013 year end; this represented a slight increase from the 111bn held by the same companies twelve months previously 16. Many are starting to view cash surplus held by UK companies as problematic to equity investors as it should either be put to productive use or paid back to investors through special dividends or share repurchases 17. If cash is returned to investors in this way, then attention will move from back to cash generation ability, thereby focusing minds again on how such cash is being applied as it is generated at the margin. An alternative might be to use surplus cash to reduce or even remove (through buy-out) a pension deficit. In 2013, for every pound spent on capital investments 28p was diverted to reduce the pension deficits. Around a third of FTSE350 companies, which have seen an increase in their between 2012 and 2013, have also increased their deficit contributions. Over the last 4 years, 21 companies from the FTSE350 paid more in deficit contributions than they invested in long term assets. Potential to buy-out Clearly, using cash reserves to address the pension scheme deficit may not be seen as a priority. However, many companies will be looking to de-risk their DB schemes which would be expected to increase longer term pension costs. Whilst a full buy-out might have only been an aspirational target a few years ago has this now changed? 113 of the companies analysed would be able to achieve a full buy-out from their, although for 27 of these companies it would have involved committing over 50% of their total cash holding. The normal level of cash held will vary significantly from company to company but around 75% could be defined as holding excess cash 18. Nearly one half of the firms with excess cash could afford to buy-out the scheme with it (in 2012, this was one quarter). There were 82 companies that could clear their IAS19 deficit from excess cash. There were 37 companies in our survey that would have been able to fund a buy-out based on the increase in their between 2012 and companies in our survey would have been able to fund a buy-out based purely on the increase in their between 2012 and This excludes companies in the Financial sector, where some or all of the capital is held to fulfil regulatory obligations and is thus not discretionary. 17 UK companies sit on giant piles of cash - Financial Times, 29 September Ozkan, A. and Ozkan, N. (2004). Corporate : An empirical investigation of UK companies, Journal of Banking & Finance, Volume 28, pp suggests that the average cash ratio is 10% for UK firms. 17

18 Market capitalisation In previous years we have highlighted the significant number of FTSE350 companies who have a DB scheme deficit that has a major impact on the company s. Fair equity market performance over the last 12 months 19 resulted in a marginal reduction of DB scheme deficits as a percentage of the market capitalisation of FTSE350 companies. This ratio decreased to 5.3% in 2013 (6.6% in 2012). This ratio was higher for the FTSE250 and for companies in certain industry sectors. The chart below highlights differences across the individual sectors although this has become less pronounced in the last few years. For 5 companies the deficit exceeds 20% of the market capitalisation of the company after removing the pension scheme liability; for 27 companies it exceeds 20% of the value of equity (again, after removing the pension scheme liability). Deficit as % of market capitalisation by sector (and % change from 2012) 8.0% 2.9% Energy 5.6% Materials Industrials 6.9% Consumer Discretionary 3.3% Consumer Staples 2.5% Health Care 1.7% 1.9% Financials IT 6.7% Telecommunication Services 4.5% Utilities -0.3% +1.3% -1.1% -5.8% -0.3% +0.3% -0.6% -0.4% -0.4% -0.5% Fig. 12 For 5 companies the deficit exceeds 20% of the market capitalisation of the company; for 27 companies it exceeds 20% of the value of equity. 19 The 2013 calendar year saw a 16.4% increase in the FTSE350 Index. 18

19 The impact of DB scheme deficits on company s varies considerably within the FTSE350, but overall things seem to be heading, albeit very slowly, in the right direction. This can be attributed to both pension plan asset recoveries, deficit contributions paid by the company and value creation within companies as economic conditions improve DB scheme deficit as proportion of the value of equity if the DB pension scheme is ignored 12.8% 13.2% 11.8% 11.0% 10.5% DB scheme deficit as proportion of the market capitalisation if the DB pension scheme is ignored 6.8% 8.3% 5.5% 5.3% 4.4% Fig. 13 Ability to raise finance One potential consequence for a company with a large pension scheme deficit disclosed on the is the impact it will have on the company s gearing ratio (a measure often used to assess financial risk or long term solvency). For a significant number of companies the DB scheme deficit exerts a significant impact on the gearing ratio, which could ultimately impact on a company s ability to raise new finance or indeed to refinance its existing debt. On average the impact was to worsen the gearing ratio by 3.6% which is 0.5% lower than a year ago. However, for 15 companies the increase in gearing was more than 10%. Financing needs vary across companies, reflecting their current level of gearing, the availability and cost of new finance, as well as long-term capital structure strategy considerations. For those FTSE350 companies which sponsor DB schemes, 98 decreased their level of debt over the course of The average repayment was 181m compared to the average pension deficit of 335m. There were also 96 companies that increased their level of debt financing during 2013, of which 53 companies made cash pension deficit contributions. In some cases, the increased gearing caused by the pension deficit may increase a company s cost of debt financing. Gearing ratios will typically vary from sector to sector, often depending on the level of fixed assets against which borrowing can be secured or factors such as industry earnings volatility. 19

20 The graph below shows the impact of the pension scheme on the gearing ratio for the Industrials and Consumer Discretionary sectors, where the impact is particularly pronounced. Impact of pension schemes on gearing ratio 35% 30% 25% Increase in gearing 20% 15% 10% 5% 0% 0 10% 20% 30% 40% 50% 60% 70% 80% 90% Gearing ratio before pension deficit Fig. 14 Industrials Consumer discretionary Size of pension risk In 2013, the total DB scheme funded assets for FTSE350 companies totalled 566 billion. In addition to studying how the deficit or surplus in the pension scheme affects the company, we have also considered the potential risk posed by the DB pension scheme to the business. This has been investigated by considering the size of the pension obligations in relation to the size of the company. The exposure of the company to equity markets via their pension scheme is often considerable. Of the companies analysed, there were 8 with an equity holding in their scheme which was more than 50% of the market capitalisation of the company (2012: 13 companies), whilst 17 companies have total pension obligations that exceeded their market capitalisation (2012: 24 companies). 20

21 In the FTSE350, 17 companies had pension obligations that exceeded the market capitalisation of the company. 8 companies in the FTSE350 had an equity holding in their scheme that was more than 50% of the market capitalisation of the company. The graph below shows both the DB pension scheme obligations and equity holdings as a percentage of market capitalisation. DB obligations and equity holdings 250% DB obligations as % of market capitalisation 200% 150% 100% 50% Indirect equity exposure greater than 50% of the company s Market Cap Total DB obligations greater than company s Market Cap 0% 0 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Fig. 15 Equity holdings as % of market capitalisation Overall DB schemes have seen their equity exposure marginally reduced from 38% to 36% over the year to 2013; meanwhile average bond holdings (including gilts and corporates) remained steady at around 40% (2012: 39%). 21

22 The chart below shows the progression of the various contributors to changes in funding levels over the past 5 years. By noting the variability of each of the components over time, we can see how the main risks to the pension scheme are linked to asset performance and actuarial losses on liabilities (in the short-term predominantly due to changes in assumptions owing to fluctuating market conditions). Contributors to changes in DB funding position bn bn bn bn bn bn bn bn bn bn bn 19.7bn 19.5bn 33.5 bn 19.9 bn 11.2 bn 18.7 bn 15.6 bn 16.5bn 23.2 bn Fig. 16 Total employer contributions Return on assets (net of interest cost) Service cost Actuarial losses on liabilities It is widely expected that an interest rate rise is around the corner, with the Governor of the Bank of England and many market analysts hinting that this could take place later in However, with interest rate rises predicted by the market already priced in to IAS19 disclosures, even in the event that rising yields were to surpass current market expectations, the overall scale of DB obligations would remain challenging (with 14 companies continuing to have DB obligations over and above their market capitalisation in the event of interest rates rising by 0.5% more than anticipated). 22

23 Historically the level of equities held by a DB scheme was seen as an indicator of the level of risk within the pension scheme. Over the last few years changes in the discount rate and inflation assumptions affecting the measurement of pension liabilities have also caused significant volatility in IAS19 funding levels. This is illustrated in the graphic below. These two issues are partially linked because traditionally schemes have held a mix of equities and bonds. However, the volatility in IAS19 funding levels in the last few years should be attributed to the fact that schemes are not holding assets that provide interest rate protection, and not just the fact that they are holding equities. Impact of equity and real yield risk 119 companies Equity holdings mostly responsible for volatility in funding level 101 companies Changing real yields has caused more volatility than movements in equity markets 45 companies Volatility due to changing real yields more than twice that caused by equity holdings Fig. 17 Companies have seen a change in their IAS19 funding level that was just as likely to be related to changes in interest rates as it was related to volatility in their holdings in equities. We would obviously expect those schemes with ample interest rate and inflation protection to be more immune to changes in real interest rates over recent years. Actuarial gains and losses, although not reported in a company s, are the main cause of change in the pension scheme liability disclosed on the. Over the last 5 years annual actuarial gains and losses on assets and liabilities have on average resulted in a 6% annual movement in the equity position of FTSE350 companies. This shows the significant volatility that the pension scheme brings to a business. For some companies, the movements have been even more severe with 10 companies seeing actuarial gains and losses leading to changes in equity of greater than 50% on average. The table below shows how this metric has trended since 2009, with 2013 presenting a more stable picture than the previous year (and considerably more so than in the aftermath of the financial crisis in 2009): Absolute movement in actuarial gains/losses as proportion of total equity 9.7% 4.9% 5.0% 5.6% 3.7% Fig. 18 The reduction in the absolute movements from 2012 to 2013 was mainly due to lower market volatility rather than an increase in the value of companies equity positions. 23

24 Service costs With DB schemes continuing to require high levels of deficit contributions, the cost associated with providing future pension provision remains under increasing pressure for companies in the FTSE350. The average annual cost of pension provision (including DC schemes) earned by employees has averaged around 2,540 per employee over the past 5 years. From October 2012, the largest employers in the UK reached the initial staging date for the new auto-enrolment regime. As a result, some employers will have seen a significant increase in the number of employees joining a pension scheme during the period covered by their 2013 accounts, particularly those largest companies reporting with a December year-end. For those companies whose largest PAYE scheme exceeds 30,000 staff in the UK, the staging date for auto-enrolment was 1 January For the below chart, we have examined the largest employers 20 in the FTSE350, many of whom would have been among the first tranche of businesses to enrol their staff under the new regime. The analysis shows that there were some substantial increases in DC-related costs for FTSE350 companies in Auto-enrolment and DC service cost 200% % change in DC costs between 2012 and % 100% 50% 0% -50% DC costs (2012, ) increases Fig. 19 There was an average increase in DC contributions of 16% for those firms analysed above, representing an increase of around 280m. This increases DC contributions as a proportion of total staff and related costs from 2.48% in 2012 to 2.64% in For all FTSE100 companies, including those not offering a DB scheme, the average increase in DC contributions was 17%. As a proportion of total staff and related costs, this represents an increase from 2.65% to 2.75%. 20 Companies in the FTSE350 employing over 30,000 staff, including those not offering DB arrangements. Note: the total staff figures include overseas employees and companies may also manage more than one PAYE scheme. Nonetheless, we believe that this represents the population of the Index who will have been expected to react quickest in order to comply with auto-enrolment in

25 For all companies in the FTSE350, it is clear that auto-enrolment is leading to increases in the total level of DC contributions being paid. However, when considered at the level of already-considerable overall staff costs, this may not be a cause for alarm for the largest companies. However, companies may be using the gradual phasing-in of minimum contribution levels prior to 2016/ So, we might expect the level of DC costs to increase further in the coming years. 21 Minimum total contribution of 5% from 1 Oct 2016 to 30 Sept 2017, and then 8% from 1 Oct 2017 onwards. 25

26 RESEARCH Appendix Appendix All data taken from company accounts published in the year up to and including 31 December Where comparisons are made with previous years, these are taken from the 2010, 2011 and 2012 accounts. Market sector classifications are based on the Global Industry Classification Standard taken from Osiris database. Fig. 1-3 Aggregate deficits calculations include unfunded liabilities. Fig Deficit contributions approximated by subtracting disclosed service cost (in respect of future pension provision) from the amount of contributions being made into the DB pension scheme. A number of companies are excluded which do not pay deficit contributions based on this method in the relevant years. Fig. 3 Where there is a difference in the expected return on assets and discount rate assumptions (as allowed under the old IAS19 regime), this is included under Actuarial Gains on Assets. Fig. 7 There are 3 BBB/BB rated companies with deficit clearing periods of greater than 50 years who have been removed from this chart. Fig companies with a negative average net operating cash flow are excluded. Fig. 12 Market capitalisation recorded at earnings publication date of each company. Fig. 13 Market capitalisation has been adjusted by adding back DB pension deficit. Fig. 14 Gearing ratio calculated using disclosed long term liability as a proportion of equity plus long term liability. Gearing ratio ignoring the pensions scheme calculated by removing the DB scheme deficit as a long term liability. Fig. 15 There are 2 companies, in the top-right quadrant, who are outside the scale of the axes. Fig. 9 Future service contributions assumed to equal disclosed service costs plus contributions paid into DC arrangements. Fig. 19 The bars on the x-axis are ranked in increasing order of disclosed DC service cost in Fig. 10 Net dividends paid calculated as dividends paid less dividends received. One significant outlier removed. 26

27 RESEARCH Appendix Deficit contributions as % of average revenue/average free by sector Sector Deficit contributions in 2013 as % of average revenue ( ) Deficit contributions in 2013 as % of average free s ( ) Energy 0.16% (-0.01%) 9.64% (-0.75%) Materials 0.40% (0.00) 8.02% (+0.01%) Industrials 1.04% (-0.32%) 33.86% (-10.33%) Consumer Discretionary 0.52% (-0.20%) 11.41% (-4.31%) Consumer Staples 0.70% (+0.25%) 13.17% (+4.72%) Health Care 0.55% (-0.92%) 3.21% (-5.39%) Financials 0.68% (-0.02%) 8.01% (-0.20%) Information Technology 0.47% (+0.09%) 5.46% (+0.99%) Telecommunication Services 0.87% (-2.57%) 7.60% (-22.40%) Utilities 0.79% (-0.14%) 50.88% (-9.03%) Deficit contributions and future service contributions by sector Sector Deficit contributions in 2013 per employee Future service contributions in 2013 per employee (including DC) Energy 2,055 6,158 Materials 2,644 2,279 Industrials 1,264 1,719 Consumer Discretionary 1,859 1,282 Consumer Staples 2,873 1,539 Health Care 2,578 2,394 Financials 6,788 4,806 Information Technology 1,143 1,903 Telecommunication Services 1,395 2,916 Utilities 5,553 4,948 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. 27

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