First Quarter 2010 Corporate Update We live in uncertain times The new decade has commenced at a time of great uncertainty. Investment markets remain a concern, with an uncertain future for the economy and no consensus as to whether UK inflation is about to take off, stagnate, or anywhere in between. This is a particular issue for companies facing triennial funding negotiations with trustees, and increasingly non-cash alternatives are being used by companies to help reach agreement with trustees. One certainty is that taxation is about to rise, particularly in relation to high earners and their pension savings, although the full details are unlikely to be clear until the summer after the General Election. You can be sure that 2010 will also be challenging from a pensions perspective and these challenges are best met by understanding the issues, and focusing on the risks that can be controlled. Company Director: What are you doing about these tax changes to pensions? Across the country, UK pension managers are taking calls from concerned directors and senior management asking the same question what does the proposed 2011 change to the tax rules for high earners pensions mean for them? During 2010, every UK company sponsoring a pension arrangement (defined benefit or defined contribution) will need to consider whether any members will have taxable income above 130,000. If so, due to the proposed tax changes, many of them may be better off leaving the pension arrangement from April 2011. The first problem is working out if an employee is above that limit, given that such employees will almost certainly have some income other than from employment with your company. Ultimately individual circumstances will influence the best route, and what the company can do to protect the competitiveness of its overall remuneration package. What to do next Communicate that: We are aware of the issue, and working on it. In the meantime, high earners need to be careful complex rules apply in the current and 2010/11 tax years. This communication may be combined with a reminder of the increase in the minimum age from which people can draw pensions. From 5th April 2010 the minimum retirement age will increase from 50 to 55 so employers should consider sending out a last call for retirements before age 55. Failing to do so could result in disgruntled employees, or deferred pensioner members, who are in their early 50s and who had failed to understand that their window of opportunity to take early retirement was closing. This could be especially problematic if the opportunity to take part of ones pension benefits as a tax-free lump sum were to be removed or restricted by a tax-hungry chancellor. Try to work out who may be impacted by the tax changes applying to high income employees, and the extent of such impact bearing in mind the possibility of key employees also having income from investments, and perhaps even pensions which they have started drawing. Look at the impact of possible solutions, from keeping it simple (offering a cash alternative) to introducing a new, but possibly more complex, tax-effective vehicle or even making no change, if the costs of changes were to exceed the value of any resulting tax savings. We are undertaking benefit reviews for many UK companies and would be happy to share our experience and knowledge of the variety of possible products and solutions. www.lcp.uk.com
Gilts a shelter through all seasons? Gilts (bonds issued by the UK Government) have become an increasingly valued source of stability in UK pension funds investment strategies and have indeed delivered this throughout a tumultuous decade. For example, gilts produced a cumulative return of about 70% if held throughout the noughties (compared to just 18% from UK equities). But do they still provide protection, particularly as pension liabilities are increasingly linked to inflation? Two key threats to the benefits of investing in gilts especially fixed interest gilts are: Inflation risk. A major theme of government and central bank crisis measures has been to counteract deflation in the economy. The resulting assortment of fiscal and monetary stimulus measures are, by their nature, inflationary. Will the effects exactly balance out as they unwind? History shows that inflation is politically easier to live with than deflation. Supply and demand in particular, supply. Quantitative Easing has to date meant that an immense increase in government borrowing has not translated into a significant net supply of gilts into the capital markets. While nobody really knows what the government borrowing requirements will be, estimates of short-term borrowing requirements in the ballpark of 150-200 billion pa are commonplace. Few expect the road back to minimal government borrowing to be easy or quick. It is not clear where demand for this level of UK government debt would come from without a substantial increase in yields relative to the slightly more than 4% pa currently on offer. If gilt yields do increase, many pension funds might find the overall result less helpful than they might expect. A 1% pa increase in nominal yields would mean a double digit percentage loss in the value of long dated gilts. For pensions that are fixed in nominal terms, or have fixed annual increases, this might be broadly offset by a reduction in the value placed on the liabilities (other things being equal always a big if ). But there would be a nasty loss relative to liabilities for inflation-linked benefits. While an increase in nominal gilt yields would have its dangers, it would also offer a number of potential opportunities: UK Key Pensions Statistics * 31st December 2008 31st March 2009 31st December 2009 IAS19 discount rate 6.0-6.7% pa 6.6-7.3% pa 5.4-5.8% pa IAS19 inflation 2.7-3.3% pa 2.9-3.6% pa 3.4-3.8% pa Long-term gilt yield 3.8% pa 4.2% pa 4.4% pa FTSE100 4,434.2 3,762.9 5,412.9 * the figures shown above are only indicative ranges, and different rates may apply with regard to individual circumstances. many pension funds stand to receive a net improvement in their funding position from any increase in gilt yields, being typically only partially matched and not fully funded. (Hence the fall in liability values would be higher than the fall in asset values.) In practice, any benefit is likely to be a by-product of historic investment decisions so any positions would merit reviewing in light of current circumstances; many bond portfolios are structured such that the duration of the bonds is less than that of the liabilities this would give the opportunity for any increase in long-term interest rates to reduce the value placed on the liabilities, with less of an impact on the value of the bond portfolio although there may be more efficient ways to achieve the same effect; and Page 2
inflation risk can be hedged separately from positions on interest rate movements. Many LCP clients have done this or are in the process of doing so, using improved market liquidity to enter into inflation swaps, while holding bonds with a shorter duration than the liabilities. Some questions to ask relating to gilt investments: How would the value of the assets respond to changes of (say) 1% pa in long-term nominal gilt yields and long-term inflation linked gilt yields? How would this compare with the movement of key measures of the liabilities? Is this acceptable? At what levels might one be content to lock in gains from increases in long term interest rates? Would your governance structure be robust enough to act quickly? How would company-initiated investment proposals best be positioned with the Trustees? In this regard, our experience is that most trustees welcome proactive and considered company engagement with investment strategy. Accounting deficits back with a vengeance Continued recovery in corporate bond prices and hence lower yields have been putting further upward pressure on the value put on pension liabilities for accounting purposes. The cash funding position is more likely to have improved although this depends heavily on the individual circumstances including liability profile. The graph opposite illustrates the general trends although the scope for variation between different pension funds is considerable, so this should not be seen as a substitute for specific analysis. In some cases this should encourage companies to see whether there are areas of prudence in their pensions accounting assumptions which should now be scrutinised more fully. More fundamentally, an accounting hit effectively brought about by improving confidence in financial markets will be the tipping point for many companies to initiate fundamental change in future pension provision. Bridging the gap non-cash assets come into their own Pension plan funding is arguably more challenging than ever before. With companies needing to retain cash in the business, eg for investment, we are increasingly seeing situations of non-cash assets and contingent assets emerging as the key to unlocking funding negotiations: a genuine win-win solution. A number of large UK companies (some shown in the table below) have transferred non-cash assets to their pension plans, or to financing vehicles in which the pension plan has an interest. Other companies have used company assets to back guarantees or letters of credit to provide additional security. Page 3
Asset transfer examples Company Date Type of transaction Value of assets transferred Accounting gain generated on transfer Interserve 2009 Transfer of PFI contracts 62m 35m Tesco 2008 Share of a joint venture involving the sale and lease back of three superstores 199m Share of 92m John Lewis 2008 Transfer of shareholding in Ocado 128m 127m Marks & Spencer 1 2007 Transfer of rights to income from a property backed partnership 500m Not disclosed BAE Systems 2006 Property transfer 242m 100m Notes: 1 Changes were made to terms of the Marks & Spencer property partnership in 2009 so that there is no automatic right for the pension fund to receive income in certain cases eg if the company does not pay a dividend to shareholders These types of transactions can bring a number of benefits for both companies and trustees. The company is able to keep more cash in the business especially helpful in an environment when availability and terms for future credit finance continue to be uncertain; It may be possible to realise an accounting gain since, under IFRS, such assets may be shown on the balance sheet at historic cost rather than fair value; The pension plan funding level is improved, and therefore should reduce future cash requirements relative to what would otherwise be the case; The trustees can have the comfort of direct access to specified assets if the company ceases to trade while minimising the risk of pension funding demands proving counter-productive by weakening the employer or at worst putting it out of business; The company can retain operational use of assets, eg such as properties or aircraft; and Providing additional security to the pension fund can provide greater flexibility in agreeing investment strategies. It would take a brave board of trustees to turn down a credible proposal based on non-cash assets, especially where cash is still constrained. Page 4
This Corporate Update is based on our current understanding of the subject matter and relevant legislation which may change in the future. Such changes cannot be foreseen. This document is prepared as a general guide only and should not be taken as an authoritative statement of the subject matter. No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this Corporate Update can be accepted by LCP. If you would like any assistance or further information on the contents of this Corporate Update, please contact Alex Waite or Michael Berg or the partner who normally advises you at LCP. Contact options include telephone number +44 (0)20 7439 2266, or by email enquiries@lcp.uk.com. Specific contacts Benefit reviews: High earner issues: Investment matters: Non-cash funding: Alex Waite or Richard Murphy Mark Jackson or Jonathan Camfield Ken Willis or Gavin Orpin Michael Berg or Bart Huby Page 5