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Business leaders in the U. K. are facing one of the biggest tests of their careers as they struggle to deal with the growing pension fund crisis. As they watch companies reporting shortfalls in their pension funds – anything from a few thousand pounds to, in some cases, more than a billion – executives are coming to realise that their businesses face potentially unquantifiable risks. While most senior executives accept managing risk as a crucial part of their job, few have been schooled in managing limitless risk. So many corporate managements have decided to close their traditional pension schemes to new members. Instead of promising guaranteed, defined benefits to retiring employees, based on final salary rather than the pension fund’s performance, they are beginning to opt for plans that limit the company’s contributions and make no promise about the returns. Management’s are increasingly seeking to transfer the risk from the company to the employee. According to the top executives, four factors have brought the crisis to a head. First changes in advanced corporation tax have resulted in a loss of about £5bn a year to the pension funds. Second, declining equity markets have wreaked havoc on the asset valuations of most pension funds. Third, in a boom years companies decided to cut costs by taking a pension contributions holiday – in effect using the surplus generated by heady markets to cover their own contributions. And fourth, the new accounting standard – FRS17 – has put the spotlight on the mismatch between the value of pension fund assets and the potential liabilities. Top executives claim that the FRS17 valuation are hypothetical and the resulting shortfalls amount to little more than scaremongering. Allied Domecq, for example, stated this year that it was facing a shortfall of £330m. The company claimed, however, that under long-term actuarial valuations, the shortfall was only a fraction of that. Nevertheless, the shortfalls under long-term actuarial valuations are smaller, principally because they assume that asset prices will appreciate significantly in the coming years. Business leaders cannot afford to be sanguine over this. Had all the previous assumptions about market performance been correct, the shortfalls would not now exist. The first thing that company managers need to do is to recognise the problem. While it is impossible to be totally accurate about the size of the shortfall, prudence rather than bullishness will serve them better in the long term. A prudent analysis, well communicated to shareholders, analysts and staff, will elicit a certain amount of understanding and co-operation. Managements face several challenges in seeking to shift the risk by changing from defined benefit to defined contribution schemes. First, they must negotiate with the unions, which point out that had the companies not stopped making contributions during the boom years, the shortfalls would not now be so big. Keeping morale high during a downturn is difficult enough without having to break bad news on their pensions. So managers must communicate with staff about the problem and possible solutions. Second, changing from a defined benefit to a defined contribution scheme raises the issue of staff retention. Defined benefit schemes, which become increasingly attractive the longer a person stays with the same employer, have tended to act as a golden handcuffs for employees. A defined contributions scheme is far more flexible and mobile. Therefore, sensible managers are now looking at alternative ways to retain staff. Companies may have to redesign long-term incentive plans. Yet not every company is giving up on defined benefit schemes, even though additional contributions may be needed to make up the shortfall. One chairman of the FT-SE 100 company, which would like to maintain the defined benefit principal, suggests average salary could become the basis of his company’s plan. Given that a person usually joins on a salary far lower than the final salary 30 or 40 years later, the average salary measure reduces the company’s liability while giving the employees the security of a defined benefit, albeit at a lower level. Whichever way a company decides to go, it is clear that management will have to pay greater attention to how pension schemes affect shareholder value. The old view that a company can sit back and let bullish markets do the work to meet pension obligations has now truly been laid to rest. The writer is chairman of Buchanan Harvey, an executive search firm.
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