The pension funds deficit – the time bomb is ticking

And, while the deficit is naturally a huge worry for employees, it’s also a factor that must be taken into account by all companies when entering into business alliances of any kind, because it can, and in some cases already has, brought many companies down.

A survey conducted by the Association of Consulting Actuaries in 2005 showed that 89% of final salary schemes in the UK alone were in deficit and together faced a total shortfall of about £130 billion. And while most companies have substantially increased both employer and worker contributions to help reduce the gap, nearly half of them said they thought it would take at least 11 years to wipe out the deficit in full.

The reasons for these massive shortfalls are many and varied. However, the most critical reasons are undoubtedly the three-year bear market at the beginning of the twenty first century, the very low rates of interest and increasing – and often underestimated - life expectancy. That many companies had taken contribution holidays when investment returns were still looking good has done nothing to ease the problem.

This is by no means just a UK problem. Most developed countries face the same demographic problem: fewer workers having to support more retired people, as life expectancy increases and birth rates decline.

In the US, for example, General Motors has had well-publicised problems and every worker it employs has to support three of its pensioners.

Pension risk exposure in top German companies is 20% higher than in their UK counterparts. While Chancellor Angela Merkel is seeking to push through reforms to reduce the pensions bill, it’s a salutary fact that only 40% of Germans aged between 55 and 65 are in the workforce.

But it’s Japan that faces one of the biggest problems, with 28% of its population forecast to be over 65 by 2025. As a result, its pension schemes are under extreme pressure to reduce benefits and increase contributions. While people feel insecure about the future of their pension system, they’re saving their money – and that’s impeding Japan’s economic recovery.

The increasing life expectancy worldwide and decline in open funded schemes are providing knotty problems for Governments looking at State provision. The only thing that appears clear here, however, is that something radical needs to be done to ensure that the private funded pensions sector is shored up or replaced.

Many companies are making immense efforts to meet the cost of their pension liabilities. So what measure are companies taking to close the gap?

Some are increasing their contributions by diverting funds from elsewhere in the business to shore up the pension scheme. Most likely to be affected here are research and development or other growth-potential activities. The ACA survey indicated that contributions had risen from 15.8% of earnings in 2002 to 22% in 2005, with the majority of this increase being made by the employer.

Others are simply closing their final salary pension schemes – either completely or to new members – to enable them to manage more easily the liabilities going forward.

However, a minority of companies are trying to dodge their obligations to their pensioners by wriggling out of any future liabilities. For example, a company might put a subsidiary in receivership – not because of poor commercial performance but because of the effect the pension deficit has on the reported balance sheet.

As a company’s pension debts, on insolvency, become just another liability along with other creditors, it may not be paid in full – or at all. The parent could then buy back their subsidiary, minus any pension liability.

There is of course, nothing illegal about this, but it doesn’t do much to lessen the problem of providing adequate pensions in the 21st century. Nor does it make it easy for companies to be assessed for investment or finance purposes.

The outlook for individuals and businesses alike is uncertain and fraught with danger. For individuals, it’s a matter of having sufficient funds to see them through their retirement. For business, it’s a question of whether their pension obligations will, at best, divert much needed funds from R&D, capital investment and profitability, and, at worst, lead them into insolvency.

Simon Groves
Atradius
www.atradius.com