Pensions: dealing with deficits

Peter
Maher, director and head of corporate benefits at Smith & Williamson
financial services group, explains how deficit problems faced by many defined
benefits schemes can be tackled

More
than 60,000 people in the UK have lost some or all of their pension after their
employers became insolvent or walked away from their debts.

However,
companies have more to worry about than the Pensions Bill, which has grown from
235 pages and 248 clauses, to 316 pages and 310 clauses in the past three
months, or the ever-present threat of the trade unions.

New
accounting standards set to come into force next year mean employers should be
taking immediate action to address deficit problems and maintain stability,
according to Maher.

From
April 2005, any gain or loss on a defined benefit pension scheme must be
recognised in the profit and loss accounts of the sponsoring company.

These
regulatory changes, introduced by a new accounting standard, known as FRS 17
(soon to be replaced by IAS 19), will mean that a scheme that is in deficit
could dramatically reduce the apparent profitability of a firm.

Moreover,
the volatility to which a pension scheme is typically exposed through equity
investment could have a direct impact on the firm’s profitability.

Maher
told Personnel Today how the deficit problems faced by many defined benefits
schemes might be addressed.

“Structured
investment arrangements are beginning to find favour with some trustee boards
of large and medium-sized pension schemes. They have been used successfully in
France, Italy and Scandinavia for years, but less frequently in the UK,” Maher
said.

“The
broad approach is to follow an investment strategy that provides only limited
exposure to the volatility of equities. Traditionally, investment managers
advising trustees suggested greater exposure to equities. However, when markets
were difficult, there was a corresponding exposure to losses.

“In
contrast, today’s structured arrangements gain much of the upside, but limit
the potential downside. To do this, roughly 80 per cent of the fund is invested
in AA-rated bonds, with the remainder exposed to call options on the total
return of, say, the FTSE 100 index.

“Such
arrangements follow a pre-agreed approach, tailored to the needs of a
particular scheme, and typically spans 10 years – which should be sufficient to
allow a scheme that has been in deficit to recover. Running costs typically
fall, largely because the need for active investment management is reduced.

“Bonds
are essentially loans made by investors to governments or companies, generally
in return for a fixed rate of interest over a fixed period. They are usually
tradeable.

Call
options are the purchase of shares at a pre-determined price. A trader who buys
call options believes share prices they have bought the options on will rise.
For example, they agree to pay 100 pence for a share they believe will be
trading at a higher price at a pre-determined date in the future.

“As
a result of this structure, the value of the fund at any time is a combination
of the call option that has matured, the discounted value of the future option,
plus the fixed-interest bonds and their accrued income.

“This
arrangement is far less volatile than direct equity investment, essentially
because there is less exposure to the future, which is unknown. For added
security, an arrangement of this type should be backed by a highly-rated bank
or similar.

“While
investment managers have traditionally sought to beat average returns,
regrettably, many have failed in recent years. As a result, all too many
trustees (and individual investors) have been left to sort out the aftermath.

“A
structured investment strategy, such as that described above, which is backed
by a strong bank, could provide a useful solution.”

www.smith.williamson.co.uk

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