FOOL'S EYE VIEW
Are Pensions Properly Funded?

By James Carlisle
August 23, 2001

There's been a lot of talk in the papers this week about the underfunding of company pension schemes. The catalysts for the recent press coverage have been a couple of reports published by actuaries. The first came from Lane Clark & Peacock (LCP) last week and goes into the level of disclosure made by FTSE 100 companies about their pension schemes. This week we had the snappily titled "SSAP24: 2001 Survey of Practice from Published Accounts" from Bacon & Woodrow, which looks at how well funded the various pensions are. As if this powerful combination needed more spice, companies are having to phase in a new way of accounting for their pensions over the next two years.

The first point to note is that all this only relates to defined-benefit, aka final-salary, pension schemes. These are schemes whereby you get a certain portion of your final salary when you retire, depending on how long you've worked for a company. The alternative is a defined-contribution, aka money-purchase pension. With these, the employee (often with the help of some contributions from the employer) puts money into a pot over the years and then, at retirement, takes the pot (which has hopefully grown to a nice size) to an insurance company and buys an annuity, which provides the income in retirement.

There's a slightly subtle, but very huge, difference between these two approaches. In the defined benefit schemes, it's the company that takes the risks of the pot not being big enough. Therefore it's only defined benefit schemes where there might be cause for concern, both for pensioners in terms of making sure that the company is making adequate provision, and for investors in terms of making sure that there are no nasty hidden liabilities.

Disclosure

The trouble with defined benefit pensions is that no one can say how much it's going to cost to honour them, so it's hard to know how much to put into them. The best you can do is make an educated guess, so the companies employ actuaries, who are very educated and make a career out of guessing. Not surprisingly, though, they all come up with slightly different guesses. In fact, the LCP report estimates that a 1% change in the assumed investment return within a pension fund can make a 20-30% difference in the cost of funding that pension. Yet the actuaries used by the companies in the report had a range of investment return assumptions of 2.5%.

So, under the current system, if we're to have a chance of making sense of a company's pension provision, they need to explain clearly how they've worked everything out. The LCP report notes that there is a trend to improving disclosure, but still only 25 FTSE 100 companies score maximum points in its tests. Mind you, only 3 did when it started the survey back in 1993.

LCP puts eight companies in the doghouse for not disclosing enough information. These were BAT (LSE: BAT), Celltech (LSE: CCH), ICI (LSE: ICI), Land Securities (LSE: LAND), Marconi (LSE: MONI), Powergen (LSE: PWR), Spirent (LSE: SPI) and Vodafone (LSE: VOD). It's important to stress that these companies only failed the tests put forward by LCP and it doesn't mean that anything fishy is going on. Celltech, for instance, had the worst disclosure but then its defined benefit pension scheme is known to be very small.

Funding

Bacon & Woodrow's report looks at the annual accounts of 92 FTSE 100 companies to see whether they're well enough funded (eight companies were excluded for various reasons, such as being subject to foreign reporting requirements or being just holding companies).

Of the 92 companies surveyed, 66 stated that they had final-salary benefits in their main pension scheme. Of these 66, 49 had "funding levels" higher than 105% of what is expected to be necessary. Of the 17 below 105%, 8 are below 100%. These are in the table below:

Company                     Annual pension cost     Average Funding
                              as % of payroll           Level (%)

BAE Systems (LSE: BA.)             8.8                  98.0
ICI (LSE: ICI)                     7.6                  99.0
Scottish & Newcastle(LSE: SN)      4.8                  97.0
BT (LSE: BT.A)                     8.2                  96.8
Marks & Spencer(LSE: MKS)         14.0                  97.0
Tesco (LSE: TSCO)                  4.9                  96.0
Vodafone (LSE: VOD)                5.4                  87.6
WPP (LSE: WPP)                     3.6                  93.0

The first thing to note about this is that most of the companies are really very close to the size of fund that their actuaries guess, using their prudent estimates, is needed. The only two that are more than 5% away are Vodafone and WPP. But then Vodafone's actuary does estimate pay increases of 7-8% pa, while most companies are closer to the 5% mark.

This sort of seemingly innocuous difference can make huge differences to the size of fund required. In any case, Vodafone is a young company, with a workforce that's relatively far from retirement, and its pension cost last year was just £42m compared to its payroll of £774m and revenues of £15 billion, so it could comfortably afford to up the contributions. WPP appears to use relatively average assumptions, but again, with a pension cost of just £41m, compared to a payroll of £1.1 billion and revenues of £14 billion, it can comfortably afford an increase.

The important thing to take away from this is that all these pensions are very close to their correct funding level and there's very little to worry about. There are a number of reasons for slipping below the 100% mark temporarily, including a poor investment performance since the last valuation. But the whole reason for working it all out is to work out the best level of contribution for the next few years to get back on an even keel.

The New Regime

In the light of all this confusion, the new rules for pension disclosure under FRS17 should be a breath of fresh air. The main provision is to standardise the way that actuaries value the funds and, as far as possible, to standardise the assumptions that they're allowed to use. That should make things a lot easier to follow.

The new rules will also force companies to show how the value of their pension fund varies from year to year with the stock market and these changes will have to be reflected on companies' balance sheets. This will cause some substantial exceptional gains and losses in the company accounts as the short-term volatility of the stock market drives pension funds from surplus into deficit and back again. No doubt it will also generate plenty of scare stories in the press. But there's little to worry about from these companies whilst we've got our eye on them. If we cast our mind back to Robert Maxwell, the problems with pensions come when no one can see what's going on.

More: Pensions centre