Sea Change in Pensions

Steve is 52. A keen pilot, he’s up in the air in his vintage Piper whenever the mood takes him, taking off from the small grass strip in the Devon countryside that’s adjacent to the old rectory he lives in.

John, who’s a year or two older, is equally active. His passion is sailing, and his yacht is moored in a marina just a 10 minute drive from home.

But the problem he faces is squeezing in time to sail it: he’s a non-executive chairman of two smallish companies, and on the board of three others.

Steve and John, believe it or not, are pensioners. Their employer, a huge multinational, restructured and downsized a year ago, and Steve and John were offered early retirement.

Roger is even more fortunate. When his employer, a giant petrochemicals company, sold part of its operations to another multinational, Roger took early retirement – but was instantly offered a job by the new owner of the business. After 30 years’ service with his former employer, his pension is good. Effectively, he’s doubled his income at a stroke.

Go back a few years, and such stories weren’t uncommon. Early retirement, observes Philip Booth, a professor at City University Business School and fellow of the Institute of Actuaries, “was a technique used to keep the costs of redundancy opaque from shareholders”. Better still, in some cases, early retirement meant there weren’t any costs of redundancy, as the pension fund picked up the tab.

Roll the clock back to when such early retirements were common, and many pension funds showed a surplus. Remember pension holidays, when companies could afford not to contribute to their schemes for a year or two, such was the surplus of assets over actuarial requirements? In such instances, why not use the surplus to fund restructuring?

“It was an easy option and one which oiled the wheels of many a reorganisation,” says Robert Hails, a partner in human resource and financial management consultancy Watson Wyatt LLP. “Employees were happy to retire early, and it suited the company to use the surplus – if there was one – to pay for it.”

For many companies, offering early retirement was a win-win situation.

Philip Skottowe of actuarial consultant HighamNobbs says: “Every £1 of redundancy costs effectively took £1 off the P&L – early retirement meant either a limited impact on the P&L, or none at all.”

Today, of course, the situation is different. For a start, the number of funds showing such surpluses has declined drastically. Many, in fact, have deficits. The John Lewis Partnership, which controls the John Lewis department stores and Waitrose supermarkets, has a deficit of £68m. Not surprisingly, it is looking at making changes to its final salary scheme in order to reduce the deficit, with one likely change being to bar new entrants until they have worked for the partnership for two years.

At least John Lewis still proposes to offer a final salary scheme to new recruits. Figures from the National Association of Pension Funds (NAPF) show that 17% of all such schemes were closed to new members in 2001.

Dixons, Marks & Spencer, Iceland and Ernst & Young have all axed their schemes. In May, British Airways announced that its scheme, too, would be replaced by a money purchase or defined contribution scheme for new recruits. Some companies, of course, have gone even further: not content with closing final salary or defined benefit schemes to new members, they are winding them up completely.

However much companies try to spin their way out of it, there’s no escaping the fact that moves away from final salary schemes are likely to be disadvantageous to employees. Yet it seems likely that many companies were only forced into abandoning final salary schemes because they raided their pension funds to finance early retirement for unwanted staff. If that is the case, today’s happily-retired 50-somethings are enjoying themselves at the expense of future 60-somethings – or even future 70-somethings if, as widely predicted, people are forced to retire later in order to compensate for reduced pension benefits.

“Some companies definitely used surpluses to fund or enhance early retirements,” says David Astley, director of benefits at the NAPF. However, he believes that the vast majority of companies have attempted to do so in an actuarially-neutral manner. In effect, they have made lump-sum payments to the fund to compensate for the burden the extra pension payments will incur. But Astley adds: “Did this happen in every case? We’ll never know.”

Untangling what happened in particular cases is extraordinarily difficult.

“It’s almost impossible to tell from companies’ accounts, because the level of detail isn’t there,” says Tim Keogh, a director at Mercer Human Resource Consulting. At the heart of the issue lies the fact that funds have a great deal of freedom in how they appraise early retirement, especially when surpluses exist. “It all depends on the rules of the fund and the trustees,” he says. “Some will insist on the early retirement extended benefit being paid for by the company, while others may say that the trustees have discretion, with the trustees choosing – or not – to allow the fund to absorb the cost.”

Indeed, as Skottowe points out, the degree of flexibility that trustees could allow even extended to decisions on early retirement benefits – as well as the resultant impact on the pension fund. An early retiree at 52, for example, could be automatically “upgraded” to age 65, and paid a pension as though he or she had indeed clocked up the extra 13 years of contributions and entitlement. Alternatively, the payment could less generously be based on years of service, but still overlook the fact that, starting at age 52, the number of those payments would go on for many more years than if the retiree had begun drawing them at age 65.

Clearly, to prevent any hint of impropriety in pension funds, trustees should be wholly independent, able to impartially assess the situation, and able to resist explicit or implicit pressures from the company. Yet, even where this is the case, the trustees have a difficult task in determining the true extent of any surplus with which to absorb restructuring costs.

“You’re really making the best estimate you can regarding future payments and comparing this with what you’ve got,” says Hails. This sounds straightforward: if the former exceeds the later, there’s a deficit. If it’s the other way round, then there’s a surplus.

The problem is that both parts of the equation have been buffeted by unforeseen events, says Keogh. Take future payments, for instance. As any actuary will tell you, people are living longer. Actuaries have always factored in rising life expectancy – but longevity rates are substantially outstripping what had been expected. A fund which might have been in balance a few years ago, might be underfunded now – simply because actuaries have increased their estimate of future payments.

Just as starkly, funds’ assets have been pushed down by a combination of declining earnings and falling valuations. Again, the impact is to throw into doubt assumptions about a fund’s degree of over-fundedness.

Projections that were perfectly sound a few years ago are now looking rather suspect.

Accounting standard FRS17 makes the situation clearer. One of the attractions of using early retirement to absorb restructuring costs was that they didn’t need to appear on the P&L at all if the trustees were pliant and the fund was in surplus. Even if the company did recompense the fund, it had a great deal of latitude as to when it made those payments. Actuarial deficits are nothing new, and companies have previously redressed the balance over 20 years or more. No longer: under FRS17, a pension shortfall is a direct hit on the P&L.

However, none of this answers the question of whether pension funds were wrong to use past surpluses to fund early retirements. At the time, to do so might have appeared right and proper. In an era of rising investment returns, and before the sharp increase in longevity become apparent, the risks would have appeared minimal. Only, falling investment returns and a horde of pensioners determined to go on for ever have changed the picture.

Yet, with many funds now in deficit and FRS17 forcing companies to address that fact, the attraction of using early retirement to fund restructuring costs has sharply diminished – at least in terms of seeing the pension fund as an easy way of keeping restructuring costs off the P&L. The loophole has been closed.