The perils of growth

The consultation phase for the government’s proposals on regulating defined benefit pension schemes has recently closed. Fundamental to the proposal is the Treasury’s determination that pension schemes should be drawn into the push for economic recovery by requiring them to support growing companies. Sustainable growth is the clear goal of government policy and correspondingly, The Pensions Regulator is asked to take into account the prospects for a sponsoring company’s growth when agreeing targets for defined benefit pension funding.

A quick survey of UK companies reveals that the life expectancy of the average defined benefit pension scheme is rather longer than the life expectancy of their sponsoring companies. Indeed, the only remaining constituent of the original FTSE 350 to exist in recognisable form today is Tate & Lyle. The other 349 companies have been acquired, sold, merged or mutated. Experience in the US is more profound. The 25 largest companies today did not exist 25 years ago. Such is the pace of technological development and the rate of patent production that the prosperity of a copper-bottom stock, such as Kodak or IBM, can wane without warning.

Implicit in the government’s ambition is a new category of investment risk to be borne by trustees. Not only must they now pay attention to the investment risk of their investment portfolio but additionally trustees are to be asked to carry covenant risk by compromising on contribution rates.

The acceptance of such increased risk might suggest that the discount rate to be used by the trustees in calculating liabilities should be increased to reflect the less prudent approach being advocated. The net effect of course may well be to get schemes back to where they started.

There are two further problems.

The Pension Protection Fund is put in jeopardy in that more schemes are likely to need to resort to this state safety net as trustees’ assessment of the prosperity, and sustained growth, turns out to be misjudged.

Similarly, trustees will face the dilemma of potentially compromising in calculating technical provisions. Rather than simply reflecting a prudent expectation of future investment returns based on actual investment calculations, they will be complicated by the need to estimate a potentially illusory projection of future corporate contributions.

In parallel with the government’s desire to promote growth prospects there has been a great deal of debate about the merit of long-dated government stocks, PFI funding and direct pension scheme investment in infrastructure as a way of boosting the economy.

This direction of thinking would seem to have far greater merit than financing growth by relaxing pension funding requirements. The paucity of investments offering long-dated fixed cash flows underpinned by a state guarantee or secured against real assets has frustrated the investment committees of defined benefit pension schemes for decades. Complex and expensive financial instruments are being used to synthesise the cash flows required for matched funding. A resurging economy boosted by investment in infrastructure guaranteed or at least supported by the state, feeds defined benefit schemes with precisely the assets which they require. The dependency on the corporate covenant and indeed the corporate’s life expectancy is removed and the cost of investing reduced.

Finally, a dependency on long-dated and infrastructure investments would remove a complication for the calculation of the PPF levy. The credit assessment of the company and the extent to which the covenant is dependent on growth ought to create a higher levy under the sustained growth proposals than would be the case if trustees were to depend on matched assets.

Further thinking would appear to be required.

Mark Wood is CEO of JLT Employee Benefits

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