Honey, I shrunk the deficit

01 June 2022

Henry Tapper, chief executive officer for AgeWage explains that deficits are shrinking in defined benefit (DB) pension schemes and the reasons as to why

I grew up in a rural area where farmers ruled the roost. “You’ll never hear a farmer tell you he’s doing well,” my mother used to tell me. It was true; when times were bad, they needed subsidy and when times were good, they were quiet. Pension schemes have that in common with farmers – employers hear a lot when schemes are underfunded and have had to cough up large amounts at the behest of trustees and The Pensions Regulator. But when times are good, there’s a hush. Say it quietly but there’s a hush about pensions right now…

The aggregate DB pension scheme surplus in the UK increased by £60 billion to £190 billion in May, according to PricewaterhouseCoopers’ (PwC’s) Pension Trustee Funding Index. The funding ratio increased from 108% at the end of April to 113% at the end of May, based on schemes’ own measures.

Liabilities fell by £110 billion to £1,450 billion over the month, largely down to the continuing drop in bond prices. And while asset values also decreased during May, from £1,690 billion to £1,640 billion, (largely down to the same fall in bond prices), the pension garden is rosy.

Most impressively of all, the Universities Superannuation Scheme (USS), the largest privately funded DB pension scheme, has seen its funding position improve from a £14.1 billion deficit to a relatively affordable £1.6 billion in the two years to March 2022.

So, what exactly has been shrinking these deficits, and will they remain shrunk?

The deficit has been shrinking because the discount rate used to value liabilities has been rising, and that’s because of inflation. Despite awful conditions in the equity and bond markets, the impact of increasing the liability discount rate has prevailed. If inflation persists (and most economists reckon it will stay at 3-4% for some time to come), then liabilities will remain much lower. If assets recover, which is likely as the impact of recent events recedes, then surpluses look sustainable. So, what does this mean for corporate pension strategies?

Well firstly, it looks increasingly likely that many employers will have the option to offload their pension schemes onto an insurance company who’ll guarantee to pay pensions to staff under the tough solvency rules of the Prudential Regulation Authority (PRA). This will mean a radical reduction of the costs of running and funding pension schemes – money that theoretically could be put into the modern defined contribution workplace pension schemes we use for automatic enrolment. This would go some way to bridging the gap between the well-heeled pensioners in DB plans and those who have relatively small pots with which to buy a pension.

Secondly, it will mean many employers will be able to make corporate decisions, such as paying dividends, acquiring companies and launching research programmes, without having to consult pension scheme trustees, whose requirement for a sponsor will be much diminished. Many pension schemes aim to be self-sufficient from their sponsors even if they’re not intending to be bought out by an insurer.

Some schemes, which put their members first, will choose to distribute their surplus by way of one-off bonuses to lucky pensioners in the form of a discretionary increase in pay-outs.

But are these surpluses (or mightily reduced deficits) sustainable? Some argue the deficits were over-inflated to market accounting methodology, which forced trustees to report their funding position as if the scheme had to wind up tomorrow. Critics of this approach say it forces companies to overfund their pensions so that there’s a huge buffer against further bad times.

They also point out this type of valuation leads to large amounts of the scheme’s assets being invested in non-productive capital, such as corporate and public debt – and cash. If you take this view, you’ll argue that just as the deficits were over-stated, so is the recovery – which is largely down to an improved valuation of liabilities (and not down to there being more money in the scheme).

Based on the scheme not having to close but being valued on a discounted cashflow basis, the actual funding position of DB pension schemes has been consistently positive for several years.

But whether you use the best estimate or buy-out method of valuation, the facts are the same: because of heavy deficit contributions and the ‘shot in the arm’ of high inflation, DB schemes are looking in better shape than at at any other time in the century.