Lee Coppack discusses the reasons for Rentokil-Initial's desire to abandon its final salary pension scheme and the problems companies face generally in funding pensions
In May 1965, Jeanne Calment sold her apartment 'en viager' to a notaire, a legal official employed by the French government. In exchange for title to the property, the notaire agreed to pay 2,500 francs per month to Calmet's grandson until her death, which surely would not be too long because the old lady was 90 at the time. Twenty years later the notaire died, still paying the rent, it is assumed, since Jeanne Calmet outlived him by another two years. She died in 1997 at the age of 122.
A similar, if less extreme, situation confronts UK companies today. Retired employees and their spouses are simply living longer than actuaries calculated so they are collecting their pensions longer. Add to this a change in the method of valuing pension fund assets and liabilities and record low yields on long dated government bonds, and pension fund risk has become one of the top, if not the top, exposure facing many companies.
As Andrew Hubbard, head of the pensions practice at accountants Mazars puts it, "It is number three, if not two or one for many companies."
In December 2005, the UK based pest control and facilities management company, Rentokil-Initial, announced that it wanted to freeze guaranteed benefits for current employees. Consultation is taking place with active scheme members. The company expects to make a final decision later in the year.
The proposal relates to the company's defined benefits pension scheme, which is automatically calibrated according to years of service and final salary. Existing employees would retain their final salary scheme benefits for their service to closure date, but further provision between now and retirement would have to come from a defined contributions scheme, where the employees would at least share in the investment risk.
Rentokil had closed the final salary scheme to new employees in 2002, and increased current employee contributions and reduced future increases in pension payments from 1 April 2005.
The reason for these measures is simple. Rentokil revealed that at 30 November 2005, its UK pension scheme had an estimated £325m deficit, and the company and pension scheme trustees agreed an additional £24m to cover a more prudent basis for estimating longevity.
The company and trustees agreed to an immediate payment of £200m, with a series of payments by January 2012 to meet the outstanding amount. Rentokil said the total funding needed to address the deficit would be between £370m and £380m.
Finance director Roger Payne had warned earlier in 2005 that the company would have to increase its contributions to the pension fund once the results of a three yearly valuation were known, but for Rentokil, the timing was particularly inopportune. Pre-tax profits were down 25% in 2004, and, as its new chairman Brian McGowan had warned, the first half of 2005 was little better, with pre-tax profits down 20% on the same period in 2004.
Rentokil has been going through tumultuous times. Its high profile chairman, Sir Clive Thompson, who had also been chief executive for 20 years until 2003, left the company abruptly in May 2004, following a profits warning and an immediate 14% collapse in the share price. Chief executive James Wilde followed in his wake.
However, although it is the first FTSE 100 company to take such a drastic step, Rentokil is not alone in facing difficult decisions. On 19 January 2006, actuaries at consultants Deloitte revealed that they estimated the deficit for final salary pension plans of FTSE 100 companies was £110bn.
The UK accounting standard FRS 17, which came into effect fully for accounting periods from June 2003, changed the methods by which pension fund assets and liabilities are valued. In doing so, it increased the volatility of the sponsoring company's balance sheet dramatically. In a period of less than three weeks, said Deloitte, there had been an increase of £35bn in the FTSE 100 companies' deficits as yields from long dated bonds dropped to record lows.
Under the previous accounting standard, the assets and liabilities of a pension scheme were valued on the basis of long-term actuarial assumptions.
With FRS 17, companies have to value the assets in the fund with reference to current market conditions, so-called mark to market. The scheme's liabilities, its commitments to its members, are valued using what is called the actuarial projected unit method discounted by reference to the current return on grade AA corporate bonds.
It is entirely possible, says Andrew Hubbard, that as a result of FRS 17, a scheme could swing from deficit to surplus or vice versa in one year. "If the finance director is trying to manage the share price, that kind of volatility is the last thing you want."
Companies also have less control over their contributions to occupational pension funds. In the past, they could suspend contributions, provided the actuarial advice said that the funding was not needed. Now, as a result of the Pensions Act 2004, the sponsoring company has to agree with the fund trustees what the contributions should be. Thanks to the same law, which highlighted their responsibility for the solvency of the scheme, trustees are likely to take a conservative view.
The impact of pension fund deficits is such that, in an extreme, a company could become insolvent. Yet, says Mark Duke, actuary and principal at Towers Perrin in London, such risks are rarely set out in the risk management policy described in the annual report, even though plenty of space is devoted to pension arrangements. "It is kind of semi-detached from the risks that are described in the annual report, such as interest rates," he says.
Management of pension issues brings with it other risks that companies have to consider, even if the need to make good a deficit is the most salient. To mitigate the impact of a deficit on the company's finances, the directors may decide to increase the retiring age for existing employees or institute or increase employees' contributions. In taking such a decision, the company has to balance the benefit to shareholders with the impact of the change in employment conditions.
The loss of guaranteed benefits is likely to upset the workforce, and perhaps affect the company's ability to attract and retain skilled employees.
As Trades Union Congress (TUC) general secretary Brendan Barber puts it, "A pension cut is a pay cut, and our members expect us to defend their pay."
Mark Duke sums up the issues in this way. "On one side, you have the corporate entity, which has to look at the pension plan as at any other business decision. But the pension plan is also part of the financial and psychological contract with employees and an important element of the terms of engagement with employees.
"Then there are the owners of the business who have to balance those interests. It is made more complex in that no one holds all the cards. They have to discuss with the trustees, whose interest is to protect the beneficiaries of the scheme. At the same time, the trustees can legitimately recognise that to kill the scheme sponsor would not be in the interests of the beneficiaries."
The impact on employee engagement and the ability of the company to attract and retain good people is usually an issue for human resources. The TUC has also drawn attention to the increasing disparity between pensions for directors and ordinary employees. Its analysis of the annual reports of 50 of the UK's leading companies, published on 24 November 2005, stated that eight out of ten of the UK's top companies provide directors with full pensions at 60 that are worth, on average, 26 times those of most employees.
Duke says that conversations about these issues are becoming commonplace.
"They are often led by the human resources professional within the firm, and clearly such issues are sensitive and can have an impact on reputation."
After Sir Clive Thompson's departure, Rentokil tacitly acknowledged that it needed to improve its human resources management. In its annual report for 2004, Brian McGowan recounted that when he became chairman, he undertook an extensive operational review of the company. One of the actions taken was to appoint a human resources director. Previously, there had been no professional human resources representation at group level. The new director reports directly to the chief executive and is a member of the group executive board.
Rentokil's earlier decision to take advantage of previously healthy pension fund valuations and take a five year holiday from contributions, at a time when its results were buoyant, has exposed it to further criticism.
In December 2005, The Guardian quoted the general secretary of Amicus, Derek Simpson, as saying: "Only an anti-union company like Rentokil would be able to get away with taking a long pensions holiday, and then move immediately to close its scheme to existing members."
These are far from the only risks posed by the pensions issue. Mark Duke says companies are now looking at pensions-related risks in the context of their overall business risk management. Some complex financial institutions, he adds, are integrating the pension plan into their own financial models.
So far risk managers do not appear to have been involved in pensions-related risk, but that, too, may change. George Cameron, a consultant with Thomas Miller Risk Management (UK) Ltd, a director of the Institute of Risk Management (IRM) and trustee of the Aviva pension fund, has asked the IRM to consider whether it should bring pension risk into its education and training programmes.
Lee Coppack is editor of StrategicRISK's sister publication, Catastrophe Risk Management. E-mail: firstname.lastname@example.org
THE ROLE OF THE TRUSTEE
Most UK company pension schemes are set up as trusts for two main reasons: to maximise tax advantages and ensure that the assets of the scheme are kept separate from those of the employer. Trustees hold a scheme's assets for the potential recipients and must act independently of the employer, for the benefit of scheme members. Their powers are contained in the trust deed and the scheme's rules. From April 2006, it will be obligatory for at least one third of the trustees to be nominated by the members.
Trustees can be personally and jointly liable for scheme losses and subject to fines imposed by the pensions regulator if they fail to comply with legislation.