Defined benefit pension schemes regularly make the headlines. Whether it is the size of deficits or the impact on corporate mergers and acquisitions, pension schemes have become a major issue for businesses.
Cash contributions are also increasing as new funding requirements have given more power to trustees who are requesting that pension promises be funded more quickly than before.
This is a particularly big challenge for construction. The Pensions Regulator and the Pension Protection Fund did research into which of the main industrial sectors posed the most risk to pension scheme members. The construction industry was among the list of high risk sectors.
Defined benefit pension schemes can have unwelcome implications for businesses and distract attention from core activities, for example:
Raising capital can be restricted by large pension
deficits which are viewed as company debt;
Free cash flow can be reduced by the need to service a pension scheme deficit;
A sale or restructuring which makes business sense can be complicated or even derailed by a pensions deficit.
So what can companies do to manage pensions effectively?
The return on the pension scheme assets will directly affect the future financial position of the pension scheme. By law, the trustees control the investment of the assets but are required to consult the firm.
You should consider the investment objectives and decide what balance between risk and return is most appropriate.
An important decision is how the assets of the pension scheme are divided between assets that might be expected to grow at a faster rate than the liabilities (‘return-seeking’) and those which might better match the scheme liabilities (and reduce volatility).
Pension scheme funding
Increasing cash contributions is one way to improve pension scheme funding but there are more palatable alternatives.
1) Take advantage of fixed assets. A property portfolio or landbank can be used to improve the level of security for the pension scheme. Arrangements can be created that reduce immediate requirements for company cash contributions and might benefit the company with a corporate tax deduction.
2) Offer security for the pension debt. This is relatively simple and common in other areas of normal business practice. Examples include:
A letter of credit from a bank;
A guarantee from a parent or associated company;
Giving the scheme a charge over company assets.
3) Place money in escrow. This is a legal trust to which the employer can pay cash or assets which are then earmarked for the pension scheme. This avoids cash being committed directly to the scheme and can be claimed back if the scheme becomes overfunded. It is more difficult for a company to benefit from excess assets held directly by the pension scheme.
Managing the financial risk of defined benefit pension schemes is now more critical than ever before. This will be a challenge for many construction companies, but the good news is that there are innovative ideas giving businesses more options than in the past.
David Robbins is pensions partner at Deloitte