Age old problem of pensions

As Southern Water incurs the wrath of The Pensions Regulator, Rachel Willcox asks whether it is time for action to redress the balance between pension deficits and shareholder dividends.

The pensions arrangements of the UK’s water companies are once again under the spotlight after Southern Water was forced to accelerate payments to plug its multimillion-pound pension deficit amid concerns by The Pensions Regulator (TPR) of unfair treatment of the company’s pension scheme.

Southern Water, which supplies 4.6 million customers in Kent, Sussex, Hampshire and the Isle of Wight, has agreed to pay an additional £50 million into its pension fund over a shorter period after being threatened with formal enforcement action by the ­pensions watchdog.

The water company prioritised dividend payments to shareholders – ironically, many of which are pension funds – over payments into the company pension scheme, despite facing a £252 million pensions black hole. Southern Water paid £190 million in dividends in 2016 and 2017, however a three-year investigation by TPR concluded the company could have afforded to pay off the scheme’s deficit far sooner given the level of dividend payments – and this amounted to unfair treatment of the scheme.

TPR’s settlement with Southern Water will see the water company now pay £223.5 million into its pension scheme over 12 years, compared with £170.5 million under its old plan, including additional contributions to cover £30 million of the increase in the ­deficit since it was last valued in 2016.

Nicola Parish, TPR’s executive director of frontline regulation, said: “The company and trustees’ decision in 2015 to halve contributions to the pension scheme and pay them over an extended period whilst later paying substantial dividends despite a growing scheme deficit meant the risk to member benefits was unacceptably high. This has now been addressed.”

Dividend-sharing mechanism

Southern Water has also introduced a ­dividend-sharing mechanism, which means if dividends are paid to shareholders above a certain threshold, the company will increase the amount it pays into its 4,000-member pension scheme. The mechanism is designed to ensure the scheme shares more fairly in the company’s success.

It is clear that defined benefit pension funds are increasingly under pressure to put in place dividend-sharing mechanisms as the regulator seeks to address the disparity with deficit contributions. However it is unknown whether Southern Water’s own mechanism was introduced as a result of pressure from the regulator.

In a statement, Southern Water said: “We are pleased to have completed negotiations for our final salary pension scheme and an updated plan is now in place. A new management team are now leading the transformation of Southern Water and are committed to dealing with historic issues such as this. Given the increased pension deficit we have agreed to increase contributions to ensure that members’ interests continue to be our priority.”

The misalignment in the way water companies treat shareholders and members of their pension schemes is far from a new concern. In April, following plans by Anglian Water and United Utilities to close their defined benefit scheme to future payments, the chair of the House of Commons Work and Pensions Select Committee, Frank Field MP, accused water companies of continuing to make large payments to shareholders while cutting their workers’ pension benefits.

In a letter to Ofwat chair Rachel Fletcher, Field highlighted that over the past five years, United Utilities had reported total post-tax profits of £1.6 billion, of which it has paid £1.2 billion in dividends to shareholders. Meanwhile, over the same period, Anglian had paid out half of its net profits of £1.6 billion in shareholders’ dividends. “There appears to be no effective restraint on these firms’ policy of distributing massive sums to shareholders while cutting the ­pension benefits that their employees are counting on for their retirement,” Field wrote.

The changes to the accrual arrangements, which unions claim could cost younger workers up to £10,000 per annum in lost retirement income, resulted in strike action by hundreds of United Utilities staff in March. Meanwhile, union Unite says more than 5,000 Anglian Water workers are affected by the pension scheme’s proposed closure and 3,700 more by proposed changes to a ­separate defined contribution scheme.

Recovery of costs

Although Ofwat granted water companies leeway in 2014 to recover some of the costs of deficit repair contributions – the amount they pay to plug their pensions black holes – through customers’ water bills until the early 2020s, it noted “there are strong arguments for shareholders to bear these costs in future”. In response to Field’s letter, Ofwat chief executive Rachel Fletcher said companies should consider pension obligations when making dividend decisions, but stressed: “It is not Ofwat’s role to regulate how much companies should pay in to their pension funds.”

Speaking at the Labour Party conference in September, shadow chancellor John McDonnell expressed his clear frustration with the situation and outlined proposals for taking back control of the water industry, vowing to end what he called “profiteering in dividends and vast executive salaries”. Labour’s policy document explains that parliament would see shareholders in privatised water companies docked compensation on the basis of pension fund deficits.

It’s fair to say, this issue is by no means unique to the utility sector. Indeed companies in the FTSE 350 index collectively paid seven times more cash to shareholders in 2017 than they did plugging their pension scheme deficits, according to analysis by actuarial consultants Barnett Waddingham. The FTSE 350 groups paid £8.7 billion in pension deficit contributions in aggregate last year, while £66 billion was issued in dividends, its analysis found.

At the same time, George Salmon, an equity analyst at Hargreaves Lansdown, said he didn’t think the Southern Water example suggested endemic problems across the ­sector. “Generally speaking, the big listed water utilities don’t have too many problems on their pension. For example, Pennon has a mild deficit of just £44.8 million, and United Utilities is currently running a surplus. While Severn Trent has a more sizeable deficit of £520 million, that’s been meaningfully reduced recently, and a funding plan is in place.

“The bigger threat to dividends is probably the tougher regulatory conditions looming over the horizon. Ofwat is currently running the rule over the companies’ plans for the 2020-25 period and we’ll know more in the new year,” Salmon said.

However the pensions issue comes at a difficult time for the water industry, still reeling following disruption to water services as a result of “the Beast from East”, which hit the UK in late February/early March this year. Water companies received widespread criticism after more than 200,000 customers across England and Wales were left without water, some for several days. Revelations of high levels of payments to bosses and investors by water companies have only served to further damage customer trust, regulator Ofwat admitted in July.

Feeling the strain

Benjamin Lind, strategy lead – utilities and energy at digital consultancy hedgehog lab, said the topic of executive pay and dividends is particularly charged at the moment, with more scrutiny than ever on payouts for C-suite executives and shareholders. Water and utility companies are no different.

“Energy suppliers, in particular, are feeling the strain as the cost-base of the big suppliers continues to be eroded by an increasingly competitive marketplace and the incoming government price cap. There’ll be even greater pressure to cut costs and, just as Centrica has proved, cuts to pension funds are a tempting target for energy suppliers looking to maintain their bottom line,” Lind told Utility Week.

“However, as we’ve seen with the backlash against Southern Water, companies that do so run the risk of propagating the assumption that they don’t care about their workers or customers and are only concerned about their balance sheets. Put simply: it’s not a good look,” Lind added.

Manbir Thandi, a director of law firm DWF, defends claims on behalf of insurers specialising in litigation involving water companies. “It’s a further reminder of the need to redress the balance between owners and employees. The pensions regulator is under pressure to counter the perception that regulation isn’t working. This is the ­regulator showing its teeth.

“All companies are under pressure to pay high dividends, but water companies need to show they’re working for everyone. The onus is on them to show they’re offering value for money to customers and behaving responsibly. They enjoy a monopoly and guaranteed income streams and mustn’t abuse that position.

“Water company executives will look at Southern Water and realise they need to behave in a more responsive way. [This is one of a number of broader issues in the sector, including attempts to address leakage, levels of gearing and use of sophisticated offshore financing.] Companies need to maintain trust and invest in customers.”

Upping the ante

TPR’s actions against Southern Water are sure to make utility companies sit up in the short term, at a time when the regulator is making noises about upping the ante. In its corporate plan for 2018-21, published in May, the pensions watchdog said it plans to increase its headcount by 12 per cent to 660 people, as a result of its increased workload and remit. It estimates a budget of £88.7 million for 2018/19, an increase of 5.2 per cent when compared with the previous year.

But given the scale of the task in hand, it remains to be seen whether utilities as a whole and water companies in particular will make any meaningful effort to redress the pension/dividend balance. Lind speculated that long-term pressures on their finances mean it is highly likely we’ll soon see another company fall foul of the regulator.