Pensions need to be de-risked

The prospect of a new Private Pensions Bill and tighter regulation ahead means managing pensions risk needs to be a priority for utilities.

The year ahead for pensions across the utility sector looks set to be an uncertain one – with the need to de-risk pensions schemes gaining traction.

Experts says a ramping up of pressure on the cost of defined benefit schemes could push more towards breaking point in anticipation of a new Private Pensions Bill later this year and tighter pensions regulation on the horizon.

Attempts by companies to limit their exposure to pension liabilities by closing defined benefit pension schemes to new entrants have had little impact. Meanwhile changes in economic conditions and increasing life expectancy have contributed to the growth in pension scheme black holes.

Against a backdrop of heightened ­political and potential market volatility, Mark Stewart, a director of Sheards Wealth Management, says the worst is yet to come.

“Pension funds are struggling after ten years of a bull market supported by unprecedented low interest rates. These rates have been kept too low for too long and this has distorted the markets, caused bubbles including the stock and property markets, and allowed for investments that would otherwise never have been made.”

National Grid is one of only 18 companies in the UK with pension liabilities exceeding £10 billion. Ranked 11th largest in the UK, its total pension liabilities of £20.81 billion represent 77 per cent of National Grid’s equity market value of £26.91 billion, according to analysis of FTSE100 pension disclosures by JLT Employee Benefits.

Charles Cowling, chief actuary at JLT Employee Benefits tells Utility Week that recognition of the need for utility companies to de-risk their pension schemes is rising. ­“Utilities have very strict pricing structures and therefore can ill afford to have a sudden cash call because a fall in equity values causes the pension deficit to balloon,” he says.

In an attempt to de-risk, companies are switching pension assets out of equities and into bonds. Severn Trent reported the largest change in bond allocation – from 52 per cent to 76 per cent – according to JLT’s most recent quarterly analysis.

At United Utilities, 91 per cent of its pension scheme assets are now in bonds. “It’s a move I’d welcome and I think we’ll see more of it going forward,” Cowling says. “Utilities are on a very necessary journey to take risk out of their pension schemes.”

As part of that de-risking process, companies are turning to various liability management exercises to limit their pension risk exposure. National Grid announced in May last year that it had agreed to an intermediated longevity swap to cover the liabilities of the Electricity Group’s UK pension scheme. The transaction, designed to counteract the cost risks associated with pensioners and future dependent members having longer life expectancies, will cover around 6,000 current and future pensioners, with a total liability of more than £2 billion.

Andrew ­Bonfield, finance director at National Grid, says the longevity insurance covers around two-thirds of the liabilities of the National Grid Electricity Group pension liabilities. “This demonstrates our ongoing commitment to the security of our pension arrangements, and represents a significant step in our long-term strategy to manage down the level of pension risk for our shareholders and electricity consumers.”

At the same time, the inherent conflict of interest involved in the running of defined benefits arrangements – between funding pension obligations and returning value to shareholders – continues to plague the sector. In particular, the obligation to fund schemes can impact on the money available for investment or recruitment; the interests of shareholders have to be balanced with those of pension scheme members; and the Pensions Regulator’s guidance and directions must also be followed. However, the involvement of the utility regulators can bring an additional tension, explains Margaret ­Meehan, a partner at law firm Burness Paull LLP and a member of the pensions law sub-­committee of the Law Society of Scotland.

“How are the interests of consumers, protected by the utility regulators ­(focusing on competitive, affordable pricing), to be ­balanced with those of shareholders ­(profitability), scheme members (scheme funding and a strong employer covenant) and the needs of the business (sustainability, growth)?” she asks. “Companies can be left feeling as if they are negotiating with their regulator as well as their pension scheme trustees. And whose interests are to have ­priority – members or consumers?”

Moves to give the Pensions Regulator more teeth are expected to be outlined later this year in a new Private Pensions Bill following frustration by politicians at the practice of prioritising investor dividend payments over plugging large holes in pension schemes, a move that prompted Southern Water to incur the wrath of the pensions watchdog.

Currently, there is little legal room for manoeuvre for the regulator if the parties are not being unreasonable and have reached agreement, explains Rosalind Connor, a partner at law firm ARC Pensions Law.

“At the moment it is difficult for The ­Pensions Regulator to take action if the business is strong enough to fund the pension scheme deficit, and by the time that ceases to be the case, it may be too late to act. The Department of Work and Pensions [DWP] is expecting to put in place a Pensions Bill next year and, following the White Paper, it is expected that this will allow the regulator to take more action.”

The question this prompts is, if a business is profitable and able to manage its pension deficit over time, and the trustees are happy with that, should the business be forced to put money into the scheme earlier? “Historically the answer was ‘no’, but we are perhaps seeing a sea change in opinion where pension deficits are perceived as a sign of poor management, however approached,” Connor says.

In a statement, The Pensions Regulator told Utility Week: “While we did issue an in-depth report on Southern Water, we are not able to discuss whether we are taking other regulatory action in this sector, or indeed to give an insight into the sector generally in relation to pensions.”

However, Cowling believes the political mood is ripe for the regulator to take a tougher stance: “Since BHS and Carillion, the regulator has been under pressure to encourage pension trustees to shore up pension schemes over dividends. At the core there is a political imperative to avoid another pension scandal, so the pressure to better fund pension schemes and take the risk out of them will continue.”

In December the Pensions Regulator announced that it had appointed chief executive of the Money Advice Service Charles Counsell as its new chief executive to replace departing head Lesley Titcomb in April this year. “Bearing in mind utilities have large pension schemes, they tend to be more affected by regulatory interest so utilities will be keenly looking to the regulator pronouncements to see how the debates on prioritising dividends over pensions pan out. Utilities companies have made significant strides in recent years but there is still a long way to go,” Cowling said.

The government is currently consulting on the use of defined benefit pension scheme consolidations, which, if introduced could provide an alternative method for reducing companies’ exposure to pension liabilities.

In the meantime, the Pensions Regulator and the utility regulators acknowledge the competing interests that have to be balanced by utility companies, but take the view that the two regulatory regimes are not incompatible. “There is no doubt that this is a difficult balancing act for companies, but it can be achieved by identifying the interests of all shareholders and working closely with pension trustees, in particular to ensure the business risks are fully understood in funding negotiations,” Meehan says.