The pension drag

Retailers and manufacturers have seen their pension deficits soar over the past year. But is the burden as heavy as it seems, asks Chloe Smith


"At times like these, you don't panic. You make sure you have a long-term strategy that is robust in bad times as well as good."

In the current climate, such a comment could easily have been made by a struggling supplier. Yet, surprisingly, it comes from a Tesco director - pensions director Ruston Smith, commenting recently on the impact of falling equity markets on its pension fund.

Post-economic meltdown, Tesco is expected to reveal an overall deficit of up to £1bn when it announces its next set of results in April (it stood at £603m in the last set of annual accounts). And it's not the only one whose pension burden is growing. At the turn of the year, the combined deficit of pension provision across UK businesses already stood at £194.5bn, up 43% on the previous month, according to the Pensions Protection Fund. So how much bigger can the pension black hole get? And what are the other challenges for the pension industry?

A look at the latest sets of annual accounts suggests even those whose pension funds have been in surplus will have to watch out. Many pension funds are large relative to company turnover - and as companies rationalise in the downturn could become larger still. A clue to the gravity of the situation came at the start of the month when Unilever confirmed its total pension deficit had more than tripled to €3.4bn (£3bn) since 2007, of which €1.4bn represented its defined benefit obligations and €2bn its unfunded arrangements.

Although everyone is to a certain extent in the same boat, those offering final salary or defined benefit pension schemes are in a trickier position. When most schemes were launched, people weren't living as long as they do these days - as Tesco recently pointed out when it lobbied the Government during the Pensions Bill consultation to allow it to cut payouts if employees live longer than expected. The problem has been exacerbated by the credit crunch, which has sent share prices tumbling and plunged many pension funds millions of pounds into the red.

Pension schemes have become millstones around company necks and a major drain on cashflow, says Charles Cowling, Pension Capital Strategies MD and author of a new report: The Global Financial Crisis - the Fall Out for Pensions. If the net liabilities of the funds were to increase 30%, which is not inconceivable given the deteriorating economic situation, a number of retailers would struggle to pay off their deficits, he says. Sainsbury's, M&S and Thorntons would all have net defined benefit pension liabilities greater than their gross cashflows at 111%, 110% and 116% respectively, though the first two boast pension surpluses.

Tesco's liability, on the other hand, would represent a more modest 36% of its cashflow, despite its deficit.

"If times get tough for the pension scheme, there's every possibility the trustees might start demanding more cash," says Cowling. "There are two things that figure in their minds: how big the deficit is and how good the employer is for that deficit. Clearly if the pension scheme is big relative to company size and the pension scheme deficit grows, then demands on cash from the trustees are likely to be harder for the company to bear."

The report also looks at the impact on profit before tax of a defined benefit scheme being closed. While M&S's pensions commitment currently represents 8% of its pre-tax profit and Morrisons' 7%, Tesco's and Sainsbury's represent 16% apiece. "It shows the provision of final salary benefits is more significant at Tesco and Sainsbury's than M&S," says Cowling, adding that getting rid of defined benefit schemes could significantly lift profit.

Tesco nevertheless continues to run its defined benefit scheme on the grounds that it helps it attract the best people. Despite posting a pension deficit of £554m in its last annual accounts, John Lewis has extended its defined benefit scheme, incurring an £8m increase in its pension charge to £50m in the past year. "We're committed to retaining the scheme because we are a different kind of business," says a spokesman. "The decision is made for the benefit of our partners, not shareholders."

However, although they still have obligations to existing final salary scheme members, most companies are closing such schemes to new members and introducing cheaper-to-run defined contribution schemes. Sainsbury's closed its final salary scheme to new entrants in 2002 and replaced it with a defined contribution scheme. M&S, whose defined benefit scheme was open to new employees until 2007, announced last month that it was capping any increases in its staff's pensionable pay to 1% per year.

Meanwhile, Asda closed its defined benefit scheme to new members in 2005. Like Tesco, it is now rethinking its pension fund investments. Last month, it employed investment manager Cardano to manage a 20% stake of its £1bn fund. Cardano will also provide advice on all aspects of the scheme's assets. "By appointing Cardano and delegating in this way the fund can be a lot more nimble," says Steve Jones, Asda's pension manager. "They can take advantage of opportunities that the typical trustee adviser model would, by virtue of how it is set up, be slower to react to."

Manufacturers, too, are faced with pension deficits running into tens of millions. Unilever, which closed its defined benefit scheme last year, attributes its deficit increase to a lower asset base - "returns on the investments in our pension funds have deteriorated like they have for everyone else", says a spokesman. For Uniq and Northern Foods, the problem is that they have downsized their businesses and their pension schemes now look large and unwieldy on the balance sheet.

There are ways to reduce their liabilities such as giving members an incentive to leave the scheme, says Investec analyst Nicola Mallard. "Dairy Crest has bought an annuity, which is supposedly going to meet part of its liabilities," she adds.

But these measures will only go some way towards mitigating the mounting pension burden on businesses across the food and drink industry. And the problem is about to be compounded. Last year Parliament passed the Pensions Bill in recognition of the problems facing pensioners of the future. By 2012 all employers will have to automatically enrol staff into a pension scheme. The aim is to ensure people have a comfortable retirement, but some fear the additional burden on businesses will end up reducing the benefits.

Employers will have to think carefully about what they can afford, warns Keith Barton, chairman of the Association of Consulting Actuaries. "Generally for members it is better to have some certainty around their benefits, but different styles of defined benefit may have to be introduced," he says. "We are trying to persuade the Government to allow some sharing of risk among members and employers in defined benefit plans. The sort of scheme we have been looking at is making some of the benefits conditional on the funding levels. So if times are hard they might not get an increase. We think it would encourage employers to keep their current plans rather than throw them away and go for a defined contribution scheme."

For the likes of Tesco the dangers remain largely hypothetical, stress analysts. "When the assets are less than the liabilities and they are in deficit, it only becomes a problem if the company is wound up," notes one. A bigger issue is that the pensions regulator will want companies to reduce their deficits, he says: "Two years ago, Tesco put in £200m to its pension, which cost its business. It could have paid that to shareholders in dividends, it could have used it to pay back debt."

Tesco remains committed to its defined benefit scheme. But given the financial burdens entailed, it surely can't be long before the final curtain falls on final salary pension schemes.