Deficit contributions: the retrospective pension pay rise

Estimated reading time: 5 minutes

It is clear that valuations of defined benefit pension schemes’ liabilities have escalated over recent years, with many employers being required to pay ever-increasing contributions to recover deficits.  

The chart is based on publically available data from valuation reports for a number of the largest UK defined benefit pension schemes.

For example, a scheme open to pension accrual in June 1980 may typically have estimated the cost of accrual at that time to be, say, 10% of the employees’ pensionable salaries (depending on the rate of pension accrual, retirement age, pension increase promises etc).  Typically this cost might have been split between the employees and employer so each paid, say, 5% contributions initially. 

Looking at how this cost has changed since 1980, with hindsight, we can now see from the chart that the expected cost of accrual of benefits has increased to be around 500% of what it was initially estimated to be – i.e. the pension accrual has increased in value from 10% to 50% of salary over time.

However, while the overall cost of accrual as a percentage of salary has increased five-fold, the associated increase in required contributions does not usually get passed on to the members retrospectively. So the employer now has to meet the total cost of 50% less the employee contribution of 5%, which is 45%, a ninefold increase on their initial expected contribution rate of 5%.

The pension pay rise

Another way of looking at this, is employers have had to fund a retrospective “pension pay rise” equivalent to 40% of the salaries that pension scheme members received whilst they were accruing pension (with this funding provided in the form of subsequent deficit contributions). For schemes with the most generous benefits the figure could be much higher.

Expressed in this way, it is clear to see why deficit recovery contributions required from sponsoring employers have created such a financial burden, and left little budget remaining for the provision of pensions for subsequent generations of employees. 

What has driven the retrospective increase in the cost of pension accrual?

We believe that there are two main reasons for this dramatic increase in the cost of providing pensions:

• Improvements in life expectancy meaning pensions are being paid for longer
• Changing market conditions reducing expected future asset returns, and resulting in lower discount rates

The chart above shows typical assumptions for the expected longevity of pension scheme members currently aged 60, within historical actuarial valuations, based on the most recently available data at the relevant times. 

Material improvements in pensioner longevity expectations over this period, particularly between 2000 and 2010, have exceeded previous projections to the extent that many pensions will now be expected to be paid for around twice the term originally expected. 

The cost of falling gilt yields and inflation

In the table above we have taken as a useful reference point for expected future asset returns the nominal yield on Government Bonds of a suitable duration. We can see that these gilt yields have fallen dramatically over the last 40 years. While the Covid-19 pandemic has increased recent volatility and suppressed yields, this is only the tip of the broader overall trend of a significant decline over this period. Methods for setting assumed future investment returns and liability discount rates within actuarial valuations relative to gilt yields have varied over this time, but the general trend of a reduction in yields has significantly increased the present value of future pension payments, increasing the retrospective cost of pension accrual accordingly. 

Of even greater importance is the trend of yields or discount rates relative to pension increase assumptions, as pension costs are most sensitive to the “net” discount rate. In the table above we have included typical assumptions over time for pension increases linked to inflation measured by the Retail Prices Index (RPI) subject to a maximum of 5% a year, which is consistent with many of the more common scheme rules over this period. We can see from the table that while inflation was high in the 1980s (and therefore the 5% cap was assumed to apply), since the mid-1990s RPI inflation expectations have been reasonably stable at around 3%pa. Taking these two measures together, we can see that the net yield has changed even more significantly, becoming negative over recent years. This has a dramatic retrospective effect on the cost of providing pensions, which are now more expensive to fund in advance, rather than being “discounted” – we have gone from needing £92 today to pay £100 of pension in a year’s time, to needing £103 now to make the same payment. This is the main driver of the cost of pension accrual doubling over the last decade. 

The benefit mitigation and hedging strategies have offered

There has been mitigation for some schemes that have adopted “hedging” strategies over recent years. Schemes that have managed their interest rate risk through “Liability-Driven Investment” (LDI) strategies will have offset the increased cost of pension accrual through increased LDI asset values. For example, a scheme that has been fully funded, and fully interest-rate hedged, for the last ten years should have escaped the effects of more recent falls in yields. Even in this case, pension costs may still be 250% of original expectations, and the retrospective pension pay rise that employers have had to fund is of the order of 15%. In practice, very few schemes, apart from those that have actually bought out in the insurance market, have been hedged against the more significant market movements of the last 40 years, although many are now better placed to mitigate the effect of further future increases in the value of pension promises.