Pension Scheme vs. Shareholders – a fine balance

David Newgrosh and Lewys Curteis contributed to the writing of this blog post

For companies with a defined benefit (DB) pension scheme, balancing the needs of the scheme with the needs of other stakeholders can be extremely difficult. This challenge is revealed most starkly in the relationship between the contributions required to clear any deficit and the payment of dividends to shareholders – an area that has come under intense scrutiny in recent years. In this blog, we look at how FTSE350 companies are dealing with this balancing act, but firstly comment on the Pensions Regulator’s most recent views.

The views of the Pensions Regulator

As part of its Annual Funding Statement published in May 2017, the Pensions Regulator (TPR) set out its views in relation to fair treatment between pension schemes and shareholders. This statement presents a further hardening in TPR’s stance on this issue and will mean employers face more difficult negotiations with DB scheme trustees in future where deficits have not decreased as expected.

TPR noted that it is likely to intervene where it believes schemes are not being treated fairly. This will particularly be in circumstances where recovery plan end dates are being extended unnecessarily, or where the company covenant is constrained and total payments to shareholders are being prioritised over payments to the pension scheme.

Where a company’s total payments to shareholders is higher than the deficit reduction contributions (DRCs) being paid to the pension scheme, TPR expects the scheme to have a relatively short recovery plan - with an appropriate investment strategy that does not rely excessively on investment outperformance.

Where this is not the case, TPR may investigate whether the contributions being paid to the scheme are too low and whether the level of payments to shareholders suggests that the company can afford a higher level of contributions.

Employers should understand the implications of the latest Annual Funding Statement before beginning negotiations with the trustees on a new actuarial valuation.

FTSE350 analysis

Our analysis of FTSE350 companies with a DB scheme, representing over 200 companies (as published in our recent ‘Impact of pension schemes on UK business’ report) showed that DRCs as a proportion of dividends have reduced in recent years, with the median ratio reducing from around 19% in 2011 to around 12% in 2016. The results of our analysis are shown in the graph below:

The decrease has mainly been driven by a significant increase in dividends over the period, without a corresponding increase in DRCs. 

However, it is worth noting  that there are large differences between individual companies. In 2016, 45 companies increased payouts to shareholders and at the same time reduced DRCs. This represents a significant decrease from the equivalent number of companies in 2014 and 2015 (79 and 61 respectively). Given that TPR has been putting pressure on companies to prioritise pension scheme funding, this decrease perhaps indicates that the message is starting to gain traction.

Summary

Dividends have increased significantly over the period since 2011 without a corresponding increase in DRCs. On the face of it, this trend could easily be interpreted as companies act irresponsibly - a popular view held by many critics in the aftermath of the financial crisis. However, it is far more likely that this trend is due to the position in the business cycle, rather than companies simply neglecting their pension schemes over the last few years. Indeed, one could argue that the increase is due to dividends returning to more ‘normal’ levels as the market has recovered from the recession of 2008/09. 

A further point to note is that while dividends vary year by year, DRCs are generally fixed for a period of time, so there may be a time lag inherent in the analysis. Indeed, TPR noted in its recent funding statement that schemes with 2014 valuations experienced relatively favourable market conditions when undertaking their last valuations  - expecting deficits in the 2017 valuation cycle to be significantly higher. In turn, this is likely to lead to a higher level of DRCs being agreed, with TPR expecting the median increase in DRCs to be around 75%-100% compared to current levels.

TPR has indicated that for 2017 valuations it will be focusing in particular on fair treatment between schemes and shareholders, so companies should expect greater scrutiny and challenge on recovery plans relative to the level of dividend payments. Of course, there are a range of factors that trustees should take into account when agreeing a recovery plan, including the interaction between the scheme funding assumptions, investment strategy and employer covenant. Similarly, there is a range of factors that companies have to take into account when agreeing pension scheme contributions, such as the need to make investments for future growth, to reduce non-pension-related debt, or indeed, to provide a cash return to shareholders.