LONDON - Elimination of tax credits on U.K. advanced corporation tax is leading to a sweeping review of U.K. actuarial practices and may spell the beginning of the end for British defined benefit plans.
Some pension experts believe the abolition of tax credits, combined with the effects of the 1995 Pensions Act and other pressures, will lead many employers to abandon their defined benefit plans in favor of money purchase vehicles.
A new survey conducted by Arthur Andersen following the budget change found 80% of employers plan to review their plan structures, with fully two-thirds saying changes would trigger a move to defined contribution schemes. The firm surveyed 50 major U.K. employers with at least 500 employees each.
"It is possible the budget could be the nail in the coffin for final-salary schemes. It certainly will accelerate the trend toward companies adopting money purchase arrangements," said Carol Woodley, partner heading Andersen's pension practice, in a release.
With the government's blessing, officials of the Faculty and Institute of Actuaries, a London-based standards-setting body, will conduct a review of actuarial practices in the next nine to 12 months.
In the meantime, government officials agreed U.K. pension funds should use existing rules for calculating pension fund compliance with the minimum funding requirement in the 1995 pensions law.
However, the test could be altered substantially for the future, actuaries warn.
"The whole structure of MFR will have to be reviewed," said Martin Slack, senior partner at Lane Clark & Peacock, a London-based actuarial firm, and a member of the actuaries' pension board.
There's no way of knowing how the review will turn out, experts said. "If I were a pension fund, I'd sit tight," said Sandy Rattray, head of European equity derivatives research, Goldman Sachs International, London.
Pension experts say abolition of the tax credit, which was announced in Chancellor of the Exchequer Gordon Brown's July 2 minibudget, will reduce potential returns from U.K. equities between 0.5% and 1% a year.
Lower expected U.K. equity returns could lead British pension funds to boost overseas equities and bonds. Most British pension funds are between 50% and 55% invested in U.K. stocks. The reduction in dividend yields also will reduce long-term return assumptions. The typical return assumption of 9% a year might get cut to 8.5% or even 8%, said Harvie Brown, a worldwide partner with William M. Mercer Ltd., Glasgow, and chairman of the actuaries' pension board.
The loss in dividend income also will reduce ongoing funding levels anywhere from 5% to 15%, depending on a fund's liability profile. That will greatly increase pension cost.
While many of the employers responding to the Andersen survey guessed pension costs would increase 5% to 10%, Andersen consultants figure the rise in costs likely will exceed 25% in many cases, especially where employee contributions are fixed.
Marc Hommel, director of PensionStore, a London-based defined contribution specialist, said in a release: "It is becoming increasingly difficult for employers who operate final-salary schemes to control or predict long-term costs and these measures will further encourage the trend toward money purchase arrangements and group personal pensions."
Changes in MFR test expected
Traditional pension funding rests on the premise that a pension fund will continue operating indefinitely, with additional contributions and returns helping to cover long-term liabilities.
In contrast, the MFR test is a snapshot of how well a pension scheme could meet its liabilities if it were shut today. But the funding assumptions laid out by the Department of Social Security for the MFR test no longer hold true with the abolition of the tax credit. The test incorporates a long-term gross dividend yield of 4.25% for U.K. stocks and 8% long-term gross redemption for U.K. bonds.
Actuaries say they need to conduct an extensive review before recommending changes to the test. Government officials concurred.
In the interim, British pension funds should continue using the current basis, government and pension experts agreed. That means pension funds will not be any worse funded for purposes of calculating the MFR test.
That's a relief to employers, who will not need to make sudden cash injections into their funds. The test, which is being phased in over 10 years, would require employers to make cash contributions if their pension plans fell below 90% funding. The average U.K. pension scheme is about 125% funded.
Future MFR options
For the future, one option would be to develop a more complex test. Currently, the test includes return assumptions for U.K. equities and gilts only. But the test could be expanded to other asset classes.
The abolition of the tax credit also set off a debate as to whether to abandon the actuarial method of valuing pension assets. U.K. equities are valued on the basis of a discounted dividend stream, but reduced after-tax dividends might make the approach less viable. If U.K. actuaries were to move to a market-based approach, they would need to adopt a similar change on the liability side.
The danger in a market-based approach is that U.K. pension funds would be subject to higher levels of volatility, Mercer's Mr. Brown said. Increased volatility could lead them to reduce their equity weightings, which have provided tremendous returns. The average U.K. pension fund has nearly 80% of assets in stocks.
A move to a market valuation also would be boosted by proposed international accounting standards. If U.K. companies adopt a market-based pension accounting approach, there could be a widening gap between disclosure in their annual reports and traditional actuarial valuations.
"All those pressure are hitting companies running final-salary defined benefit schemes," Mr. Slack said. Employers could come up with one conclusion, he said: "Why on Earth are we still running defined benefit schemes?"