Defined benefit plans under watch in U.K.

The U.K. pension fund industry is coming under increased scrutiny by politicians and regulators with two recent cases of employers struggling to reconcile corporate considerations with defined benefit promises.

Particular scrutiny will come from the House of Commons Work and Pensions Select Committee, which on May 27 said it would launch an inquiry into DB funds in the U.K. The inquiry follows the emergence of problems for two pension funds in particular: The £13.3 billion ($19.4 billion) British Steel Pension Scheme and the £558.3 million pension funds of retailer BHS Ltd. All are based in London.

“The state of the British Steel Pension Scheme is further worrying evidence of a wider danger to one of the biggest savings successes in Britain during the last century — occupational pension schemes,” said Frank Field, a member of Parliament and chair of the Work and Pensions Committee, in a statement regarding the inquiry. “Pension law and regulation must urgently adapt to the issues of the future, rather than the problems of the past. The whole savings edifice is in danger.”

The inquiry, which is yet to be launched, will be “a major inquiry considering radical solutions to one of the great problems of this age,” Mr. Field said, and will consider “radical solutions that could be more easily implemented if real returns on capital rise again.”

The U.K.'s private defined benefit plan market provides benefits to more than 11 million people. More than 5,000 of the associated funds have a combined deficit of £805 billion.

The inquiry follows a consultation paper published by the U.K. government on May 26 into how to keep the British Steel Pension Scheme — which has a £700 million deficit — afloat and out of the Pensions Protection Fund, London, the country's lifeboat for the pension funds of insolvent companies.

The government is looking for comment from members of the pension fund industry regarding a number of proposals, including regulatory changes to allow trustees of the fund to transfer members into a new, successor pension fund with reduced benefits for these participants without their consent.

“This is the first example of "too big to fail' in a private pension scheme,” said Clive Fortes, partner at consultant Hymans Robertson in London. “There are genuine issues here that need to be resolved.”

“With (British) Steel, what we have in effect is (that) the financial future of the steel industry in the U.K. is in play because ... the U.K. does not have a policy in reconciling the interests of plan participants or retirees in DB plans relative to other creditors,” said Gordon Clark, Oxford, England-based director of the Smith School of Enterprise and the Environment. “As a consequence, in this particular case, both the government and the various stakeholders are at a bit of a loss of how to proceed.”

If the fund is allowed to fall into the PPF, there are a number of issues. One is that members would lose 10% of the value of their DB promises. (The PPF typically pays 100% of compensation to those that have already retired, but 90% of a member's DB fund to those who have yet to retire.) A second is the significant impact the £13.3 billion pension fund would have on the £22.6 billion PPF itself. The PPF had more than 222,500 members as of March 31, 2015; BSPS would add another 130,000.

“You can see the scale of what we are looking at here. That is what makes it different,” said Mr. Fortes.

There is also the issue of concentration. The majority of the steel workers are based in Wales. “Taking it to the extreme, if all former steel workers lost their pensions, we may well have ghost towns in parts of the U.K. We have scale and concentration that makes it quite political,” said Mr. Fortes.

Mr. Fortes is also concerned that the pension fund, under one of the proposals, might be allowed to “divorce” from its sponsoring employer, restructure in a way that allows it to survive by itself, but still be underwritten by the PPF in case it fails.

“Every other sponsor of a U.K. scheme would be underwriting the BSPS. Having that to fall back on in case going it alone doesn't work is a dangerous precedent,” he warned.

Sources said the situation with BSPS calls into question the structure of the U.K.'s DB market.

“It is fine to launch an inquiry into DB, but DB promises are promises,” said David Pitt-Watson, London-based executive fellow at London Business School. “If they were made, then (companies) should stick to them. Tata Steel (BSPS' sponsoring employer) is a bit of an exception because there is a choice at this point: either (BSPS participants) are put into the PPF and lose 10%, or are given another deal and kept afloat, but the (pension) is not as good as before. The danger is that this becomes a precedent for others.”

As for BHS, two committees in Parliament — the Work and Pensions Committee and the Business, Innovation and Skills Committee — are jointly taking evidence on the retailer's two pension funds. As a part of the inquiries, the committees are looking into the growth of the funds' deficits, which totaled £571 million as of Jan. 23.

Mr. Clark said a fundamental issue is that there is “no obvious way of reconciling, in extreme situations, the interests of the different parties to a bankruptcy,” and pension fund participants do not have special status relative to other creditors in those situations. “That works only as long as individual bankruptcies are not large, and/or don't carry an entire sector with them,” he said.

The U.K.'s pension system had flexibility until the 1980s, when pension funds were in surplus.

“Companies asked if they could stop putting in money, and trustees agreed, but only on the basis that companies would guarantee every last penny of the pension promise,” said Mr. Pitt-Watson. “But as people started living longer and returns diminished, companies closed down their DB schemes and replaced them with (defined contribution.) A DC pension just gives you a worse and much less predictable income in retirement than DB, even for exactly the same amount of money.” n