LONDON - Changes in the U.K. tax treatment of pension funds will cause 27% of U.K. pension funds to fall below full funding requirements, up from only 4% before this summer's budget.
Not only will the tax changes cause U.K. companies to boost pension contributions, but they also may cause British pension funds to raise fixed-income allocations at the expense of equities, and may further encourage a move to defined contribution plans.
Elimination of the credit that pension funds previously received for advanced corporation tax will have a particularly harsh effect on U.K. subsidiaries of U.S. corporations, which tend to be more tightly funded than British companies.
Forty-four percent of those subsidiaries will fall below the 100% funding level, nearly triple the previous rate of 16%, according to calculations by Watson Wyatt Worldwide, Reigate, for Greenwich Associates' annual report on U.K. pension funds.
And 3% of U.K. subsidiaries will find themselves below the 90% mark, at which level they would have up to one year to make a cash infusion under the U.K.'s minimum funding requirement.
The situation is even worse for U.K. public funds.
Public funds feel heat
Watson Wyatt estimates 84% of such plans will be under full funding after the ACT changes, compared with 65% before Chancellor of the Exchequer Gordon Brown announced the sudden removal of the tax credit in July (Pensions & Investments, July 7).
Nearly three-fifths of local authority funds will fall below the 90% funding threshold, up from 42% before the tax change. However, local authorities are not subject to the 1995 Pensions Act's minimum funding requirement, and thus do not face the same potential cash squeeze as companies.
Under the U.K.'s imputation system, companies pay advanced corporation tax of 20% on dividends. Before the change, tax-exempt investors could reclaim that 20%, but the budget immediately removed the credit for pension funds and eventually will do the same for charities
As a result, U.K. pension fund income from U.K. equities shrank by 20%. Because U.K. pension funds are valued on the basis of a discounted income stream and not on market values, the effect is to slash their funding levels.
Watson Wyatt's calculations were performed assuming pension plans were ongoing, not on the MFR basis, which takes a snapshot of a fund's assets and liabilities.
Plus, investment assumptions may be adjusted by plan, depending on how aggressive the actuary was, explained Craig Gillespie, senior investment consultant at Watson Wyatt.
"At some of the schemes, there may be a bigger reduction than we've allowed for, and at some of the schemes, there may be no adjustment at all," he said.
A previous study by actuaries Lane, Clark & Peacock, London, showed 44 of the top 100 U.K. companies would become unfunded on an ongoing basis following the ACT changes, said Martin Slack, senior partner.
The Faculty and Institute of Actuaries is conducting a wide-ranging review of actuarial practice that could lead to abandonment of traditional actuarial valuations in favor of a market-based approach.
In the meantime, the government and pension experts are advising pension funds not to change their methodology for calculating the minimum funding requirement (P&I, Aug. 4).
Shift toward fixed-income
Early analyses are predicting a shift away from U.K. equities as a result of the ACT change.
Preliminary findings by Paul Marsh and Elroy Dimson, finance professors at the London Business School, show the average allocation (excluding real estate) in British stocks dropping to 51% from the year-end 1996 figure of 56%. Overseas equities also would fall one percentage point to 22%, while cash would shrink to 4% from 6%.
The big gainers would be U.K. bonds, increasing to 12% from 7%, Messrs. Marsh and Dimson found. In addition, overseas bonds would edge up to 4% from 3%, and index-linked gilts to 7% from 5%.
Donald Duval, director of research at Aon Consulting Ltd., London, said ACT changes also could affect corporate financing behavior.
U.K. companies - long used to raising money from equity issuance - might choose instead to issue corporate debt for part of their capitalization. This would avoid both ACT and regular corporate tax, as well as take advantage of low interest rates, he said.
Another possibility would be issuance of bonds with equity characteristics, such as warrants.
Move to defined contribution
But the other main impact of the ACT changes might further push British companies to adopt defined contribution plans, Greenwich officials said.
The move already was under way, driven by desires to end companies' open-ended liabilities for defined benefit plans, shift investment risk to participants, avoid potential minimum funding requirement problems, and provide portability of benefits to a more mobile work force, Greenwich consultants said in their report.
The survey found 24% of U.K. companies surveyed are using defined contribution plans, up from 16% two years ago.
What's more, the proportion planning to start up defined contribution plans has jumped to 17% now from 5% two years ago.
U.K. defined contributions assets, while still relatively small, are growing. Greenwich officials found the assets had risen to 1.7 billion Pounds in 1996 from L586 million in 1996.
Greenwich officials project defined contribution assets could total between L10 billion and L15 billion in 1999, some 10% to 15% of U.K. corporate pension assets.
One question is whether defined contribution plans will supplement or replace defined benefit plans. One indication is the percentage of British companies with defined benefit plans has fallen to 92% from 98% just two years ago.
But employee resistance to the change and increased emphasis on employee benefits over cash compensation in Britain might mitigate that trend, the report said.
Asset mix changes
The need to remain at full funding also is driving a desire to reduce volatility, Greenwich officials said. As a result, bonds now comprise 14.3% of plan assets, up from 11.4% five years ago. Bonds are expected to rise to 15.5% of assets within three years.
Despite market gains, equities have remained steady at 75% and are expected to remain close to that level for the future, the survey said.
In other trends, interest in passive investment continues to rise, growing to 21.8% now from 17.2% five years ago. While 30% of U.K. plan sponsors invested passively in 1992, 40% do so now.
The trend might be greater, noted consultant John Webster, if the fee differential between active and passive fees were bigger. While U.S. passive fees are less than one-tenth of active fees, in Britain indexation costs about half as much as active management.
In addition, interest in small-cap and emerging markets managers has leveled off, around 40% and 50%, respectively.
Greenwich consultants also noted the role of investment consultants in setting asset allocations has grown dramatically, at the expense of traditional balanced managers.
Now, 57% of plan sponsors rely on consultants, up from 45% two years ago. In contrast, only 34% depend on their balanced managers, down from 44% in 1995.
Consultant Rodger Smith encouraged plan sponsors to involve their balanced managers in the asset allocation decision, while applauding efforts by plan sponsors to use their consultants.
