Tesco Pension Scheme deficit risen sharply due to artificially depressed bond yields
Pensions Regulator faces interesting challenge – what’s most important, fixing the business or its pension?
Good test of Regulators powers of judgment
by Dr. Ros Altmann
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Tesco has had a torrid year and, as 2014 draws to a close, its woes are under the spotlight again with talk of having to plug its rising pension deficit.
In August 2014 Tesco reported a £3.4bn pension fund shortfall. It has over £8bn of assets (up from around £6bn in 2012), but its liabilities have grown even faster to reach more than £11bn as bond yields have plunged.
Tesco is one of the very few remaining large firms to offer final salary benefits to its staff and the scheme has 170,000 members, making it one of the country’s biggest. With such a significant reported deficit, what will serve the members’ interests best – for the Regulator to force the firm to fix the shortfall speedily, or for it to be given extra time to manage its funding level while focussing on reviving the fortunes of the business itself?
Clearly, the best protection for pension members is a strong, committed employer. The strength of the company is currently somewhat uncertain, however the commitment to its scheme seems strong. In 2012, it started its own in-house investment operation to cut the costs of managing its fund. It also changed the inflation linking of its benefits from rpi to cpi, but retained a cap of 5% even though the law only requires up to 2.5% inflation protection. In addition, the company increased pension age for future benefit accruals by two years. However, these changes are relatively minor compared to most other private sector schemes and, by also pledging property assets to the pension trustees, there is clearly a willingness to support the pension fund.
Now that Tesco has hit harder times, with the threat of online shopping undermining its long-term prospects to some extent, the company management will clearly need time to refocus the business to revive profitability and growth. The company’s strength is crucial to job prospects as well as pension prospects of thousands of people. Tesco has also offered a solid dividend for shareholders.
This is the dilemma facing the Regulator: if the company needs time to strengthen its business, would it make sense to allow the firm to take longer to fix the deficit and focus its efforts on securing the future of the company. Or should the Regulator insist that, as the company is now weaker than before, there is a bigger risk of failure and the funding level should be improved urgently. This would mean paying shareholders much lower dividends, if any, until the deficit is corrected. But that would also potentially weaken the company’s ability to overcome its trading difficulties.
The Regulator’s new powers require it to take the long-term future of the sponsor’s business into account when deciding on how fast deficits should be fixed. The new rules were also introduced in light of the exceptional interest rate environment in which pension funds are currently operating.
The main reason for the rise in Tesco’s deficit to £3.4bn in August 2014 was said to be due to the sharp fall in bond yields. Long bond yields have sunk to unprecedented lows and falling interest rates lead to rising pension deficits because the liabilities increase by more than their assets when rates decline. This leaves many pension schemes facing a difficult choice. Even though it is clear that long yields have been artificially depressed by official purchases of long bonds by central banks, the distortion of yields has been going on for so long now that many trustees are being advised to simply bite the bullet and buy bonds in an effort to keep the change in their assets closer to the change in their liabilities. This is meant to ‘de-risk’ their pension schemes. The idea is that, if their liabilities are measured relative to long bond yields, then holding long bonds will mean assets move in line with the mark-to-market measurement of their liabilities. But, in the current environment, there is an element of circularity in this which could become a vicious circle. If official policy is trying to depress long bond yields by buying gilts, which increases pension deficits and this forces pension funds to buy more gilts themselves, the deficits just keep worsening which forces firms to put more money into their pension schemes rather than their businesses.
A look at the charts of long bond yields shows just how far away from historic norms the yields levels have moved.
It is clear that long gilt yields are in uncharted territory. Indeed, if bond yields are in a bubble because there is so much buying from both central banks and pension funds, then this could be adding, rather than reducing risk over the longer term, even if trustees feel they are reducing risk in the short run. At the same time, there has been a sharp reduction in the amounts of money invested in stock markets. In 2006, the Pensions Regulator figures show that pension funds invested over 60% of their assets in equities, but that has now fallen to just 35% in 2014 (with less than half of this in the UK stock market itself). Over the same period, the proportion invested in bonds has risen from around 28% to 44%. This sharp fall in institutional investment in the UK stock market could weaken the corporate sector, to the detriment of the economy and pension schemes.
Ironically, the aim of official gilt purchases has been to revive the economy, although it the UK is much more sensitive to short rates than long rates. If, however, the fall in long yields forces major firms like Tesco to divert resources away from their businesses and into their pension schemes in the near term, there is a risk of damage to economic prospects. That is why, in my view, there is a strong case for the Regulator to allow Tesco more time to fix its deficit, rather than insisting on huge sums being ploughed into the scheme straight away. Such judgments are always tricky, but in the current unprecedented interest rate environment, I believe there is a strong case for supporting large firms through this exceptional period and giving time to see what will happen when long rates normalise in the coming years, even though we do not know how long that will take.