Saturday 22 July 2017

Why Irish companies are facing massive deficits in pension funds

It's a problem that won't go away and is getting worse as investment returns have been negligible over the past 10 years

George Garvey

The collapse in global financial markets, with the London FTSE index down 15pc and the American S&P index falling by 12pc since the middle of the year, will be causing severe unease in many Irish boardrooms.

After a period when it seemed as if Ireland's major companies were getting to grips with their pension fund deficits, the crash of 2011 is threatening to undo all of their recent good work.

Virtually all of the major Irish companies, both those whose shares are listed on the Stock Exchange and the semi-state ones, have significant deficits in their pension funds.

It is only the handful of companies who have defined-contribution pension schemes, where the amount paid to retirees depends on the investment performance of the pension fund, rather than defined-benefit or final salary schemes, who have managed to dodge the bullet.

In its most recent annual report, which was published in June, the Pensions Board warned that up to three-quarters of Irish defined-benefit pension schemes were in deficit.

While the Pensions Board hasn't put a figure on the total deficit in Irish defined-benefit pension schemes, some analysts reckon that the figure could have been as high as €25bn in late 2009.

Since then several major Irish companies have taken drastic action to cut their pension fund deficits.

Cap payments

Bank of Ireland, which had a pension fund deficit of more than €1.6bn at the end of 2009, has since pumped €750m into its pension fund and agreed with staff to cap future pension payments. As a result, the deficit in the Bank of Ireland pension fund had fallen to €163m by the end of June 2011.

Plugging the hole in the AIB pension fund involved even more drastic action, with staff agreeing to a 20pc cut in payments and an increase in employee contributions.

These changes have resulted in the AIB pension fund deficit falling from €1.2bn at the end of 2009 to €277m by the middle of this year.

Despite this reduction, AIB's pension fund deficit is a multiple of the value of the tiny sliver of its equity, about 0.2pc of its total shares worth €43m, now traded on the Irish Stock Exchange.

It's a similar story with the other Irish bank now more than 99pc-owned by the Government, Irish Life & Permanent. It had a pension fund deficit of €35m at the end of June, while its remaining Stock Exchange-traded shares, just 0.75pc of the total, are worth a mere €7.5m.

Bank of Ireland, which has managed to keep the state shareholding at 15pc and has a market capitalisation of more than €2.25bn, is the only Irish-owned bank whose pension deficit is less than its market value.

While the banks are an admittedly extreme example, there are several other major Irish companies, both Stock Exchange-listed and semi-states, with very large pension fund deficits.

Packaging group

In the private sector, the company with the largest pension fund deficit in nominal terms is undoubtedly printing and packaging group Smurfit Kappa.

It had a €611m hole in its pension fund at the end of June, up €16m from the end of December 2010. This represented more than 60pc of Smurfit Kappa's market capitalisation of €1.04bn.

At least Smurfit Kappa's pension fund deficit, large and all as it is, is less than its market value, which is more than can be said about Aer Lingus.

When the airline published its half-year results last month it warned shareholders that there was a €400m deficit in the Irish Airlines Superannuation Scheme (IASS).

This is considerably greater than Aer Lingus's current market value of €344m. The old adage about BA, that it was a pension fund with an airline attached, springs to mind.

However, the IASS also covers staff of the Dublin Airport Authority (DAA) and the other former Aer Rianta companies.

How much of the €400m pension fund gap relates to Aer Lingus staff and how much to the staff from the other companies? Unfortunately, Aer Lingus chose not to share that information with its shareholders.

Two other Irish-quoted companies with high pension fund deficits relative to their market capitalisations are Independent News & Media (INM) and Greencore.

International News and Media had a €127m pension fund deficit at the end of June. However, there are plans in place to restructure INM's scheme.

Greencore, the former Irish Sugar Company, had a €91m pension fund deficit at the end of March as against a market value of €237m.

However, several major Irish quoted companies have apparently managed to significantly reduce their pension fund deficits in recent times.

CRH, Ireland's largest industrial company, showed a €300m deficit in pension fund when it published its half-year results last month -- a reduction of €257m on the same period last year.

So how was CRH able to almost halve the hole in its pension fund? Improved market conditions certainly helped, with the gross value of its pension fund assets increasing by almost 10pc to €1.86bn.

Even more significant was the €177m reduction in the fund's gross liabilities, which fell by over 9pc to €2.24bn.

How did this happen? When actuaries are calculating the value of a pension scheme's future liabilities, among the key implements in their toolkit are discount rates.

Although these can be fiendishly complex in practice, the underlying theory is quite simple. This is that a euro today is worth more than a euro tomorrow.

How much more? That's where things start getting complicated. If current interest rates are high and the actuary expects them to stay high, then the present value of future liabilities will be less than if interest rates are low.

High interest rates thus allow the actuary to discount the present value of future liabilities by a greater percentage than would be the case if interest rates were low.

Over the past year, CRH has increased the discount rate it uses to value future pension liabilities by as much as 0.45pc.

While that might not seem like much, when you are dealing with a fund that has gross assets of almost €1.9bn and seeking to value liabilities stretching out over the next 60 years or more, the numbers soon add up.

CRH isn't the only Irish-quoted company to have tweaked its discount rate. Kerry Group, whose pension fund deficit apparently fell by almost 40pc to €130m over the past 12 months, has also increased its discount rate, a move that knocked almost €25m off the present value of its future pension liabilities.

Higher discount rates have been similarly kind to Glanbia whose pension fund deficit has been reduced by almost three quarters to €29m over the past year.

Interest rates

With interest rates now set to fall, can these higher discount rates still be justified? Throw in the poor performance of equity markets since mid-year and how many Irish-quoted companies that reported lower pension fund deficits at the half-way stage will be forced to perform a U-turn when they announce their full-year results?

It may be little consolation to Ireland's quoted companies but pension deficits are if anything even worse in the semi-state sector.

Last year, the ESB agreed to pump €329m into its pension fund. Yet despite this massive cash injection there was still a €567m hole in the ESB pension fund at the end of last year.

Other semi-states also have huge pension fund deficits, including An Post with €368m and CIE with €348m.

Add it all up and, when one includes the DAA's share of the IASS deficit, it can be seen that the principal "commercial" semi-states have a combined pension fund deficit of well over €1.3bn.

For most Irish companies, large and small, with defined-benefit pension schemes the reality is that no amount of smoke and mirrors with discount rates is going to solve the problem of pension fund deficits.

The future for most companies and their workers is going to be one of increased contributions, later retirement and reduced pensions when they do eventually retire.

One casualty of the Irish pension crisis is likely to be the old-fashioned defined-benefit (DB) scheme, where companies guaranteed the pensions paid to their workers when they retired.

Reduced investment returns, longer life expectancies and more stringent funding standards are gradually forcing companies to close their DB schemes to new members or, in some cases, shut them down entirely.

Pensions Board

According to the Pensions Board 2010 annual report, 1,108 DB pension schemes were notified to it last year. Between them these schemes had 550,000 members.

While that might seem like a large number of schemes and members, the reality is that the number of defined-benefit schemes fell by almost 200 last year while the number of people who were members of such schemes dropped by 36,000 to 550,000.

As they rapidly become an unsupportable liability, more and more companies are closing their DB schemes to new members. Among the major Irish companies to have done so in recent years are NIB, Aer Lingus and Bank of Ireland. Other companies such as Readymix have gone even further and shut down their DB pension schemes entirely.

Employers are being forced to ditch their DB schemes by a combination of longer life expectancy, poor investment returns and tougher enforcement by the Pensions Board.

The average life expectancy for an Irish male was 76.8 years in 2006 -- an increase of almost six years since 2006; while female life expectancy rose from 76.7 to 81.6 years over the same period.

With half of all baby girls being born now expected to live until at least their 80th birthday life expectancy is going to keep on rising.

This increase in life expectancy coincides with a catastrophic fall in investment returns. The average Irish-managed pension fund has delivered an average annual investment return of just 0.9pc, less than the rate of inflation, over the past decade.

If it weren't for the tax advantages it is difficult to see how either companies or their workers could be persuaded to contribute to pension schemes.

Add to this tough enforcement by the Pensions Board, with two directors of a Wexford building firm being jailed for pension offences this week and hundreds of more prosecutions in the pipeline, and the alacrity with which companies are shutting their DB schemes isn't difficult to understand.

With an estimated 80pc of existing schemes now closed to new members, the defined-benefit pension scheme is well on its way to extinction. In the years to come, workers will have to take their chances with much riskier defined-contribution pension schemes, where they rather than their employer bears the investment risk.

Hundreds of thousands of workers retiring in coming decades are facing into a very uncertain old age.

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