FTSE 350 pensions: A year of transformation

VIEW DB END GAUGE ANALYSIS

FTSE 350 pensions - a transformational year

The last year has seen a fundamental change in the funding of the UK's defined benefit (DB) pension schemes. After over a decade of historically low bond yields and seemingly relentless demands for contributions from sponsoring companies to plug pension deficits, the material increase in bond yields has transformed the DB pension landscape.

Lewys Curteis

Principal and Senior Consultant - Corporate Actuary

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As companies deal with the challenges of inflationary cost pressures, tight labour markets and continued economic uncertainty, the improvement in DB funding levels provides a unique opportunity to reduce pension risk. For those targeting the removal of pension risk, the gap to buyout funding may have reduced to cheque-writing distance, or even disappeared completely. But in an extremely busy bulk annuity market, it will no longer be sufficient just to have the required level of funding – preparedness is key.

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Introduction

DB End Gauge

Funding

Materiality

Buyout

Strategy

Endgame

Authors

In this analysis of the DB pension schemes of the FTSE 350 companies, we examine how the recent economic changes have impacted the progress to endgame for the FTSE 350 DB schemes, highlighting some of the key trends and issues for companies and trustees to consider.

Our DB End Gauge index provides a measure of the average time to buyout for the FTSE 350 DB pension schemes. This chart shows the sharp fall in the average time to buyout for these schemes since the start of 2022.

Index recalibrated to reflect updated FTSE 350 DB scheme data

At the end of May 2023, we estimate that the average time to buyout for the FTSE 350 DB pension schemes was around five years - a reduction of over three years compared to the equivalent position in May 2022, and around half of the index's value at the start of 2022. The dramatic increase in bond yields is the main reason for the fall in the index, as shown in the chart below.

Long-term government bond yields increased by around 2% p.a. over the last twelve months, reducing DB liability values by around 30% on average. While short-term price inflation has been very high in the UK - resulting in large increases for inflation-linked DB pensions - the overall impact on DB liability values has not been as marked as one might expect. This is because long-term inflation expectations have remained relatively stable, and in fact have fallen slightly over the last twelve months. Overall, these financial market changes mean that the average UK DB pension scheme is now in a far stronger position than it has been for some time.

Despite the overall positive picture, the average view does disguise a degree of variation in individual schemes’ experience over the past year. While we estimate that financial market changes have improved the average FTSE 350 DB scheme’s buyout funding level by around 10% over the last year, not all schemes will have experienced the same improvement. A scheme’s investment strategy prior to the increase in bond yields, as well as its experience dealing with the LDI challenges brought on by the September 2022 “mini budget”, will have determined the degree to which they benefited from the changing economic environment. Schemes with high levels of interest rate hedging may have seen little change in funding position over the last year, and even a reversal in some cases. The chart below shows the distribution of the estimated change in buyout funding levels for the FTSE 350 DB schemes over the year to 31 May 2023.

Tracking the improvement in funding levels

Funding improvements - a varied picture

This chart clearly shows that the majority of schemes experienced a material improvement in funding positions over the year, but there is a reasonable subset of schemes where the funding level remained fairly similar, or even worsened. Our calculations suggest that for around 12% of the FTSE 350 DB schemes, the buyout funding position remained unchanged or worsened over the year. For a further 16% of schemes, the buyout funding position improved by less than 5%.

One of the repercussions of the financial market changes is that DB schemes have reduced in materiality, both in terms of the exposure for sponsors and in terms of their significance in the UK economy. The chart on the right shows our estimate of the aggregate value of the FTSE 350 DB scheme assets and buyout liabilities at 31 May 2022 and 31 May 2023.

Reducing materiality of DB schemes

This shows that the value of FTSE 350 DB scheme assets and buyout liabilities have fallen by around £160bn and £250bn respectively. Not only does this illustrate the significant improvement in funding levels, it also shows the reduction in the materiality of DB schemes in the UK. For sponsoring companies, the fall in the absolute value of DB scheme assets and liabilities has lessened the burden of DB scheme funding. Even for the 12% of FTSE 350 schemes where the buyout funding level remained unchanged or worsened over the year, the majority saw a reduction in the absolute value of the buyout deficit. This provides companies with a unique opportunity to revisit their scheme’s funding and investment strategies. The same cash contributions being paid a year ago will now have greater purchasing power, whether this is to reduce scheme deficits or support further de-risking activity.

The demand for bulk annuity transactions is at an all-time high following the material improvement in funding positions over the last year. A number of FTSE 350 companies completed bulk annuity transactions during 2022, including Beazley, Smiths Group, Mondi, Hammerson, Ibstock, British American Tobacco and IMI. Unsurprisingly, our analysis shows that demand for bulk annuity transactions from the FTSE 350 DB schemes will only increase over the coming years. The chart to the right shows our estimate of the expected time to buyout for the FTSE 350 DB schemes at 31 May 2023, compared to the position at 31 May 2022. This assumes that the contributions currently being paid by companies continue until buyout funding is reached.

We estimate that around one third of FTSE 350 DB schemes were fully funded on a buyout basis at 31 May 2023. This compares to around 11% of schemes at 31 May 2022. The FTSE 350 DB schemes estimated to be fully funded on a buyout basis represent liability values of around £160bn. The bulk annuity market is not yet close to writing this level of business in a single year (the record year to date is around £45bn, written at a time of low bond yields), so it will not be practical for all of these schemes to secure a bulk annuity contract in the immediate future.

Another important point is that buyout affordability does not necessarily mean buyout readiness. A significant amount of preparatory work is required prior to any insurance transaction, meaning that a transaction may still be some distance away for many of these fully-funded schemes (particularly those where achieving full funding on a buyout basis has been something of a surprise). In a busy market, schemes that can demonstrate their buyout readiness will be at a significant advantage. It is worth pointing out that for a number of FTSE 350 DB schemes, particularly the larger schemes, buyout may not be the overall objective, with a risk-controlled run-off of liabilities deemed to be a better option.

The battle to buyout

This analysis shows that when considered in aggregate, schemes that are estimated to be over 100% funded on the buyout basis have less well-matched investment strategies than those that are yet to reach the buyout target. This is likely to be a feature of the characteristics of the schemes that experienced the greatest funding level gains over the last year, i.e. those that had lower levels of liability hedging. Due to the timing of the collection of the FTSE 350 company data, it is likely that many of these schemes have now taken action to de-risk their investment strategies, but where this is not the case companies and trustees should be taking action to future proof their current strong positions.

Irrespective of the ultimate objective, all schemes should be considering the appropriateness of their investment strategies following the recent financial market changes. For the cohort of schemes that have experienced an improvement in funding levels, reviewing the options for locking-in these funding gains should be an urgent priority.

As an example of this, we would typically expect to see a difference between the asset allocations of schemes at different buyout funding levels, with those closer to buyout funding running less investment risk and better matching insurance pricing. The chart below shows the average investment allocation for the FTSE 350 DB schemes, varying by buyout funding level.

Investment strategy review

Higher yields and shrinking deficits have presented sponsoring employers with a unique opportunity to reduce pension risk, and in some cases remove this risk entirely. All companies and trustees should be working to understand the impact of the changes in financial markets on their scheme’s funding position, and the implications this has for achieving their long-term objective. In many cases, the scheme’s funding and investment strategy will need to be altered to reflect the changed economic environment.

For those schemes that are approaching or have reached full funding on a buyout basis, understanding the actions required and the expected timescales for achieving a transaction should be top of the agenda. Given the significant demand for bulk annuity transactions, insurers can currently cherry-pick the most appealing deals to pursue. Preparedness is therefore crucial - engaging with an adviser that has a detailed understanding of the bulk annuity market and the trust of insurers will be invaluable. Please get in touch with our risk transfer team for further details.

Endgame planning

The data used for this analysis has been collected from the accounts of FTSE 350 companies for their 2022 year ends (i.e. up to and including the year ending 31 December 2022). Liability values on a buyout basis have been estimated by approximately updating these results and using Barnett Waddingham’s view of average buyout pricing. Asset values have been estimated using index returns and the asset split disclosed in the pension disclosures. The current level of deficit contributions have been estimated based on information set out in the pension disclosures.

11.0 10.0 9.0 8.0 7.0 6.0 5.0 4.0

31 Jan 2022

28 Feb 2022

31 Mar 2022

30 Apr 2022

31 May 2022

30 Jun 2022

31 Jul 2022

31 Aug 2022

30 Sep 2022

31 Oct 2022

30 Nov 2022

31 Dec 2022

31 Jan 2023

28 Feb 2023

31 Mar 2023

30 Apr 2023

31 May 2023

7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0%

31 Dec 2021

30 June 2022

31 Dec 2022

31 May 2023

Bank of England Gilt Implied Inflation (annual) (18 years)

ML Nominal AA Corporate Spot - annual yield curve (18 years)

Bank of England Nominal Spot Curve (annual) (18 years)

25% 20% 15% 10% 5% 0%

< -10%

-10% to -5%

-5% to 0%

0% to 5%

5% to 10%

10% to 15%

15% to 20%

20% to 25%

> 25%

Proportion of schemes

Change in estimated solvency funding level

900 800 700 600 500 400 300 200 100 0

31 May 2022

31 May 2023

Assets (£bn)

Buyout liabilities (£bn)

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

31 May 2022

31 May 2023

Fully funded

Less than 5 yrs

5 to 10 yrs

10 to 15 yrs

Over 15 yrs

Under 90% funded Over 90% funded Over 100% funded

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Protection

Growth

Calculation details

SECTION 01: INTRODUCTION

SECTION 02: DB END GAUGE

SECTION 03: FUNDING

SECTION 04: MATERIALITY

SECTION 05: BUYOUT

SECTION 06: STRATEGY

SECTION 07: ENDGAME

Professional use only. This report is intended for information purposes only and should not be construed as regulated investment advice. Please discuss the particular circumstances of your scheme with your local Barnett Waddingham consultant.