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Article:

DB Pension Provision in the Charity Sector

25 May 2018

Should we be worried about the state of defined benefit pension provision in the charity sector? We take a look at the changes over the last two years.

The aggregate balance sheet deficit of the Top 50 charities(1) is £1.5bn, having increased from £1.2bn two years ago (and £0.9bn four years ago).

On a positive note, pension scheme assets have done well, supported by strong equity markets (the FTSE All Share index is up 17% over the two-year period to 31 March 2017, the most common year-end date in the data set) and rising bond values. In aggregate, assets increased from £5.9bn to £7.7bn (i.e. a 31% increase, including additional contributions received in the period). Unfortunately, pension scheme liabilities increased by 31% over the same period (£7.1bn to £9.2bn), and there appears to be two principal reasons for this: reduced discount rates, and increased inflation expectations.

Liabilities have increased by over 20% in 2 years

For accounting purposes, pension liabilities are determined by discounting members’ benefits at a rate based on yields available from high quality corporate bonds. Corporate bond yields have fallen over the last two years, with the average discount rate adopted by the Top 50 charities being 2.6% p.a., compared to 3.4% p.a. two years earlier; an 80 basis point reduction.

The majority of pension benefits increase in line with some measure of inflation. Long-term inflationary expectations have risen over the last two years, increasing pension liabilities. The average RPI inflation assumption adopted by charities in our analysis was 3.3% p.a., compared to 3.1% p.a. two years earlier; a 20 bps increase.

Compounded over a 20 year period (a reasonable pension scheme duration), the changes that we have seen to discount rates and inflation assumptions, could have increased the liabilities by over 20%.   

The pension liabilities recorded on a charity’s balance sheet do not reflect the ‘true cost’ of its pension obligations (as contrasted to the Scheme Specific Funding basis - which determines the actual cash costs; or an insurance company buyout basis - which determines the cost of removing the pension obligations from the balance sheet).

Charities, and other UK employers, are not required to publicly disclose their pension scheme deficits on either a Scheme Specific Funding or a buyout basis, although in our experience, there has been an improvement in pension scheme disclosures in relation to the Scheme Specific Funding position and the annual payments which have been agreed to fund any deficit. DEFICITS

Top 50 charities’ deficit contributions rise 33%

In all, the Top 50 charities contributed a total of £168m in contributions in their most recently reported financial year. This compares to £165m two years ago – barely any change. However, we estimate that around £108m of these contributions were in relation to deficit payments compared to ‘only’ £81m two years ago – a 33% increase. Therefore, a larger proportion of the total cash cost was used to fund historic deficits, and not in remunerating existing employees.

Despite the rise in deficit payments, deficits have still risen. Could, and should, charities be paying more? Alternatively, are they better using their cash to ensure that the charity itself is in the best possible financial position?

Unrestricted income increased by 20%

The total unrestricted income of the Top 50 charities with defined benefit pension schemes rose from £6.9bn to £8.3bn (20% increase) over the past two years. Total restricted income rose more significantly, from £1.6bn to £2.9bn (78% increase) in the last two years. It is possible that in some cases major charity donors are becoming more savvy with their donations, alive to the risk that their donations could be used to pay pension deficits if they do not restrict its use. Equally, charities may be alive to the same accusation in their own fundraising approaches, and so deliberately restrict their appeal.

Over the last two years, the total unrestricted funds(2) of the Top 50 charities have grown from £3.8bn to £6.3bn. One contributing factor may be the strong equity (and bond) markets; improving returns on charities’ investment portfolios, in the same way that pension scheme assets have also increased. If this is true, then the Top 50 charities appear to be exposed to the risk that the performance of their investment portfolio is positively correlated to the performance of their pension scheme’s funding position i.e. a weakening balance sheet would occur at the same time as a deterioration in the pension scheme’s funding position, which is a worst case scenario for both the pension scheme and the charity. This should be addressed by charities (and the pension scheme trustees) through an “integrated risk management” process, and if necessary, include an explicit recognition of the pension scheme investment strategy in the charity’s investment policies, in order to potentially include some level of hedge against this worst case scenario.

Cost of insuring the pension liabilities is estimated to be £5bn

We estimate that on a buyout basis, the total deficits of the Top 50 charities could be around £5bn, compared to £6bn two years ago. Our estimate of the reduction in the buyout deficit is based on anecdotal evidence of improved pricing in the pension buyout market. Still, even with this reduced buyout deficit, and the improvement in underpinning assets (unrestricted funds), we do not envisage swathes of charities rushing to use their unrestricted funds to buyout their pension schemes just yet!

Pension cost affordability and the need for good governance

On the face of it, as incomes are up, charities may be able to afford to contribute more to managing their pension liabilities. As our analysis considers only the highest 50 income generating charities, they may be in a better position than many others to service their pension obligations. Failure for these charities, or an inability to increase pension contributions, may be more remote. For other charities, the same conclusion may not be able to be drawn.IC PERCEPTIONS

A number of high profile cases of corporate failure, with suggestions of poor pension scheme management and insufficient regulatory intervention have made headlines recently. Although these have fallen outside of the charity sector, public awareness and government sensitivity to the protection of pension benefits has increased.

Charities may need to consider not only heightened public interest in seeing strong pension scheme governance with benefits adequately protected, but also, the possible impact that perceived poor governance could have on their future incomes.

Would you donate to a charity if you thought that it had not managed its pension scheme well? Would you donate to that same charity if you thought that a large part of your donation would be used to fund a legacy pension deficit, rather than fulfilling a charitable cause?

There is a trade-off for a charity in balancing the need to maintain a financially sound organisation (the ‘employer covenant’ in pension language), funding charitable objectives, and paying down any pension deficit.

Good governance consists of far more than increased deficit payments. Indeed, ensuring that the sponsoring charity has as strong and stable an employer covenant as possible is arguably more important than the short-term funding position of the pension scheme. Increases in both unrestricted incomes and unrestricted funds over the past two years suggest that the Top 50 charities appear to be doing a good job in managing their employer covenants. This conclusion may not be true for other, smaller, charities.

As with most things in life, it is always worth asking yourself, could you be doing more? If the music stopped, how might your actions be judged in the court of public opinion?  

 (1) by average total income over the last three years up to and including 31 March 2017

(2) excluding the Wellcome Trust, an outlier whose unrestricted funds are larger than all of the other Top 50 charities’ unrestricted funds combined