Two factors are prompting UK companies to consider replacing their defined benefit (DB) plans with defined contribution (DC) pension schemes – cost and risk.
Moving to a DC scheme can reduce employers’ costs. More important, it can shift market risk (the risk that pension fund investments will go up or down in value) from employers to employees.
However, an alternative to a move from DB to DC is emerging. Employers can retain their DB schemes and still reduce cost and risk. The UK chemist chain Boots has shown the way by moving the entire equity holdings in its £2.3bn (e3.7bn) DB scheme into bonds. Boots says this was done primarily to reduce the risk of unmatched liabilities. However, it will also reduce costs by saving on active management fees.
This poses the question of whether such an investment strategy could slow the adoption of DC schemes by UK employers (because switching to bonds can cut costs and reduce risk) or whether the case for DC schemes can be made irrespective of investment decisions.
Four out of five UK companies still operate DB schemes, but the number of corporate DC plans is growing. A survey by Lane Clark and Peacock showed that a third of FTSE 100 companies now offer DC schemes.
These are likely to be schemes provided for new employees. BT, for example, has established a DC scheme for all employees recruited after 1 April 2001. Other companies are following suit.
The cost argument is compelling. A typical DB plan can account for up to 15% of total payroll. An analysis of FTSE 100 companies by Deutsche Bank published in September showed that Land Securities’ pension fund represented 14.7% of total wages, Marks & Spencer’s pension fund 14% and British American Tobacco’s 11.4%.
Companies can save money by switching to a DC scheme. A survey of smaller companies by the Association of Consulting Actuaries suggests that employer contributions to DC plans are typically 3% lower than those in DB plans.
Companies have a further incentive to switch to DC schemes with the introduction FRS17, the new accounting regulation that will require companies to recognise on their balance sheets the true costs of funding final salary pension schemes. FRS 17 also requires pension funds to record assets at the current market price, and the liabilities must be valued according to the bond yield on AA rated corporate bonds.
This will particularly affect pension schemes with large equity allocations. Several UK company pension schemes – including Reuters, Vodafone and Shell – have more than 80% of their funds invested in shares.
Merrill Lynch has identified a number of UK companies that have equity holdings in their pension funds that dwarf their market capitalisation. The pension fund of Corus – the company formed by the merger of British Steel and the Dutch firm Hoogovens – has a £5.9bn equity fund that is 347% of the company’s market capitalisation of £1.70bn. Marconi’s pension scheme has a £3bn equity fund that is 337% of the parent company’s market capitalisation of £890m.
FRS 17 will also end the practice of companies taking contribution holidays on the strength of their pension fund surpluses. The Deutsche Asset Management survey shows that several large companies report large negative pension costs. These include Lattice Group, where costs are –15.2%, BG Group with costs of –10.3%, Lloyds TSB Group with costs of –5.6%, Rio Tinto –4.6% and Allied Domecq –3.4%.
However, even if companies do start to contribute, the profit and loss cost could still be much less than it would be in a DC scheme, since it is spread over the life of the benefit. If companies decide to move over to DC schemes, the pension fund cost will be taken in total immediately.
Companies are more likely to retain their DB schemes for existing employees and introduce DC schemes for new employees. The £2.3bn Boots pension scheme has set up a DC scheme for new employees to reduce the volatility of pension costs.
Boots has transitioned its portfolio into bonds to reduce its financial risk by matching pension assets and liabilities. John Watson, chairman of the trustees of the Boots pension plan, says, “Holding equities creates the risk of a deficit which would have to be met by increased company contributions. The matched bonds move closely in line with the value of pension liabilities, drastically reducing the risk of a deficit.”
The Boots DB scheme had no pressing need to switch in to bonds. It has a surplus of £130m and a funding level of 138% against the legal minimum funding requirement (MFR). However, the switch will reduce costs. Management charges and dealing costs for the largely equity fund are about 0.5% or £10m a year. The switch will reduce this to £250,000.
Bob Semple, a member of the equity research team at Deutsche Bank, says that the Boots move demonstrates that companies do not need to move out of final salary schemes into defined contribution schemes to minimise the effects of volatility on their pension fund portfolio.
“Before Boots made its move, the easiest way for a company to reduce the impact of volatility on its pension fund portfolio was to switch into a defined contribution scheme. What is interesting about the Boots move is that they are making it while staying within a defined benefit scheme.”
Semple says Boots is giving a spin to a wheel that was already turning and that the shift into bonds has been happening for some time. The UK’s soon to be scrapped MFR has also had the effect of reducing the risk profile of pension fund portfolios. Equity exposure in UK pension funds fell from 80% to 70% over the past decade as a result of MFR.
“What Boots has done is focus attention on bonds,” Semple says “Had they moved part of their portfolio into bonds it would not have had the impact. But when they moved all of it people began to ask ‘am I missing a trick here?’
Whether a move from equities to bonds will slow the move to DC schemes, however, is debatable. Ralph Turner, group pensions manager of the EMAP pensions fund, doubts whether the option to switch into bonds will influence companies decision to switch from DB to DC schemes. “The decision to introduce a defined contribution scheme should be unaffected by investments decisions,” he says, “This decision is based on whether a defined benefit or defined contribution scheme is more suitable. This will depend on factors like costs and how long members are going to remain in the scheme.
“Investment should be a strategic decision that should be behind the scheme,” he adds. “I don’t think investment choice should drive the choice of pension scheme.”
Turner also doubts whether other companies will follow the example of Boots. “The switch to bonds is against the perceived wisdom of pension funds, but being such a large company it will cause other companies to take another look at the strategy. Personally I wouldn’t see a big movement in that direction.”
However, John Shuttleworth, partner at PricewaterhouseCoopers, says that Boots has produced a win/win solution to the problem of corporate pension provision. “Its employees’ pensions are more secure, and its shareholders’ risk has been reduced,” he says.

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