BT GROUP PLC
Pension teach-in
27 November 2013
Company speakers:
Alex Pike
Paul Rogers
Glyn Parry
Mike Smedley
Investor Relations
Head of Pensions Risk
Director Group Financial Control
Pensions Partner, KPMG
Alex Pike
Slide 1: Thank you very much for coming along today all of you and also for those of you on the
phone today. For those of you that haven't been to one of these before this is a series of regular
teach-ins that we do. They are designed to be educational as much as anything else and not to
give any new financial information.
Today of course we are looking at the pension. So we have 3 people that are going to be talking
to you. Glyn Parry is the Director of Group Financial Control and he leads on interacting with the
BT Pension Scheme Trustee on behalf of the BT Pensions Committee.
To the right over there is Paul Rogers who is an actuary working for BT. He supports Glyn on his
interactions with the Trustee.
Finally on the left there we have Mike Smedley who is a Pensions Partner at KPMG. He isn’t
involved directly with anything to do with the BT Pension Scheme so he is here to give an external
perspective on the key themes in the pension industry.
Slide 2: If we just have a quick look at the agenda. Paul is going to start by looking at the overview
of the UK schemes and the various ways in which we value them. Glyn will then give you an
overview of pensions accounting under IAS 19. Finally we will take a deeper look at the actuarial
valuation first with Mike giving a view of the external landscape and then with Glyn giving BT’s
position. That should all take about an hour. If you could hold any questions to the end that would
be great. We will have a Q&A session and Mike, Glyn and Paul will be more than happy to take
questions then.
We should wrap up shortly before 3pm I would have thought. With that I will hand over to Paul.
Paul Rogers
Slide 3: Thanks Alex, and good afternoon everyone.
Slide 4: I am going to start with an introduction showing our two main UK pension schemes. The
first is the BT Pension Scheme, or BTPS, and that is a defined benefit scheme which means
member benefit is calculated looking at a predetermined formula. The benefit terms are defined
and the contributions required for those benefits are uncertain. The eventual cost will depend on a
number of factors such as investment returns, how long members will live, and therefore the
investment and other risks are borne by BT and we are focusing on the majority of the session on
the BTPS.
The second scheme is the BT Retirement Saving Scheme, or the BTRSS, and that is a defined
contribution scheme meaning the contributions payable are pre-determined and the eventual
pension a member receives is uncertain depending on factors like investment returns and the rate
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at which they can buy an annuity at retirement. For members, they bear the investment and other
risks which leads to limited financial risk with BT.
New entrants to BT join the BTRSS. The scheme is administered and run by Standard Life with
each member having an individual contract with them.
Slide 5: Now before going into the BTPS in some more detail I will just provide a short overview of
the BTRSS. Now there are currently roughly 25,000 employee members contributing into the
scheme and BT’s contributions depend on the level of contributions made by the employee and
are set out in the table shown on the slide. So for example if a member paid 5% of their
pensionable pay then BT will make a corresponding payment of 8%.
Members can then choose how they invest their contributions from a range of investment fund
options or there is a default fund for those that prefer not to select their own funds. Contributions
get paid into a member’s individual account and they roll up with investment returns and are
subsequently used by the member at retirement to purchase pension benefits.
New entrants enter the BTRSS and this is a vehicle used to meet the government’s new auto
enrolment requirements. We have complied with those requirements and rules since they applied
for us on 1 November 2012 when we were one of the first employers in the UK to be compliant.
Slide 6: So I’ll now move to focusing on the BTPS on the next slide. There are three main
sections to the BTPS titled (a) (b) and (c). The section that a member is in will depend on when
they joined the scheme and that is shown on the slide. Membership numbers are shown on the
table at the bottom. One point to note here on the table is we group section (a) and (b) together
on the slide and also in our annual disclosures and that’s because section (a) members have the
option to elect section (b) benefits before retirement and it's usually more beneficial for them to do
so, so most members do convert to the section (b) terms. There are also less than 1,000 active
section (a) members; the majority have now retired.
In terms of numbers as of 31 March 2013 roughly 60% of the membership was pensioners. 25%
were deferred members and by deferred member I am referring to former BT employees that are
no longer earning benefits but have not yet retired. Then we have 15% that are active employee
members. Liabilities are broadly split: 80% for sections (a) and (b) and 20% for section (c) using
the IAS 19 basis.
Slide 7: This slide is giving an outline of the benefits that we provide in the BTPS and I will spare
you the finer details of exactly how all the scheme benefits are calculated and for those interested
there are member booklets on the Trustee’s websites that give you more details on the sections
and the benefit formulas if you need them.
So what we have concentrated on doing on this slide is show how the benefits increase from a
financial perspective. So taking the first column of the table showing active members. We
amended benefits in the BTPS in April 2009. When the changes were made the formula for
benefits earned before that date was unchanged with the new formula used to calculate benefits
for service after that date. For service before April 2009 the benefit formula is based on a
member’s salary at or close to retirement, referred to as the final salary benefit, and for service
after April 2009 the benefit formula uses a career average approach.
So here benefits at retirement are based on a member’s average salary rather than the salary at
retirement. In the BTPS, salaries from earlier years are indexed up each year by the lower of RPI
and the member’s actual salary growth.
Now to meet the cost of these active member benefits being earned BT and the employee pay a
combined rate of 13.5% of pensionable pay and that will be next reviewed at the June 2014
valuation.
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Moving onto the second column showing deferred members. Once a member leaves the scheme,
their benefits are fixed at that point and those benefits are then increased up to a member’s
retirement broadly in line with CPI inflation. The final column shows the pension increase for
pensioners. Once members retire and benefits are in payment the benefits are increased annually
on 1 April. For section (a) and (b) members the annual increase is based on CPI and for section
(c) the increase is based on RPI with a cap of 5%. Some members have some smaller statutory
and other elements of their pension that don't increase but the majority of benefits are inflation
linked.
Slide 8: In terms of governance for the scheme. In BT we have a Board sub Committee chaired by
Patricia Hewitt which is responsible for overseeing the relationship with the Trustee of the BTPS.
The Committee also considers pension policy and strategy for the group. It covers investment
strategy and performance in the BTPS as well as reviewing and making a recommendation to our
board on the actuarial valuation.
It also reviews and approves our risk management activities relating to pensions. For example,
this year we launched a pension increase exercise which offered pensioners the option to give up
inflationary increases on part of their pension and receive an initially higher amount. This exercise
was about giving members additional flexibility and choice but also providing increased certainty to
the scheme and BT on future pension payment amounts.
Slide 9: Governance on the Trustee side. The scheme itself is run and managed by an
independent Trustee body. There are 9 Trustee directors appointed by BT. 4 of which are
nominated by the trade unions and they are required by legislation to operate the scheme in
accordance with the trust deed and rules and to act in the best interests of the scheme’s
beneficiaries. The day-to-day operations of the pension scheme are managed by the Trustee’s
executive arm and the BT Pension Scheme management.
In common with other UK pension schemes, investment policies are set by the Trustee, the
Trustee is required to consult with the company before making any changes on the investment
strategy and we have a good two way dialogue with the Trustees in that area and BT regularly
attends meetings with the Trustee’s investment committee.
So when investing in these assets the Trustees use a range of fund managers across different
asset classes. Including Hermes which is a fund manager owned by the Trustee. The annual
report published by the Trustee is on their website and again contains further information on
governance, the assets, performance and experience over the year. The scheme’s year end has
been amended to 30 June and that will bring it in line with the valuation date of the scheme and
that next set of accounts is expected to be issued later this year.
Slide 10: I am now going to move onto discussing the assets and liabilities of the scheme starting
with assets. As of 30 September 2013 the scheme assets totalled £39.3 million and the charts on
the slide are showing the move in the target asset allocation over the last 10 years. There are a
few points that I want to draw out from the charts: the reduction that can be seen in the level of
equity allocation that has reduced the equity component in the scheme from 63% down to 29%.
Correspondingly there has been an increase in diversification across the portfolio so there is now
a more balanced portfolio that isn’t overly reliant on returns from any one particular asset class.
There is also an increased allocation to inflation linked assets that you can see up from 9% to
31% which is reflecting the nature of the scheme’s inflation linked liabilities.
The discount rate for the pension scheme is driven by that asset strategy and the actuarial
funding assumptions to allow for that asset mix to gradually move towards lower risk assets over
time.
I will just give you a little bit more detail on the asset classes. The equities is a diversified mix
across equities from around the world and around 75% of these are held in overseas equities. The
fixed interest portion holds both government and corporate debt again in the UK and overseas.
The inflation linked section is similar again and it is also invested in government and corporate
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debt and it also has an allocation within that bucket to infrastructure assets. The property section
is again diversified across countries but is typically mainly invested in the UK and the other assets
categories include some other allocations including hedge funds, commodities and high yielding
and emerging market debt.
Slide 11: So looking at returns, the table on the slide shows the Trustee’s expected returns on the
different asset classes and that leads to an average expected return of 2.5% above RPI as of 31
December 2012. So as shown below the actual returns have exceeded that level in recent years
with a 7.5% return in the year to 2012, 4.4% above RPI, and over a longer 10 year period returns
have been 8.3%, so 5% above RPI.
Slide 12: Now moving to liabilities. Before I come onto the different valuation approaches I just
wanted to give a quick explanation of how the actuaries will approach valuations and essentially
this is looked at in two parts. Firstly there will be a calculation of the value of the past service
liabilities and this is looking at how much money is needed to provide the benefits promised based
on service up to the valuation date. It uses a discounted cash flow approach in calculating those
liabilities. That figure for the liabilities is then compared across to the assets to determine whether
there is a surplus or deficit in the scheme. Secondly there is a separate calculation of the liability
for future service benefits. This looks at the cost of the new benefits being earned and leads to
the regular cash contribution amounts. Or for example determines the service costs under IAS 19.
Slide 13: In terms of looking at those past service liabilities in more detail. The discounted cash
flow approach will make a projection of the expected pension payments under the scheme for
each year into the future. That is shown in the chart which shows the expected benefit outgoing
for each year for the BTPS. What you can see is the benefit payments will increase up in the early
years as members are retiring from the scheme before tailing off over a period and stretching out
to around 80 years from now. In order to calculate those cash flows the actuaries will need to
make a number of assumptions such as when members will retire, how long people will live and
future inflation which affects how pensions will increase in the future.
That will all be played back into the present value using a discount rate and that is one of the key
assumptions in determining the liabilities. The chart is shown using the IAS 19 assumptions of our
last year end when the present value of the liabilities was £47 billion.
Slide 14: So this is a slide we showed at our half year results presentation outlining the three main
approaches that we focus on and I will just spend a little bit more time on this now. The first
column shows the IAS 19 valuation which is a prescribed measure that we are required to
disclose every quarter. The second column is our median estimate which is taking out any prudent
margins and that is our best estimate of the underlying financial positions. The third column is the
actuarial valuation which we carry out every 3 years and used to set cash contributions.
Moving on to IAS 19 and firstly the discount rate. The Accounting Standards require that the
discount rate is based on high quality corporate bond yields for the appropriate duration for the
liabilities. So for this we use a AA yield curve produced by our actuaries and the cash flow in each
year as set out on the previous slide is then discounted at the relevant rate from the yield curve.
So that allows accurately for the duration of the liabilities. The discount rate is then expressed as
a weighted average of those rates. So projecting liabilities and changes in liabilities from one date
to another using the movement in an index yield such as the iBoxx might not always given an
accurate result for example if you have a change in the shape of the yield curve over the period
you can have a greater or lesser move than there has been in the index.
For RPI inflation we look at different market indicators including the Bank of England data on
implied inflation when setting out that function. For CPI inflation if there is no relevant market
indicator for that we assess the long term expected difference between RPI and CPI and we look
at differences in how those two indexes are constructed for coming up with the difference.
Demographic assumptions such as life expectancy are typically reviewed following each actuarial
valuation.
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Moving onto the middle column the median. This is stripping out, as I said, the margins of
prudence and determining what we believe are the most realistic assumptions for the future.
Therefore the discount rates allowing for our expectations of returns for the current investment
strategy but also how we expect it to develop over time. And, as I said, it’s assumed both in the
funding and median valuation that the scheme will continue to move to lower risk assets over time.
On funding, the assumptions have to be agreed between BT and the Trustee. As required by
legislation they have to be prudent overall and in particular the discount rate is set based on a
prudent view of expected future returns. All those methodologies use the market value of assets.
Slide 15: The next slide is again based on a slide we showed you in our half year results and the
grey line is showing the movement in the IAS 19 deficit over recent periods which has been
volatile and we have also added the green line on the chart which is showing the real discount
rates and that is the discount rate above RPI inflation in this case on the right hand scale. What
you can see is that the deficit moves are influenced by the real discount rates and clearly the
other factor driving the deficit figure is the asset value. The other point that I will draw out from the
chart is the fairly substantial fall in discount rates over the period of around 2.5% - starting at
around 3.5% at the start of the period and falling to around 1% more recently.
Slide 16: This chart is just bringing together all the three measures that we look at. The pink
circles are median estimates. The green circles are showing the last two funding valuation deficits
and the difference between those funding and median measures represent our view on the
prudence incorporated at that time. A couple of points just to pull out from the chart. We
commented at the half year the median remains in surplus and that stays relatively consistent in
recent periods. Another point to note is that the funding deficit IAS 19 don't move in the same way
and nor would you expect them to given the different approaches, particularly to discount rates.
For example the 2008 funding valuation which is the first outlined box the IAS 19 deficit was just
over £2 billion and the funding deficit was £9 billion. At the 2011 valuation in the second outlined
box the IAS 19 deficit was at a similar level of the 2008 valuation level and the funding deficit had
moved to £4 billion.
So that is it from me and I will now hand you over to Glyn who will take you through the IAS 19
pension accounting in a bit more detail.
Glyn Parry
Slide 17: Thank you Paul. So IAS 19 pension accounting. What you have all been waiting for! I
guess it can be quite complex in terms of accounting because we have different schemes. We
have DB [defined benefit] and DC [defined contribution] schemes and also the impact can be seen
in various elements of our accounts and whether that be income statement, cash flow, balance
sheet, statement of comprehensive income. It touches all those areas. It can be difficult to follow. I
will try and demystify some of that for you.
Slide 18: Starting with the overview. So this shows the last financial year the various elements
from the impact on our accounts. So if you take the first column for defined contribution schemes,
the income statement charge was £136 million and that was also reflected in a cash outflow of
£136 million. As Paul said earlier with all the investment risk lying with the member there no
further balance sheet exposure to the company and hence zero in the balance sheet row.
On defined benefit schemes the operating charge or the service cost (i.e. the cost of that period’s
accrual of benefit under IAS19 assumptions) was £263 million and the net interest or the unwind
of the discount on the deficit was £117 million. So that is what flows through the income
statement. In terms of the balance sheet position at the end of March, net of tax, the deficit was
£4.5 billion and from a cash perspective there were two elements of cash flows. There were the
regular contributions - so Paul referred earlier to the 13.5% of pensionable pay that is set out in
the last funding valuation - that amounted to £217 million and then there were the deficit
contributions set out as part of the recovery plan from the 2011 valuation and that amounted to
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£325 million. So that in a nutshell is a very simple overview. What we are going to do on the
following slide is take each of those areas in a bit more detail for the defined benefit schemes.
Slide 19: So firstly on slide 19. In overview in terms of looking at how one reconciles from the
deficit at the start of the year on the left hand side to the deficit at the end of the year there is a
number of factors to take into account and that flow through there. Firstly on the left hand side you
have got the service costs, annual accrual of benefits earned in the year, the net pension interest the unwind of the discount. Those increase the deficit. Then the next two bars you have got the
cash contributions going in the regular contributions and deficit contributions. Both of which are
reducing the deficit and then on the right hand side you have got the actuarial movement in the
assets and liabilities which can either increase or decrease the deficit depending upon the
conditions. There are two constituent elements of those actuarial movements. Firstly there are
differences between the actual experience in the period versus the assumption at the start of the
year. So for example if investment returns are different to that assumed within the discount rate
then that will give rise to an actuarial gain or loss on the assets and then the second element is
actually as a result of changes in assumptions. So when a discount rate changes or there is a
change in the inflation assumption that will give rise to an actuarial gain or loss. So with that as
background, let's look at the BT position through last year in more detail.
Slide 20: The chart shows from the left hand side the IAS 19 deficit at the start of the year which
was £1.9 billion net of tax £2.4 billion gross of tax. Move across to the right where the closing
deficit at 3 1 March 2013 was £4.5 billion net of tax and £5.9 billion gross of tax. What that chart
shows is that the big driver of the change is all in the actuarial movement. It's those actuarial
gains and losses that gives the volatility that you see in our quarterly IAS 19 numbers. It's not due
to what is going through the income statement or the cash it's the actuarial movements that tends
to drive that volatility. So on the next few slides I am going to break out each of those components
in a bit more detail.
Slide 21: So on slide 21 in terms of the income statement. As I said the service cost or operating
charge, the cost of an additional years benefit, that’s been earned by the active members of the
scheme. The active members are those that are still employed by BT. It also includes within that
the administration costs of the scheme and the levy that is paid across by the scheme to the
pension protection fund. That was £263 million last year. Now when it comes to our disclosure that
included within our staff costs and when you look at our quarterly KPI cost analysis it's within the
staff cost line. The next component, the net interest, that is not a cash item it's a notional item and
it's the unwind of the discount on the deficit. You can broadly estimate what that is by looking at
the opening deficit at the start of the year and applying the discount rate to that deficit. Now there
are small adjustments to that for the known cash flows during the year but that gives you a pretty
good steer as to what the answer is. As you can see, the £2448m being the opening deficit and
4.95% being the discount rate would give you £121m.
Now when it comes to our classification cost in the PNL account we treat that as a specific item
and have always done. So that is the income statement.
Slide 22: Moving on to the cash really the 13.5% of pensionable pay that is the regular
contribution there and that was £217 million. You will see that there is a difference between that
and what we charge through the P&L account as an operating charge. I referred earlier to £263
million as being the operating charge. The reason that there is a difference is because those two
valuation bases use different assumptions and so that drives a different cost, for example the
discount rate will be different. The difference between those two items when you look at our KPIs
you will see in the “Other” category in our normalised free cash flow analysis. Then when it comes
to the deficit contributions that is set out in the triennial funding valuation and so that gets revisited
and reset every 3 years. We exclude that from our definition of normalised free cash flow.
Slide 23: So onto slide 23 where we explode out the actuarial gains and losses. On the asset
side of the equation there were actuarial gains in the year of £2.7 billion. Basically that reflects the
difference between what was actually generated in terms of investment returns versus what was
assumed within the discount rate. So the scheme generated a 12% return in the year to March
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2013 and that compared to the discount rate, which is a double AA corporate yield based discount
rate of 4.95% so clearly there is a considerable degree of outperformance there and you see that
coming through the actuarial gain. This goes directly to reserves through the statement of other
comprehensive income rather than going into our P&L account.
The second element, the pink element, is an actuarial loss on the liabilities. That is made up of a
number of components that I will explode on the next slide.
Slide 24: So on slide 24 you will see the actuarial losses of £6.3 billion. The biggest component of
that of £4.65 billion, is due to the change in the discount rates. So the discount rate changed from
4.95% to 4.2% reflecting the change in the AA corporate bond yield curve. So that 75 basis point
fall gave rise to that increase in the liabilities.
The next component up of £1.45 billion is due to changes in the assumption around future
inflation. So during that period expectations of inflation increase by 25 basis points up to 3.3%.
That 25 basis points change increased the projected liabilities. Then finally at the top of around
£150 million you have the liability experience. This is where member experience has differed from
the assumptions for things such as pay increases, mortality and leavers from the scheme. That is
due to actual behavioural changes or experience changes.
So what this chart really shows is that those actual changes are not generating much of that
actuarial loss. The actuarial loss has been generated through changes in assumptions. The most
significant in that year being the discount rate change. That is not a reflection of what we actually
expect to generate in terms of return from the scheme but merely against the IAS 19 benchmark
of the AA corporate bond yield.
Slide 25: So moving onto slide 25. In term of some of those key assumptions I thought that it
would be useful to summarise some of the sensitivities. So the impact of changes that some of
those assumptions can have on the liabilities of the scheme. So starting with a 25 basis point
increase to the discount rate. That would lead to a reduction in the liabilities of £1.7 billion. On the
inflation side of things, if the assumption for future inflation was to increase by 25 basis points that
would give rise to an increase in the liabilities of £1.5 billion. You will note the those two don't
exactly contra each other out. That is because, as Paul said earlier on, some of the benefit
streams under the scheme are not inflation linked, some of them are fixed. And so that differential
reflects the fact that you have some fixed liabilities that are not therefore impacted by that inflation
assumption.
Then if we look at the assumption around salary increases. To the extent that we assume salary
increases increase by 25 basis points above RPI which is the assumption made in the valuation.
To the extent that they were 25 basis points higher that would give rise to 0.3 billion increase to
the liabilities. Then finally on the slide in terms of mortality, if we were to assume that people lived
for a year longer than we have assumed in the valuation, then that would generate an increase in
the liabilities of 0.9 billion. The actual detailed assumptions around mortality, they’re all set out in
the accounts and in the glossary to the presentation, so I won't go through them individually here.
But it gives you a degree of understanding of the magnitude of change that those assumptions
can have on the overall liabilities of the scheme. In particular with the discount rate and inflation
gives you a sense of why on a quarterly basis you can see big swings in that IAS 19 deficit
position that gets reflected on the balance sheet.
Slide 26: So hopefully that has given you a better understanding of some of the moving dynamics
when it comes to the IAS 19 accounting for pensions. Hopefully it hasn't sent you to sleep. But
having looked at the accounting, we are now going to move on and look at the actuarial funding
valuation which is obviously the important measure that then determines the cash contributions
into the scheme.
So Mike, a pensions partner from KPMG, he’s going to give you the landscape in terms of what’s
happening in terms of external developments in pension funding, and then I will come back and I’ll
talk more specifically about the BT position with regards to that. So I shall hand over now to Mike.
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Mike Smedley
Thanks Glyn and afternoon everyone. As you have heard a couple of times I don't advise BT. I
suspect that I am probably the least knowledgeable person in the room about the BT Pension
Scheme but I do know a lot about other pension schemes and the market generally and that is
what I am going to give you a sense of here.
Slide 27: I guess I wanted to start with the high level principles on page 27 about pensions funding
and this is quite simplistic but it gives you the right picture. So there’s a sort of circle here, if we
start at the top, the starting features clearly, what are the benefits that have been promised to
pensioners and future pensioners, and for most pension schemes these are now largely known.
Most the promises have been made in the past and you can effectively, the cash flows that are
due out to future pensioners and current pensioners are largely known. So that little piece is
largely set down.
If you move around clockwise on the circle to the assets and the investment returns this is, for
most pension schemes, this is the most important element of the valuation. So what's in the bank
already in terms of the assets of the pension scheme that the Trustees own, and critically what
are the future investment returns going to be on those assets. Bear in mind for a pension scheme
they are looking at investment returns up until the point ultimately - actuaries are good at being
morbid - until the last member dies. So you are looking at a very long term time horizon. So you’re
looking at investment terms over 20, 40-60 years potentially.
The point at the bottom there around the covenant and prudence is slightly more subtle and I will
just explain what I mean. When you are doing a funding valuation with the Trustees, there is a
requirement in the law which we will come onto to be prudent. In a sense you could clearly argue
that what is going on in the business and what is going on in the pension scheme are different
things, and on one level they clearly are. The way that the pensions market work and the ways the
Trustees think and the Pensions Regulator means that there is an interaction. How that typically
works is in how much prudence is factored into the actual evaluation. So if you like, how much of
a buffer is built in because, for example, the investment returns might not be delivered as hoped,
and how big is that margin. The way that directionally it works is that if you have got a stronger
company they can probably afford to bear more financial risk and therefore there is less need for
prudence and a bigger buffer in the funding valuation. Conversely, a weaker company the
Trustees might feel that they need to be more cautious about the financing of the scheme and
have more prudence in the assumptions. There is no science to this, this is an area of judgment.
But it does meant that there is an interaction there.
Finally moving around on the left hand side the contributions from the company is one of the key
outputs if you like from the actuarial valuation process. And typically expressed both as an
ongoing rate at a % of pay for the staff that are still in the scheme plus some funding to meet the
deficit. That is the typical way that the valuation is structured.
Slide 28: So that is the basic framework and moving on to the next page, 28. It's worth spending a
couple of minutes on the regulatory landscape of pensions funding because it is an area that is
regulated, and the three legs which are put up there. So there is what is in the legislation, there’s
the pension funds trustees and then there’s the Pensions Regulator.
If we start with the legislation and what is actually in the legislation. There isn’t a great deal
specified in the legislation on pension funding. Basically it says that pension schemes have to be
funded and that the actuarial valuation assumptions must be set prudently. So there must be
some prudence but beyond that there’s a lot of flexibility and the legislation is very clear that
pension schemes should be funded on what’s called the schemes specific basis i.e. reflecting
their specific circumstances. There isn’t a one size fits all for pensions funding.
So the legislation is relatively flexible. There is one change in the legislation recently which is
highlighted on the slide there. I will read it because it is quite important and this came in only
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recently around the statutory objectives that are set out for the Pensions Regulator by
government. And previously the Regulator’s objectives have been primarily around protecting
members of pension schemes and there was a sense that the Regulator needs to take a more
balanced approach between members and employers and therefore there’s a new objective which
is the Regulator should seek to minimise any adverse impact on sustainable growth of an
employer. Which effectively is government saying that if an employer is investing in their business
the Regulator shouldn't stop them doing that for the sake of the pension fund. Because actually
the government and the Pensions Regulator will all say the best thing for a pension scheme is a
strong employer. The two should go hand in hand.
The second leg that’s in here, and this is probably the most important part, is the trustees, in the
middle. The trustees have an important role in any pension scheme. They look after the money,
look after the interest of members. They have to apply the legislation of pensions funding, they
have to negotiate and usually agree with the sponsor how the actuarial valuation is done, the
assumptions that are used and the outcome in terms of contributions. Finally, legally the trustees
control the investment strategy. There is a requirement to consult the employer and typically there
is a close working relationship, but ultimately the trustees control the assets. So that makes them
quite key in any given situation.
Then finally on the right hand side there we have got the Pensions Regulator, who in a sense is in
the background. They like to describe themselves as an interested bystander in some way. But
clearly they’re still very influential either by intervening in individual circumstances or by way they
say to the pensions industry and trustees generally.
In terms of what the Regulator is looking for, I have put 3 points up there which I guess are some
of the things that we see that the Regulator has asked at the moment. Clearly they want deficits to
be met and all else being equal the Regulator likes more prudence rather than less. But equally
they recognise that there is a balance between different stakeholders. One thing that they are
particularly concerned about is the trustees going backwards if you like, particularly in a
transaction or something like that, where the trustees are disadvantaged to the advantage of
another creditor. So if there was a refinancing of the business and the bank took security over
everything and leaving the trustee high and dry. They don't like that sort of thing and so they have
got quite a strong look out for situations that could be a step change for the trustees.
And finally they are moving towards an outlook that says pension funds should have an integrated
plan looking at the funding of the scheme, the covenant of the employer that’s supporting them
and the investment of the assets. And that those should be more joined up than they might have
been in the past for some schemes, and that trustees should start to have some contingency
planning. So if the funding level improves for some reason what then would the trustees do? If
something happened with the investments of the scheme what would the trustees do? So they
have got more of a dynamic plan. So there’s been some criticism that the trustees can be too
disjointed in managing schemes.
Slide 29: That’s the regulatory framework. I just wanted to move finally onto the practical issues
where you have got an actuarial valuation going on right now, what are the big issues and things
that are coming out? I have put 4 on the page there. The first one and this is probably the most
important one most of the time, is what’s the discount rate used to value the liabilities? To
discount those cash flows. And particularly when a lot of pension schemes would use gilt yields for
example as one of their reference points. Gilt yields are looking very low at the moment, what
does that mean for the discount rates and the valuation and clearly if you take a macro view,
discount rates and actual valuations have been falling over the last few years which means the
deficits have been rising. So there’s that happening in terms of direction, but for any individual
scheme there’s a big debate to have and discussion around what’s the right discount rate given
the investments that the scheme holds, given the reference points in the market. And also given,
and Paul touched on this earlier, given the investment strategy of the pension scheme not today,
but what it will be in the future. Because the trustees are looking for long term returns, not just
today.
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And of course one of the big discussion points in that negotiations is how much prudence do we
need and that’s one of the big points of discussion that gets you to an agreement ultimately.
The second point up there on mortality. I guess this is becoming less of an issue perhaps than it
has been in the last 5 years or so, in that there seems to be less rapid improvement in mortality
assumptions. People are still living longer, and I can say this as an actuary, but perhaps the
actuaries are starting to get the assumptions right or at least changing their minds less frequently.
So although there still is some movement in mortality assumptions it is becoming a less
contentious, less significant point than it has done in the past few years. Cleary on mortality
though there is still a big long term risk and uncertainty. And if there was, I know that the cure for
cancer is one that normally gets quoted and those sorts of things could still have a big impact
clearly.
The third point up there on contributions and this is really company contributions. We are seeing
more flexibility in terms of what trustees are prepared to agree in terms of funding of pension
schemes. I think that there is a bit of an attitude that says we recognise that we are in a slightly
funny environment and bond yields and gilt yields are very low. Some trustees will think, well the
deficit we are not really sure it’s as big as it's looking like it is and so there is more flexibility that
we’re seeing in funding plans. That can be longer term, so let’s not fund the deficit over 7 or 10
years but let’s fund it over longer, or let's have a different shape of contributions, or let's anticipate
some more investment returns in arriving at our contribution plan. Generally we are seeing more
flexibility than there’s been recently.
Then the final point up there that seems to be coming through quite strongly, is that trustees in
looking at their valuations are saying it's not just about the valuation today but actually we’d like to
have a discussion about where it is going longer term. Where will the pension scheme be in 5, 10,
20 years time. Let's have half an eye for that and not just agree a valuation today and then go into
a different room and come back in 3 years time. Actually let's try and have a discussion about the
longer term too. And the Pension’s Regulator is keen for that debate to happen as well.
So that was really a picture of some of the things that we are seeing in the market. I will hand
back to Glyn who is going to talk about the specifics of the BT scheme.
Glyn Parry
Slide 30: Thanks Mike. So the BT Pension scheme. The last funding valuation was June 2011,
showed a deficit of £3.9 billion gross of tax and in simple terms was based on a discount rate of
2.0% real relative to RPI.
When thinking about the discount rate in terms of funding valuation, as Mike said, there is a duty
on the Trustees to be prudent and to take a prudent view. And that’s why in the past we have
given you updates on what we think the median estimate is and that is based upon our view
stripping out prudent margins in terms of returns. And so in June 2011 on the right hand side, the
discount rate was 70 basis points higher than the actuarial funding valuation. That was the
principle reason why in June 2011 our median estimate was up there with a surplus of circa £2.5
billion versus the funding deficit.
I think that it's also worth being conscious of movement in index linked gilt yields when thinking
about the discount rate as well. Because whilst the scheme actuary doesn't use a gilts plus basis
to derive the discount rate, it is something that the Regulator looks at, to do something that
trustees look at and think about, in terms of a benchmark in terms of assessing prudence. So it is
something to consider. At June 2011 the gilt yield was 0.6%, so you can see that the actuarial
funding discount rate was between those two. So between the median and between the gilt yield.
At the previous valuation in December 2008 whilst the actuarial valuation discount rate was a bit
higher at 2.5% the median estimate rate was also higher, as was the gilt yield as well. I guess it's
also worth noting that since June 2011, as Mike said with QE etc, gilt yields have been very low at
the flat to negative levels recently.
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When it comes to the construction of the discount rates, Paul said earlier that that discount rate
takes into account how it’s assumed that the investment portfolio will develop over time. As the
scheme matures and you have less active members and more pensioners drawing pension, the
assumption within that strategy is that there is a de-risking of the investment strategy, such that
there is a move into more gilts and bonds over time. That is built into the construct of the discount
rate. We quote a single equivalent rate of 2.0% just to try and simplify that and taking into the
account the duration of the liabilities.
Slide 31: So if I look at what happened between December 2008 when the deficit was £9.0 billion
and June 2011 when it had reduced to £3.9 billion, the big driver of the change was the actuarial
gains on assets. The actual investment returns on the asset portfolio was substantially greater
than had been assumed in the discount rate, and so on the previous slide I said that the
December 2008 discount rate was 2.5% so the returns were materially above that and that is what
gave rise to that £4 billion gain.
But if I go across to the left [of the slide] and just work it through. The first pink bar, the £1.3
billion, that is the unwind of the discount on the liabilities during that two and a half year period.
The next two boxes, the benefits earned and the regular contributions, offset each other which
should be no surprise in as much as the monthly contributions that are being paid into the scheme
for the accrual of benefits is offsetting the benefits earned by the members. So there is a plus
£0.8 billion and a minus £0.8 billion.
Then the next line is the £1.6 billion deficit contributions. Those were the contributions that were
set under the 2008 valuation and were paid during that two and a half year period. As I said there
was an actual gains of £4.2 billion. Then on the liability side of the equation there was a net
actuarial gain of £0.7 billion. Now within that there was the gain that arose on the change to CPI
when the government made their change in terms of the basis of state pension increases. That
has an automatic flow through to some of the sections of the pension scheme. That effect is within
that actuarial gain there. So that was what happened within that two and a half year period.
Slide 32: So moving onto the recovery plan. So having agreed what the funding position is, the
other part of the actuarial valuation process is to agree a recovery plan that makes good the
deficit, and the plan that was agreed with the Trustee in 2011 was a 10 year recovery plan with a
£2 billion lump sum payment in March 2012, two subsequent payments of £325 million in 2013
and 2014 followed by 7 annual payments of £295 million through to 2021.
When you take those cash payments and whilst they add up in aggregate to £4.7 billion, the
present value of those is £3.9 billion. That payment schedule made good the deficit and within that
there was no assumed allowance for outperformance in terms of investment returns. So one of
the things that Mike referred to earlier was flexibility in recovery plans where you might make an
allowance for investment outperformance against the prudent measure.
The valuation documentation gets signed off and certified by the Scheme Actuary and that was
submitted to the Pensions Regulator and they informed us that their position would be informed by
the final Court ruling on the Crown Guarantee case. So that is where the 2011 valuation stands.
Slide 33: As part of the valuation and recovery plan we also pre-agreed, for clarity, what would
happen at the 2014 valuation in the event that the remaining recovery plan was not sufficient to
make good the position at 2014. So the table, if I go to the column under the £1.0 billion there,
what that is saying is that if the deficit at the time exceeds the 2011 recovery plan by £1 billion, so
taking all things into account and using the 2011 discount rate we would expect the 2011 recovery
plan to have a remaining value of £1.7 billion at 2014. So if the deficit is greater than £1 billion
over that then these three payments in 2015, 2016 and 2017 kick in. So £199 million in 2015,
£205 million in 2016 and £211 million in 2017.
If I move across to the right hand side, if it exceeds the recovery plan by £2.9 billion, so if it’s £4.6
billion, then these three payments kick in. So £360 million in 2015, £371 million in 2016 and £381
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million in 2017. So this provides a starting point for the 2014 position and if those 3 payments are
not sufficient then that would get incorporated into a revised recovery plan. We also agreed a
similar mechanism that would apply at the 2017 valuation as well.
Slide 34: In terms of other considerations, we also had a number of other aspects of the
agreement with the Trustees to provide them with protection in certain circumstances. The first of
which is with regards to shareholder distributions. The agreement here was that if the distribution
to shareholders exceeded the £2.945 billion of deficit contributions in the period from 1 March
2012 to 30 June 2015, so if we were to pay distribution to shareholders in excess of that, then
there would be a matching contribution into the scheme to level the playing field there. Now that
distribution definition excluded any buyback of shares to meet any employee awards and so
excludes our current share buyback programme.
There was also a commitment around disposals and acquisitions to the extent that if we
generated more than £1 billion from disposals net of acquisitions in any one year, then a third of
that net proceeds would get paid into the pension scheme.
There was also a negative pledge to Mike’s point earlier around Trustees wanting to make sure
that they are not disadvantaged in terms of the pecking order. If we were to raise any secured
financing greater than £1.5 billion then we would be required to give equivalent security to the
pension scheme so that they kept to a level peg there. It's worth pointing out that our practice is to
raise unsecured debt. In that regard, these were part of the agreement and as part of the next
valuation they would all be subject to renegotiation.
Slide 35: So looking forward to 2014 – amazing how quickly it’s come around actually! In terms of
the key actions that need to be taken and the schedule of work that needs to be undertaken. I
thought that it was worth giving you some context and background on what needs to go on. So if
you take the membership data, for example, that all has to be collated and checked as at 30 June.
You can imagine with that sort of level of membership, we have got 320,000 members, there are
numerous data points that feed into that valuation calculation. It is not an insignificant piece of
work just to undertake that.
There is also a requirement for the Trustee and for us to consider any changes from the last
valuation in terms of legal, demographic or economic position and assess what impact that may
have on the assumptions or approach. Clearly as Mike said the sponsor covenant is an important
part of the dynamic for the Trustees to consider. All of those things need to be taken into account
when considering the level of prudence that is appropriate to incorporate into the valuation.
On the asset side of the equation the assets have to be audited. They have to be marked to
market as at 30 June. So when we have got all of those pieces the actuary can plug all that into
their models, update their calculations and give us an updated position. Clearly there are some
negotiations between us and the Trustees around the assumptions, around what we consider is
an appropriate level of prudence. When we have got a position on the funding deficit or surplus
then we enter into a negotiation around what is an appropriate recovery plan and schedule
contributions to make that good and whether any other protections are appropriate.
At that point when there is an agreement reached between us and the Trustees, the Scheme
Actuary is required to certify all of the valuation documentation and then that gets submitted to the
Pensions Regulator. From a regulatory perspective that is required to be submitted within 15
months of the valuation date, so by 30 September 2015. Clearly we will be seeking to undertake it
quicker than that and in the past we have done so. That gives you an idea of the steps that need
to be worked through post 30 June.
Slide 36: I just wanted to pull together some of the key factors that we need to work through and
need to be considered in the context of the 2014 valuation. So firstly market conditions. The
market conditions are clearly a key factor to the assets, because the assets have to be marked to
market. Also market conditions will affect views on future returns and will affect views on future
inflation expectations and clearly those two have an important influence on the liabilities because
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the returns, less a prudent margin, drives the discount rate and clearly the inflation is another key
factor when looking at the liabilities. So market conditions are a key point.
The second key point is the Trustee’s assessment of the company covenant. That is important
because as Mike said there is a need to take that into account when considering prudence. So we
will be providing them with our views on the future of the business and they will be looking at that
and we will be providing our views on the opportunities to the business and to the risk of the
business and what our expectations are. At the end of the day they have had to make their own
assessment, but I think if you look at the improved financial performance of the business since the
previous valuation, if you look at the operational progress that we are making, if we look at how
we are delivering against our strategic investments then I think that there are some compelling
reasons why one would take a stronger view of the covenant than one might have done in the
past. I think the other important factor is also the cost transformation journey and the future
opportunities around that, and also when thinking about the long term sustainability of the
business from the eyes of the pension scheme there is obviously the fact that we have a core
infrastructure asset at the heart of the business and we have a regulated asset there as well
which provides them with significant additional comfort when it comes to that long term position.
Thirdly, the level of prudence is clearly an important factor. As you can see, at the previous
valuation that 70 basis points had a material effect in terms of the liabilities. I think the prudence
also needs used to be considered, not just in the context of what it means for the liabilities, but
also what it means in terms of shaping any associated recovery plans. Also, not on the slides but
as an aside, by the time we come round to the valuation we are also likely to have the judgment
handed down from the next trial on the Crown Guarantee, and so that will be another piece of
information that we will have at that time.
So I guess in summary as you can appreciate I can't predict what the position is going to be at 30
June. I can't tell you what the assumption will be around the discount rate and inflation at this point
in time. But what I can assure you of is that we will be putting our position forward very robustly
and we will be working very hard to ensure that we can reach an agreement that is in the best
interests of all the parties. Also we do recognise the uncertainty that this creates and we will be
working hard to ensure that it is completed in a very timely manner as I think you will agree we
have in previous years.
I think that we have got quite a bit of work ahead of us in that regard, but I do hope that you have
found this afternoon informative and I do hope that we’ve demystified some of it and we are more
than happy to take any questions that you may have.
QUESTION AND ANSWER
Wilton Fry: Bank of America Merrill Lynch
Just a quick general question probably for Mike Smedley. It strikes me that the industry (the
pensions industry and the regulators) are potentially blowing a mass bubble here. They are talking
about de-risking pension schemes by forcing them into fixed income yet government bonds
arguably represent the classic return-free risk nowadays. Why should we be putting more money
into fixed income right now with the perils of inflation and potential interest rates being calamitous
of those asset prices and therefore what changes are potentially due from a regulatory point of
view?
Mike Smedley
That is a nice easy question to answer there! I think your point of view is shared by a number of
people and some Trustees. There is clearly no right or wrong answer to it. I think the Regulator
and Trustees, some of them would certainly share that view and they would not be rushing to buy
bonds. There are a lot of pension schemes that aren’t rushing to buy bonds. On the other hand
there are quite a few pension schemes that are going and buying bonds or buying insurance with
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the agreement of the employer. I think it depends how you look at it. The Regulator and Trustees
look at it and simplistically say, we have got some liability outflows, some cash flows to pay, which
are either fixed or inflation-linked and therefore we can perfectly hedge them or pretty perfectly
hedge them with some bonds or gilts and therefore that is the least risky in terms of volatility
which is true. So that is one perspective.
I think that it depends heavily on how well funded you are. If you have got a really well funded
pension scheme you might decide to do that and if you haven't and you have got different views
on the market you might not do. I don't think that we are expecting any change to the regulation
framework because what the Pensions Regulator and the Government will say is that it's entirely
open for any set of Trustees or company to agree what is right for their circumstances. No one is
telling anyone to buy bonds. We are just telling you that if you don't buy bonds you are running a
risk and you have got to understand that and have contingency plans. That is the way they would
look at it, I don't think that we are expecting anything to change other than every company that we
talk to would be saying to their Trustees that we don't want you going and buying a load of gilts
right now, because they don't necessarily take the view that it’s the right time. But I think that it
has to work for each circumstance and there is nothing coming top down I don't think.
Carl Murdock-Smith: JP Morgan Cazenove
Just a question for Glyn. One thing that you haven't talked about at all today is the option to
potentially put in assets instead of cash as a contribution. Obviously that is something that BT has
erred away from in the past. KCom has recently done an asset based scheme and I just
wondered whether you could talk around BT’s views on potentially putting in assets, things like the
building we are sat in?
Glyn Parry
I think that you have to take into account what you are getting from it, so from a return perspective
can you generate more from the asset running it yourself than you are going to get putting it into
the pension scheme. I think that you also have to take into account what flexibility does it take
away from you? By wrapping it up into something does that take away any future flexibility from
you, from an operational perspective. I think one of the key questions in terms of return is actually
the Trustees will give you more or less value depending up on how valuable they see the asset for
themselves. I guess you have to ask the question of do they have any appetite to actually run and
operate the assets?
James Ratzer: New Street
A couple of questions please. Firstly on the general pension landscape is the 10 year commitment
to show a recovery plan still in place - you mentioned that it could move to a longer journey.
Secondly how in practical terms does the Crown Guarantee actually realistically affect things?
Surely the Trustees aren’t sitting there going we are worried about BT going bankrupt. They will
see it as a going concern, especially if there is a 10 year recovery plan, how does that actually
change any assumptions?
Mike Smedley
I think 10 years became a rule of thumb about 10 years ago, as it happens, for the length of
recovery plans. The Pensions Regulator has been saying for about 5 years that 10 years shouldn’t
be a fixed number and I think that what in practice you see is that for a lot of small pension
schemes they take about 10 years as that seems to be the standard. Once you get to larger
schemes, I have seen 3 or 4 year recovery plans from FTSE100 and I have seen 22 years. There
is really a wide spectrum. I think that most people say that 10 years doesn't really have any
relevance anymore except it is still stuck in a lot of people’s minds and therefore 10 years feels a
nice comfortable point but it doesn't have any real relevance beyond that. I think that we will see
longer and shorter.
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Glyn
When it comes to the Crown Guarantee, from the company’s perspective we are planning to fund
the scheme as a going concern. The Crown Guarantee is not an asset to the company. It's
effectively a contingency asset of the members that they can call upon in the event that we go
insolvent. So in terms of what does it mean practically? At this point in time, whilst there is the
uncertainty around the specificity of the scope and the extent of it, I think that it's very difficult to
pre-judge what it means in practical terms because I think that when we have got the final legal
outcome then undoubtedly we will be looking at that and forming our views and the Trustees will
no doubt form their views and the Pensions Regulator will form their views. But here and now
today it doesn't affect us because we are looking at continuing as a going concern.
Simon Weeden: Citi
I am not going to entirely let you off the hook on the Crown Guarantee question. But I am going to
try and come at it from a slightly different angle and direct the question at Mike if I may.
You mentioned the spread for prudence is approaching £6 billion as of the last review and the
prior one was £6 billion exactly and that equates to a 70 basis points spread on the discount rate.
I have also seen it in the past expressed as a percentile above the median, i.e. around 65ish I
think. I can't actually remember where BT’s was at the last triennial in and you didn't mention it
today. But if you look at the BT scheme relative to the market and if you think about the fact that
BT has become stronger again since the last review, if the Crown Guarantee is something the
Trustee may be able to take into account, where are other pension schemes (not that there’s
many out there with Crown Guarantees helping them out) but where would be a normal place for
the Trustee to position a BT. I’m not expecting you to give me a number, but a range would be
nice. Is 65th, where you are today, [where a Trustee would normally position the company]?
Mike Smedley
I am not familiar with the BT data so I can't comment on that specifically, I think that from what
you see from Trustees there is no absolute measure of prudence and the circumstances of each
one are different, so for example you might have a pension scheme that’s invested heavily in
bonds, whether you think that is a good idea or not, and actually it doesn’t have much margin for
prudence and it actually doesn't need it because it's not taking any risk in the first place or it might
have a very small scheme and a very very strong sponsor and therefore its definition of prudence
can be different. So it’s quite hard to pin down what prudence means.
In terms of two things that are probably helpful, one is that certainly we see companies where
their covenant is improved and they can demonstrate that the business is stronger saying to
trustees, look the business is stronger you don't need as much prudence as you had last time. I
would be amazed if Glyn isn’t arguing that, but that would be a fairly typical thing to do particularly
in the current environment where a lot of companies’ strength has improved.
On the specific percentile thing, there is a range in the market and different actuarial firms come
up with different percentiles and different methods. I think one of the challenges depends on
whose assumptions you start with in the first place and how bullish you are on market returns as
to what you come up with. I think from trustees’ point of view 50% confidence doesn't sound like
very much. Trustees like to be at the two thirds or two out of three or 60%+, all those sorts of
things that normally goes through trustees’ minds. So not unusual to hear those sorts of numbers.
Don’t know if you want to add some more specific Glyn.
Glyn Parry
All I would add is that the covenant is one piece and it's also thinking about changes from a
demographic perspective or an investment perspective. If you look at the scheme since 2008
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there are more fixed liabilities as a result of the Pension Increase Exchange exercise. So there is
a greater degree of inflation protection. So I think the covenant is one thing and it's also looking at
what has happened on the investment side of things and considering whether because of
changes on that side of the equation, whether you need as much margin for prudence as well.
Steve Malcolm: Arete
I will go for a couple and follow up on Simon’s, one for Glyn and one for Mike. One for Glyn, it's
disappointing to hear someone whose biggest fear is the cure for cancer, but outside that – we
can all see the kind prize of lower prudence and what that might bring, but what is the thing that
makes you worry the most? Inflation has gone away a little bit as an issue for this, capped at 5%
on a large part of the scheme, Is it a market crash? What are the things that would keep you
awake most of the night. And then a follow up on Simon’s item, are there any specific examples
you can give us of recent settlements where the prudence has come in a lot where companies
have shown significant improvements in financial strength, and also give us a flavour of the sort of
things. Is it standard Debt to EBITDA, is it EBITDA over Interest, is it the size of the scheme
against the size of the company? The standard metrics that the Trustees are looking at when
determining what constitutes improved financial strength would be great. Thank you.
Glyn Parry
The things that worry me are the things that I don't know about. That’s what worries me. Illogical
behaviour. Things that you don't think will happen, and things that you don't think will happen
whether that be in the markets or in regulation. It's those things, the things you don't know about.
Mike Smedley
And there was another part of the question about settlements. I can't think of any in the public
domain. This isn’t to do with BT obviously but the whole sort of covenant question with trustees is
difficult. Different trustees look at it in different ways. They do look at a lot of them, they’ll normally
employ an advisor to them who will look at it maybe like some credit worthiness. They will often
look at it through the eyes as if they are holding debts and what’s the credit good for so those
sorts of metrics. Clearly depends on what sector they are in, what those are. Trustees will often be
concerned about the long term covenant. So for example, and this is not specific to BT, but in
infrastructure assets and companies with monopolies or regulated licence holders, trustees
generally like because that gives them a lot of comfort about sustainability and helps them
[inaudible – talking in background: what about credit ratings…credit ratings upgrade …few years,
that’s the big deal….. look at credit ratings now, I wouldn’t personally, they’re rubbish. They will
look at credit ratings basically will they?. ]
Glyn Parry
It’s one of the things, I don't think they put a huge amount of weight on it but it is one of the factors
that they will look at.
Mike Smedley
That is just observational on covenants, is that you can have companies that are really strong,
and can be a really strong covenant and can arguably need less prudence. Then the trustees will
sit and say that’s fine but means you can pay off our deficit in 2 year’s time doesn’t it, if you are
that strong. So there are pros and cons.
Robert Grindle: Espirito Santo
I think Mike was talking about the flexibility in funding plans when the deficit is inflated by gilt
yields. Gilt yields have been pretty low for a while now and they have fallen again recently, so is
16
there a point where the trustees go ‘Oh my goodness we’re in a new world’ in terms of QE and
things reign longer or is there absolutely things will get normal going forward. Is there any sign
that could be the change in the sustainability of low gilts?
Secondly is the whole Solvency II thing now just kicked into touch because there were some
pretty bonkers suggestions out there on discount rates.?
Then just a quick one. What were the benefits of the Pension Increase Exchange exercise and
when did that happen? If possible.
Mike Smedley
In terms of trustees and low gilt yields. There are some sets of trustees out there and their
advisors that say well the market’s the market they must be right and therefore gilt yields are low
and won't listen to any counter argument. So in a sense there is no right answer to that. There are
different views and each set of trustees and companies has a different discussion if you like
around that issue. We are seeing more flexibility in the market but it doesn't mean it's universal.
There are still some trustees who say well no, we don't believe in any of that, we just want to look
at gilts. On Solvency II, I think the sense is that it has sort of gone away, doesn't mean it won’t
come back at some point in the future but the sense is it seems to have gone away politically. I
know the UK government has been fighting quite hard against it as well, along with some of the
others and so I think with changes at the European Union, I don't think anyone is getting worried
about that and anything happening anytime soon. That seems to have gone off people’s worry list
generally.
Paul Regers
The Pension Increase Exchange exercise that was started in June of this year and as you can
imagine we are doing it for around about 120,000 of our pensioners. So it’s quite a long exercise
that we are doing over a series of months, so that will be largely completed by our financial year
end, so there should be some results at that point as to how its turned out.
David Wright: Deutsche Bank
A couple of questions. Just on slide 34 where you mentioned the other features associated with
the 2011 agreement. For instance matching contributions along with shareholder distributions etc
and Glyn I suspect this is a question for you. You mentioned disposals and acquisitions. Are there
any conditions on mergers and could you remind us what the conditions are or how the Trustees
would react to a change in control of the company. For instance is there an immediate actuarial
triennial valuation, does one of those trigger? Does for instance the 2011 agreement stand in
terms of the recovery plan and could you give us a bit more on that.
Glyn Parry
In those sorts of scenarios the Trustees have the protection of law. So from a pensions
regulations perspective, if there is an event such as a takeover or merger that they believe
significantly impacts the strength of the covenant that they have as operating the scheme, so if it's
significantly weakens the sponsor in their eyes, then they have the power to involve the Regulator
to ensure that they are appropriately protected in such an event.
There have been instances where a transaction hasn't been able to complete because they
haven't been able to satisfy the trustees that they have got appropriate protections.
David Wright: Deutsche Bank
What would be the very early KPIs or the early measures that the Trustees would look at when
considering the risk? Would it be a very simple gearing measures, interest cover, that kind of
thing?
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Glyn Parry
When you say risk, in terms of the covenant?
David Wright: Deutsche Bank
Yes
Glyn Parry
When they are assessing the covenant, as Mike said, it's a very long term view. If you like they’re
sitting there as a long term creditor of the sponsor. So invariably they are not so worried about
what is happening next quarter, what they’ll be worried about is in 15 years time if there is a need
for cash to be paid into the scheme, that there is a viable sponsor there who can provide that
funding.
John Karidis: Oriel
Can I just check that there is a link between the magnitude of the prudence baked in and the
duration of the recovery plan? So if you were to recover it faster would you build in lower
prudence?
Glyn Parry
I think the answer to that is that there is not a formula, is there as such?
Mike Smedley
No. I think in practical terms they often are linked and a company will often say to a set of
trustees, if we agree these assumptions then we can pay these contributions in, and that is the
way of getting to a compromise that both trustees and sponsors are happy with. There is no direct
link in terms of regulation or any guidance or anything, so there is nothing written down that
there’s this link. But in practical terms as an observation if you like, you will see companies be
more willing to fund a deficit that they think is realistic, faster, and one that they think is less
realistic, they will be wanting to fund slower. There probably is an linkage in outcome rather than
guidance, if that sort of helps.
Guy Peddy: Macquarie
A question to both Mike and Glyn actually. I am referring to page 13 which shows the gilt forecast
of benefits payable under the BTPS and obviously we have got a situation where we have got a
rapid acceleration of the annual payments. Now firstly to Mike, is that a theme that is in most UK
corporates? That because of where pensions are we’re entering a period of dramatic increases in
payments? Secondly more for Glyn, do you have a sense of what each year what the NPV impact
moving each year is as you get closer to closer to spending £2.6 billion a year is actually on that
liability, even if you do it on an IAS basis for example. Then on a secondary point on a prudence
issue and slightly tongue and cheek here. The content investment, is that a rational investment
from a prudence perspective given that you are going to have pitch to your trustees with a huge
risk element two years out in your business model? So do you think that is actually being helpful
to your pitch for prudence or actually a detriment to your pitch for prudence given the volatility
that’s two years out?
Mike Smedley
If you like that chart on page 13 of the profile, is now fairly typical so if you wind the clock back 20
years when pension schemes were still open it would have been a lot longer term and a lot longer
peaked but that sort of being in run off now is quite typical. Actually the way that I look at being in
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run off is actually it reduces risk because the pension scheme is starting to shrink, ok there’s still
quite a few years to go let’s face it, but you are in run off and the scheme is shrinking eventually.
It’s quite common, but it’s not unhelpful in a sense in managing risk.
Glyn Parry
On the question about content, given that we have not started any discussions with the Trustees
around the valuation I don't think that it's particularly appropriate to make any comment on that
one.
Paul Rogers
I don’t have the numbers in front but I think you will see in IAS 19 that the value of the interest on
the liabilities is broadly equivalent to the cash flows at the current time. You would expect that
NPV to stay broadly similar for a few years, before in the longer term tailing down as you move
along the cash flow profile.
Maurice Patrick: Barclays
On slide 33 where you have got the March 15 to 17 payments, so based upon the June 2014
valuation, if it's a billion larger or 3 billion larger, the additional top ups. When you compare that to
Mike’s statement around the growing flexibility in the funding plan for the deficit inflated by gilt
yields, presumably since the last plan you have seen that happen. Should we just take this as
hard or there is some wriggle room regarding that point around the flexibility?
Glyn Parry
Mike’s point around flexibility stands. What we agreed as part of the 2011 valuation was, if you
like, a starting point, so undoubtedly as we go through the process it is in negotiation and it will
take into account covenants etc etc. So this is simply a starting point for that negotiation. It's no
more than that.
Carl Murdock-Smith: JP Morgan Cazenove
You have not been shy in the past of taking advantage of pre paying to take advantage of high tax
rates before tax rates drop. Obviously UK corporate tax rate drops 2% in April. How difficult would
it be at this point with that full triennial to reach an agreement on the early years of the pay back
schedule, in order to take advantage of the higher tax yield that you would get by doing a payment
before April?
Glyn Parry
I think my observations would be that it would depend whether we feel we have got surplus cash
at that point in time. I think the other factors are whether we would be comfortable paying funds in
before reaching an agreement on the valuation. You wouldn’t want to find yourself in a situation
whereby you end up with a trapped surplus. So I think those are the two key things that one would
need to take into account.
Alex Pike
OK so we’ll wrap up there. Thanks again to Mike, Glyn and Paul, and thanks very much for
coming.
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