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When he spoke to a CIMA meeting on pensions, Douglas Flint used a dramatic analogy to underline the pension challenge facing companies. He said that any company with a defined benefit scheme effectively has a hedge fund, an investment vehicle which could bring with it more risk and volatility than it may have in its underlying business. This is because while a firm could be making widgets or running launderettes, the incremental obligation that could arise from changes in inflation, interest rates, discount rates, yields on assets, could have a far more significant impact on aggregate financial position than all the things it spends time managing.

Historically, says Flint, pension schemes were run by somebody sitting in the HR department, talking to the actuaries once a year. He recalls that HSBC began to look at its own pension scheme in a different way.

‘The possible volatility of outcome in the scheme was about three times that which we would accept over the aggregate of our dealing rooms. And in those dealing rooms we had thousands of people who were risk

managers, controlling risks against limits using all sorts of sophisticated metrics and measurement bases.’

In Flint’s view, when people broke down the mystique of what actuaries were saying about pensions, they began to understand the real drivers of underlying risk.

‘I think the change in the accounting rules, although much criticised and unwelcome at the time, brought a way of looking at pension fund valuation that was in itself meaningful and caused people to question what was driving the changing surplus or deficit.

‘And they could see more clearly that on that basis – and it is only one basis – there was potentially an incredible volatility of outcome that they ought to be aware of, because to the extent that a scheme has a deficit, it can only be repaired in one of two ways. Either the assets have prospectively to perform more strongly than the liabilities that accrue or the company has to put more money into the scheme. If neither occurs, the beneficiaries of the scheme don’t get what they think they’re going to get.’

Hedge your betsThis January a National Association of Pension Funds survey found that while 31% were still open, 15% of final salary pension schemes in 369 companies surveyed will close to new joiners by 2012, and 6% will close even to existing staff. Pensions are in play and according to Douglas Flint, CFO of HSBC, the stakes are getting higher.

‘The possible volatility of outcome in the [pension] scheme was about three times that which we would accept over the aggregate of our dealing rooms. And in those dealing rooms we had thousands of people who were risk managers.’

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Flint sees a role for both the government and the companies in educating employees, in engaging them in thinking about their pensions. ‘Unless you are fortunate enough to be the beneficiary of a civil service pension and therefore you do not have to worry about anything because you have an indexed linked income out of the public purse, you need to understand where your retirement benefit is going to come from – to what extent it is going to be state pension, to what extent it will be a company pension, what in today’s money that will allow you to do and if you need to set aside more for retirement.

‘I think people are very bad at thinking about whether the financial resources available to them from all forms of saving will actually give them the sort of life style that they hope to have’. Flint is also critical of the pensions industry which does not always set out clearly that the monetary value of a pension quote today is likely to be significantly lower when it comes to be collected.

He counsels: ‘Pensions schemes only work if it is possible to put the money away for the long-term, invested in a way that retains and adds value through growth because of retained dividends and capital growth because investments are successful. For that to happen, companies need to make money.

‘You sometimes see the media or the government saying the oil companies, the banks, the pharmaceutical companies, the telecom companies are making too much money. But there are an awful lot of people whose pensions depend on those companies making money because the discounted value of those cashflows is going into pooled saving vehicles to fund pension. For pension schemes to be successful, the companies that operate them must not have unexpected demands on their cash flow to fund higher pension deficits. Their investments have to be successful, which means they have to make money.

‘There is a holistic view that says the economy needs to be run in a way in which value is created for everybody and one should not simply say that shareholders are taking too much, because shareholders essentially are the mass market, interested through their savings and pension vehicles.’

Flint argues that, while the government funds state pensions from revenues, it needs to worry that its fiscal receipts give it enough taxation to pay public sector pensions without raising taxes.

And of course, this is linked, because, for public sector receipts from taxation to grow, employment taxes have to rise because more people are in jobs and are earning more money and for that to happen the economy has to be successful and companies need to be making money to be able to employ more people. You get into a virtuous circle.’

Flint thinks the structure of pension benefits will change in the next ten years, moving away from a defined contribution

to an average salary basis. He sees little future for final salary schemes, not least because of the extremely high cost of funding to cover pay rises in the final years of employment. Increased compensation will come through bonuses.

He believes that those few companies that have begun a ‘menu-based’ pension scheme have started a trend. ‘This basically means an organisation is going to say to an employee it thinks their contribution to the company is worth, say, £50,000 a year. Their basic salary is going to be £34,000. They have to spend at least £5,000 on their pension. But they choose the rest from a flexible menu, covering, for instance, individual, partner or family health care, a company car, further contributions to the pension or a slightly higher salary.’ This way, the individual circumstances of employees will be catered for and they can make decisions there and then about their future lifestyle. ■

Pension funds: The bad old days

The antediluvian days of Robert Maxwell and the outright plunder of pension funds are gone says Flint.

‘I think the bigger mischief as people look back was not so much that people took pension holidays because of surpluses but that people used pension surpluses to enhance benefits because it was an easier negotiation with labour.

‘Companies said, “We cannot afford to give you any more salary but we’ll give you a better pension”. It was all real cost. So too was using the surplus in the pension scheme to fund early retirement programmes, which was using that surplus to benefit individual generations or even individual people. With hindsight, making that more broadly available would have been a better thing to have done. But in the days of inflation, for pension liabilities with schemes that had capped increases, the pension surpluses grew because the assets were growing with inflation but the pension benefits were.’

Such abuses have gone says Flint, adding: ‘I do think that the distinction between the roles of the trustees and the company management are properly separate, to the extent that both sides are getting independent actuarial advice – the actuaries are saying they cannot advise both the company and the trustees, whereas in the old days the scheme had an actuary who was probably closer to the company. Now big schemes have two actuaries and their own lawyers.’

Douglas Flint

Douglas Flint is group finance director of HSBC Holdings plc and chairman of HSBC Finance Corporation. He is a non executive director of BP plc. He began his career with Peat Marwick Mitchell & Co (now KPMG), where he trained as a chartered accountant. He was appointed a partner of the firm in 1988.

Flint joined HSBC Group as group finance director-designate on 30 September 1995 and was appointed to the board on 1 December 1995.

‘I think people are very bad at thinking about whether the financial resources available to them from all forms of saving will actually give them the sort of life style that they hope to have.’

In April, CIMA is launching an executive report: ‘Apocalyptic demography? Getting longevity risk in perspective.’ Visit: www.cimaglobal.com/pensions

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Flint believes the future of UK pensions rests in a competent framework in which companies, the financial services industry and the regulators and government work together.

‘The best way of looking at pensions schemes is that they have had an advantage when you think about them as deferred pay. It is entirely logical that money in pension schemes should roll up broadly tax free on the basis that the remuneration has not yet been paid out to the individuals.

‘Therefore, the employees can save out of their gross pay, contribute to their pension schemes and the company can also contribute and watch those assets accrue on a gross basis, to be taxed as they come out as pensions. There are some distortions because of the tax system but it is entirely logical, in terms of deferred pay, that there is tax advantage for pension schemes. I think that the government’s role is to make pensions legislation transparent and simple and to avoid changing it very often, because people who enter into long-term planning want to be confident that something isn’t going to change half way through.’

Pension funds: To sell or not to sell?

A business that decides its core competence is not running financial liabilities and wants rid of its pension obligations can, says Douglas Flint, CFO of HSBC, very reasonably decide on disposal.

‘If a company is in the fortunate position of having a fully-funded scheme, not just on an actuarial basis but in the sense that you could transfer the value and someone could take on the pension commitments (which tends to mean that you are more than fully-funded on an IRS or actuarial basis), the person buying it out would want a premium to that for the risk he is taking on.

‘The decision the company has to make is how much – given that they are going to have to pay something for someone to take on the risk that they are releasing – is the risk that they are getting rid of commensurate with the additional money that they are going to pay, or the pension scheme is going to pay to lose that risk.’

There is, says Flint, also another risk. At some future date, the pension provider

that has assumed the liabilities might fail. At that point, employees would understandably challenge the original choice of provider. While legally the company would be protected, morally and reputationally it would face a serious knock, which it might find difficult to withstand.

‘The pension fund trustees therefore have quite a big decision over selling a pension book,’ warns Flint. ‘How do they rate the covenant of the employer against the covenant of the new pension provider?’

Flint adds that there have been cases where it has been done very positively in buyouts. The trustees have had the obligations fully funded by the company and passed to a big organisation like the Prudential or Legal & General. Companies that had business plans that called for very aggressive financing, could thereafter pursue such an option without any longer having the pension trustees in their hair.

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