30 July 2007
What goes up must come down' is the old adage; and this is often true of the stock market. The effects percolate through the economy and any business with a final salary pension scheme, including many law firms, will feel the impact.
Although some firms have closed their final salary schemes to new entrants, the deficit persists. And while the strength of equity investment over the long term is well reported, the inevitable volatility of the stock market has an immediate effect that impacts on the size of a firm's pension deficit.
Now that more than half of the larger law firms have converted to LLP status, their pension deficits (or credits) are shown loud and clear in their annual reports, accessible to anyone who cares to look.
The main cause of these substantial pension deficits is increased life expectancy. Over the past 20 years or so medical advances have led to an increase of four or five years in projected lifespan. As a result pension liabilities rise as the financial cost of supporting pensioners increases.
Add to this a low return on bonds, the 10 per cent tax on dividends imposed by the Chancellor in 1997, poorly performing stock markets early in this decade, not to mention increased compliance costs, and it is clear to see why pension deficits have become so serious.
So how large are these deficits? Allen & Overy's 2006 LLP accounts show that it closed its final salary scheme to new entrants in 1998 and disclosed that the scheme had a deficit of £22m. This equates to an average of more than £50,000 per member, based upon assumptions disclosed in the accounts.
Eversheds' final salary scheme was still open to new entrants in April 2005, but the deficit only represented an average of around £5,000 per member. Looking at Withers' latest accounts, we see that the average deficit per member is £22,000, whereas Herbert Smith and CMS Cameron McKenna average more than £30,000.
Arguably these amounts are well within the ability of the respective firms to service, although the extent to which each equity partner is aware of their share of this liability is less clear - not least because accounting standards have historically only required a rather technical explanation and disclosure of the deficit.
It is also worth bearing in mind that these are firms whose partners have decided voluntarily to incorporate as LLPs and therefore accept that their financial positions will be open to scrutiny.
However, we can only speculate on the size of the deficits facing those practices that have not converted to LLPs - and the potential exposure facing their partners. Given the very valuable protection provided to partners after conversion to an LLP, and the fact that this is now a tried and tested formula, one wonders whether some of the larger firms may be deterred from incorporating partly because of how the size of their pension deficit may be perceived.
While there is no 'one size fits all' solution, the key is to combine a number of strategies that together can control an organisation's pension deficit.
Leveraged buyout bonds can be particularly helpful. The use of such vehicles allows the employer to crystallise the full buyout liability by transferring all of the assets of the scheme to an insurance company that will secure deferred annuities for scheme members.
The deficit that exists between the value of assets transferred and the cost of purchasing the deferred annuities becomes a loan to the sponsoring employer afforded by the insurance company. The trustees are discharged of their liability and the employer has a fixed target to fund the loan from the insurance company.
The use of structured investment products has also gained ground recently, whereby the conventional 80/20 per cent equity/bond portfolio is turned around so that 80 per cent of the funds are put into AA-rated bonds, with the remaining 20 per cent used to buy call options on, say, the FTSE100 total return index for 10 years. This time horizon enables long-term exposure to equities while protecting the downside.
This approach also helps reduce volatility since the fund value is not determined by stock market levels, but by the total value of the bond holding, the cash received from maturing options and the present value of the unexpired options. Additionally, since funds are less actively managed, ongoing running costs should fall.
A rather more recent introduction to the market is a product issued and underwritten by one of the largest banking institutions in the world. It potentially provides for a minimum of a deposit-based return and an upside of 20 per cent per annum, subject to a basket of blue-chip shares remaining at a higher value than a predetermined floor price, typically around 75 per cent of its original value.
The product has a 10-year lifespan (although it can be traded in between times at the prevailing market price) with an undertaking that the capital will be returned (minus charges) at the end of the term, and returns of up to 200 per cent of the original investment are possible. Furthermore, if any of the fixed annual returns do not become payable because the floor price is breached, they can be reclaimed so long as all the stocks remain above the floor price in the final year, in what could be thought of as a 'second chance'.
It can also be worth looking at deficit insurance. Typically the funding deficit can be insured so that an insurance company extinguishes the debt upon the principal employer going into liquidation or certain other notifiable events. This vehicle is finding great favour in the M&A market.
No businesses, particularly partnerships, can operate successfully if their hands are tied by excessive pension funding and fluctuating costs; and law firms are clearly not immune from the pension problems facing many large companies.
A measured approach combining a number of strategies should help many firms to deal with their pension difficulties.
Giles Murphy and Peter Maher are directors at Smith & Williamson