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Understanding Pension Contributions and Their Impact on Company Finances

Pension Contributions
Written by Andy

What are pension contributions exactly? Why does a company have to pay historical contributions to its employees? Is this something that is no longer applicable these days?

Pension contributions are payments made by a company into a pension fund to provide retirement benefits to its employees. The term “pension contributions” typically refers to contributions made to a defined benefit (DB) pension scheme. In a DB pension scheme, the company promises to pay a specific benefit to employees upon their retirement, usually based on factors like years of service and final salary.

‘Pension contributions’ usually means that a company has a defined benefit pension (DB) pension scheme that the actuaries say has liabilities that exceed its assets. The company then has to agree with the trustees of the pension fund a plan of contributions to eliminate the deficit over a few years. Companies have been closing their DB pensions to new entrants, but many still have pensioners whose pensions the scheme is responsible for.

It’s firms which have defined benefit pension schemes ie they have backed a scheme which has promised workers a certain level of benefits on retirement. If that scheme has insufficient funding to meet present or future benefits levels then the firm (in the first instance) takes the hit. The reality is a lot more complex as it is a whole area of specialist accounting and actuarial work based on schemes liabilities and assets forecast many years into the future. The situation wasn’t helped by many companies awarding themselves money back from the pension scheme or contribution holidays for a while when times were good 30 years ago.

These days most firms do not now have these types of pension schemes open to join but the old members still have guaranteed entitlements. Sometimes companies pay the insurance sector to take the whole issue off their hands (and balance sheet/P&L).

Here’s how it works:

  1. Defined Benefit Pension Scheme: In a DB pension scheme, the company assumes the responsibility for funding the pension benefits promised to its employees. The company calculates the pension contributions required to ensure there are enough funds to meet the future pension obligations.
  2. Actuarial Assessment: Actuaries play a crucial role in determining the amount of money the company needs to contribute to the pension fund. They consider various factors such as the number of current and future pensioners, their expected lifespan, investment returns, inflation, and other economic variables.
  3. Pension Fund Deficit: If the actuarial assessment shows that the pension fund’s liabilities (the amount required to pay future pension benefits) exceed its assets (the amount currently in the fund), there is a pension fund deficit.
  4. Historical Contributions: When a company has a pension fund deficit, it means that in the past, they might not have contributed enough money to cover the future pension benefits they promised to their employees. As a result, they may have to make additional contributions to eliminate the deficit gradually.

Historically, defined benefit pension schemes were more common, and companies were often responsible for providing retirement benefits to their employees. However, over the years, these pension schemes have become less prevalent due to their high costs and financial risks for companies.

Many companies have shifted to defined contribution (DC) pension schemes, where the employees contribute to their retirement fund, and the company may or may not match their contributions. In DC schemes, the retirement benefits are based on the performance of the investment fund and are not guaranteed by the employer.

De La Rue (LON:DLAR) and Pension Liabilities: A Risk Assessment

For instance looking at De La Rue (LON:DLAR)’s annual statement it states:

• Agreed contributions of £15m per annum (for three years to March 2023 then £24.5m thereafter to FY 2028/29) under the Recovery Plan pension contributions agreed in June 2020.

My take is that you need to check every company you may invest in to see if there is a historic or even current pension issue. It was traditional to have defined benefits (DB) but they are very rare now. The problem is even when these schemes are closed for future entrants you are still in hock for what your past promises were (and future stuff too possibly).

Regarding De La Rue – at March 2020 they had current obligations owing to pensioners of over £1 billion. They have a matching pot of funds invested give or take (the deficit or not).

However, if the investment pot doesn’t generate expected returns or the pensioners live longer than it is estimated they will live now or if inflation is too high or if anything else goes wrong – then the company is on the hook for the shortfall compared to what they have put aside. Like a giant bank of mum and dad that should never run dry.

On a scale of 1-10 ref size of pension obligations pot compared to profits made (simple measure of risk) I would say De La Rue is probably 9.5 out of 10 – i.e. very risky. With £1 billion pot if they had 2% shortfall each year either with bods living longer than expected or investment pot not making sufficient returns that would cost the £20 mil quid a year.

Note practically speaking I may be over egging the risk somewhat I am no specialist here but facts are as per quoted figures – De La Rue will have as things stand out today cash cost of £24 million per year that they need to fund from ongoing “cashflow”; that will be out of business profits unless they take more drastic action to find that cash from other means.

As for De La Rue (LON:DLAR), it seems they have a significant pension obligation, and this can be a concern for investors, as it creates a financial burden on the company. Investors may be wary of investing in companies with substantial pension liabilities because it can impact the company’s profitability and cash flow, as they need to allocate a portion of their earnings to fund the pension contributions. However, each investor’s risk tolerance and investment strategy may differ, and some investors might still find value in the company despite the pension obligations. It’s essential to thoroughly research and understand a company’s financials and potential risks before making investment decisions.

About the author

Andy

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