Phillip Inman

Britain's flagging pensions system is undermining the prospects of major businesses and putting companies from rival countries at a competitive advantage, according to a major study today.

An over-reliance on stockmarkets to satisfy pension commitments has driven down the value of retirement funds to a point where employers cannot expect to meet the expectations of staff. Though it served to make Britain's pension system the envy of Europe in the 1990s, it has rapidly become a drag on company profits and the source of industrial strife.

The study by pension fund advisers Aon Consulting argues that pensions put UK businesses at a "severe competitive disadvantage". The research found that other European models of retirement funding have withstood the shocks of the global downturn much better, "putting companies based in these pension regimes at a competitive advantage over their UK counterparts".

The report echoes findings by pensions analyst Ros Altmann, who accused the government of betting on stockmarket growth to pay the pensions of millions without putting in place safeguards against recession. She said she wanted to challenge standard investment thinking because "the idea that equity markets might not deliver over the long term was never seriously entertained by policymakers".

Britain has developed a system that by the beginning of the 1990s came to rely on stockmarket gains to fulfil a pledge of retirement on about two-thirds of a worker's final salary. Most guaranteed schemes were in surplus and personal pension-style occupational funds kept pace on the back of booming share prices. But since the start of the decade funds have suffered from a declining stockmarket, increasing life expectancy, low interest rates and rules that gold-plate the benefits of defined-benefit (DB) schemes.

Aon said stark disparities in state pension provisions are also affecting companies' ability to compete.

In Germany the maximum state pension is €26,400 (£23,250) compared with €5,100 in the UK. To close the gap UK ministers have put in place a complex system of means-tested benefits that almost doubles the proportion of GDP dedicated to the over-65s from 5.8% to almost 12%.

UK employers must follow strict rules to satisfy regulators that they can meet pension commitments.

Aon said the Netherlands was suffering similar problems to the UK, while Sweden, which like Germany has a universal and flexible system, and countries with a relatively young workforce were avoiding the worst problems.

Paul McGlone, Aon director, said: "While volatile securities markets may be a global phenomenon, the way in which this volatility impacts pension scheme sponsors is not. There are winners and losers, with UK business a clear loser.

"The pension model in Germany and Austria, once regarded as unsustainable, is demonstrating its mettle and is now a competitive advantage in capital-constrained conditions.

"With three quarters of UK pension fund assets held in DB schemes, UK companies who have DB pension schemes are at a severe competitive disadvantage to their European peers. Recession is increasing the pressure on these companies, and those which have already scrapped their DB schemes now hold a competitive advantage over those who haven't. Of course, the ultimate advantage lies with those that never had such schemes in the first place."

He added: "Continuing recession will hasten UK companies' efforts to reduce their DB liabilities. More schemes will close, both to new members and to future accrual for existing members." Indeed already 80% of companies have already closed to new members and 20% have now also closed to accrual for existing members. We expect this proportion to rise above 50% within three years."

Ministers will today be urged to rethink their decision to restrict tax relief on pension contributions for higher earners, with two leading industry bodies warning of the serious damage it could do to retirement saving.

The National Association of Pension Funds (NAPF) said there was a risk the proposed changes could "destabilise" workplace pensions at a time when they were already under pressure, while the Association of British Insurers (ABI) warned of a "massively increased" public bill for looking after people in retirement if the public decided that saving in a pension was not worthwhile.

The measures, which limit pensions tax relief from April 2011 for those earning more than £150,000, were announced by the chancellor, Alistair Darling, in last month's budget.

Speaking ahead of her appearance today before a House of Lords committee that is considering aspects of the finance bill, Joanne Segars, NAPF chief executive, urged the government to "maintain an open mind" on whether or not to go ahead with the measures.

She said they posed a danger to the squeezed occupational pension system. "If executives can no longer fully benefit from pension saving, they may disengage from workplace pensions and be less inclined to provide high-value pensions for those on average incomes," she said.

She added that there was also a question mark over whether the changes would bring in the £3bn of tax revenue hoped for, because higher earners were bound to find ways around the new system.

Maggie Craig, the ABI's director of life and savings, is expected to tell the committee that restricting tax relief would add an extra layer of complexity to pensions.

Engineering firm caps its liabilities by hedging the risk of retirees living longer than expected

Engineering firm Babcock International has finalised a groundbreaking pensions deal to cap the risk of its retirees living longer than expected, in a move which could put pressure on other companies with big pension deficits.

The company said the deal would add to its overall costs, but would fix the amount of money needed to fund potential increases in life expectancy. Shares in the company, which has contracts with the Ministry of Defence, jumped 16% to 480p as investors welcomed the agreement to hedge £500m of life expectancy risks.

Pensions adviser Watson Wyatt said it was working on 10 similar deals covering £10bn in pension liabilities, although it said the growth of the market depended on the appetite of banks and insurers to take on the risks.

Under the deal, Babcock's pension trustees have agreed with an unnamed bank to provide details of the life expectancy of the fund's members. If they live longer than expected, the bank will pick up the extra cost of paying their retirement incomes. If they die earlier, then the bank gains from unpaid pension payments.

It is understood that Babcock has adopted more conservative mortality rates as part of the swap deal, which has increased the fund's deficit. The company, which saw revenues and profits rise 22% in the last year to £1.9bn and £147m respectively, said it had agreed with trustees to spend the next 20 years closing the shortfall in its pension fund.

Leading companies have come under increasing pressure to cap ballooning pension deficits. A collapse in stockmarket values forced the UK's 7,200 major schemes into a £240bn deficit last year until a rally last month brought the figure nearer to £180bn.

John Ball of Watson Wyatt said the risk possibility of poor investment returns remained a risk for the fund, but the significant additional risk of current pensioners living longer "was taken off the table". Babcock said it was also seeking to hedge the risk of volatile interest rates and inflation.

Martin Bird, of consultants Hewitt Associates, said retaining control of the scheme's assets was important when there was still a need to tackle pension fund deficits. "The ability to continue to invest in growth asset strategies is a key part of many scheme financing plans, and at a time when most pension schemes have significant deficits to address, a longevity only solution provides a very attractive solution," he said.

A longevity swap can be an alternative or the first step to a full pension buyout, whereby the scheme offloads all its assets and liabilities to a third party. Unlike buyouts, longevity swaps do not involve the transfer of pension assets and liabilities, and the payments are staggered.