A5 Retirement benefits

Defined benefit schemes

The group participates in two major funded defined benefit pension schemes in the United Kingdom – the United Utilities Pension Scheme (UUPS) and the United Utilities PLC group of the Electricity Supply Pension Scheme (ESPS), both of which are closed to new employees. The assets of these schemes are held in trust funds independent of the group's finances.

The trustees are composed of representatives of both the employer and employees. The trustees are required by law to act in the interests of all relevant beneficiaries and are responsible for the investment policy with regard to the assets plus the day-to-day administration of the benefits.

The group also operates a series of unfunded, unregistered retirement benefit schemes. The costs of these schemes are included in the total pension cost, on a basis consistent with IAS 19 'Employee Benefits' and the assumptions set out below.

Information about the pension arrangements for executive directors is contained in the directors' remuneration report.

Under the schemes, employees are entitled to annual pensions on retirement. Benefits are also payable on death and following other events such as withdrawing from active service. No other post-retirement benefits are provided to these employees.

The defined benefit obligation includes benefits for current employees, former employees and current pensioners as analysed in the table below:

Group2016
£m
2015
£m
Total value of current employees benefits831.6839.9
Deferred members benefits624.1666.5
Pensioner members benefits1,514.71,548.1
Total defined benefit obligation2,970.43,054.5

The duration of the combined schemes is around 20 years. The schemes' duration is an indicator of the weighted-average time until benefit payments are settled, taking account of the split of the defined benefit obligation between current employees, deferred members and the current pensioners of the schemes.

Funding requirements

The latest funding valuation of the schemes was carried out by an independent qualified actuary as at 31 March 2013 and reported a deficit. The basis on which liabilities are valued for funding purposes differs from the basis required under IAS 19. Under UK legislation there is a requirement that pension schemes are funded prudently.

The group has a plan in place with the schemes' trustees to address the funding deficit by 31 December 2020, through a series of annual deficit recovery contributions.

The group and trustees have agreed long-term strategies for reducing investment risk in each scheme.

For UUPS, this includes an asset-liability matching policy which aims to reduce the volatility of the funding level of the pension plan by investing in assets such as fixed income swaps and gilts which perform in line with the liabilities so as to hedge against changes in swap and gilt yields. For ESPS, a partial hedge is in place to protect against changes in swap and gilt yields.

In addition, the group has had an Inflation Funding Mechanism (IFM) in place since 2010; details of this are outlined in the 2011 annual report. In 2013, it extended the mechanism to the ESPS and increased the fixed percentage rate used to 3.0 per cent per annum from 2.75 per cent per annum. To the extent that inflation, as measured by the RPI index at each 31 March preceding the payment due date, is different from 3.0 per cent per annum, the inflation reserve will increase/decrease. Additional contributions are then payable annually based on the size of the inflation reserve.

The group expects to make contributions of £64.2 million in the year ending 31 March 2017, comprising £38.9 million to UUPS and £4.1 million to ESPS in respect of deficit repair contributions, £19.8 million and £0.8 million in respect of regular contributions to UUPS and ESPS respectively, and £0.6 million in respect of expenses to the ESPS.

Impact of scheme risk management on IAS 19 disclosures

Under the prescribed IAS 19 basis, pension scheme liabilities are calculated based on current accrued benefits. Expected cash flows are projected forward allowing for RPI and the current member mortality assumptions. These projected cash flows are then discounted by an AA 'corporate bond' rate, which comprises an underlying interest rate and a credit spread.

The group has de-risked its pension schemes through hedging strategies applied to the underlying interest rate and the forecast RPI. The underlying interest rate has been largely hedged through external market swaps and gilts, the value of which is included in the schemes' assets, and the forecast RPI has been largely hedged through the IFM, with RPI in excess of 3.0 per cent per annum being funded through an additional schedule of deficit contribution.

As a consequence, the reported statement of financial position under IAS 19 remains volatile to changes in credit spread which have not been hedged, primarily due to the difficulties in doing so over long durations; changes in inflation, as the IFM results in changes to the IFM deficit contributions rather than a change in the schemes' assets; and, to a lesser extent, changes in mortality as management has decided not to hedge this exposure due to its lower volatility in the short-term and the relatively high hedging costs.

In contrast, the schemes' specific funding basis, which forms the basis for regular (non-IFM) deficit repair contributions, is unlikely to suffer from significant volatility due to credit spread or inflation. This is because a prudent, fixed credit spread assumption is applied, and inflation-linked contributions are included within the IFM.

In the year ended 31 March 2016, the discount rate has increased by 0.3 per cent, which includes a 0.7 per cent increase in credit spreads offset by a decrease in swap yields over the year. The IAS 19 remeasurement gain of £160.1 million reported in note 18 has largely resulted from the impact of the increase in credit spreads during the year, partially offset by the impact of a 0.2 per cent increase in inflation.

Reporting and assumptions

The results of the latest funding valuations at 31 March 2013 have been adjusted to take account of the requirements of IAS 19 in order to assess the position at 31 March 2016, by taking account of experience over the period, changes in market conditions, and differences in the financial and demographic assumptions. The present value of the defined benefit obligation, and the related current service costs, were measured using the projected unit credit method.

Financial assumptions

The main financial and demographic assumptions used by the actuary to calculate the defined benefit surplus of UUPS and ESPS are outlined below:

Group2016
% p.a.
2015
% p.a.
Discount rate3.43.1
Pensionable salary growth and pension increases3.23.0
Price inflation3.23.0

During the year, the group has undertaken a review of its pension assumptions and has made a number of amendments as a result. To align with market practice, the discount rate is now based on an AA 'corporate bond' curve rather than a broader AA 'non-gilt' curve that was previously used. This has resulted in a 0.2 per cent increase in the discount rate during the year and a 0.2 per cent increase in credit spreads. In addition, the allowance for inflation risk premium has been removed from the basis of the inflation rate assumption to better align with the risk management strategy, which has increased the inflation assumption by 0.3 per cent.

Demographic assumptions

Mortality in retirement is assumed to be in line with the Continuous Mortality Investigation's (CMI) S1NA year of birth tables, with a one-year age rating for males in the UUPS only, reflecting actual mortality experience; and CMI 2014 (2015: CMI 2014) long-term improvement factors, with a long-term annual rate of improvement of 1.75 per cent (2015: 1.5 per cent). The current life expectancies at age 60 underlying the value of the accrued liabilities for the schemes are:

Group2016
years
2015
years
Retired member – male27.126.6
Non-retired member – male29.228.3
Retired member – female30.730.2
Non-retired member – female32.932.0

Sensitivity of the key scheme assumptions

The measurement of the group's defined benefit surplus is sensitive to changes in key assumptions, which are described above. The sensitivity calculations presented below allow for the specified movement in the relevant key assumption, whilst all other assumptions are held constant. This approach does not take into account the inter-relationship between some of these assumptions or any hedging strategies adopted.

  • Asset volatility
    If the schemes' assets underperform relative to the discount rate used to calculate the schemes' liabilities, this will create a deficit. The schemes hold some growth assets (equities, diversified growth funds and emerging market debt) which, though expected to outperform the discount rate in the-long term, create volatility in the short-term. The allocation to growth assets is monitored to ensure it remains appropriate given the schemes' long-term objectives.
  • Discount rate
    An increase/decrease in the discount rate of 0.1 per cent would have resulted in a £58.4 million (2015: £60.1 million) decrease/increase in the schemes' liabilities at 31 March 2016, although as long as credit spreads remain stable this will be largely offset by an increase in the value of the schemes' bond holdings and other instruments designed to hedge this exposure. The discount rate is based on AA 'corporate bond' yields of a similar duration to the schemes' liabilities.
  • Price inflation
    An increase/decrease in the inflation assumption of 0.1 per cent would have resulted in a £55.3 million (2015: £56.6 million) increase/decrease in the schemes' liabilities at 31 March 2016, as a significant proportion of the schemes' benefit obligations are linked to inflation. In some cases, caps on the level of inflationary increases are in place to protect against extreme inflation. The majority of the assets are either unaffected by or loosely correlated with inflation, meaning that an increase in inflation will also increase the deficit. Any change in inflation out-turn results in a change to the cash contributions provided under the IFM.
  • Life expectancy
    An increase/decrease in the mortality long-term annual rate of improvement of 0.25 per cent would have resulted in a £45.4 million (2015: £36.7 million) increase/decrease in the schemes' liabilities at 31 March 2016. The majority of the schemes' obligations are to provide benefits for the life of the member and, as such, the schemes' liabilities are sensitive to these assumptions.

Further reporting analysis

At 31 March, the fair value of the schemes' assets recognised in the statement of financial position were as follows:

GroupSchemes'
assets
%
2016
£m
Schemes'
assets
%
2015
£m
Equities9.8318.39.9308.7
Other non-equity growth assets9.4304.310.2320.4
Gilts36.91,196.214.7461.8
Bonds41.01,332.743.61,365.8
Other2.994.121.6677.0
Total fair value of schemes' assets100.03,245.6100.03,133.7
Present value of defined benefit obligations(2,970.4)(3,054.5)
Net retirement benefit surplus275.279.2

The fair values in the table above are all based on quoted prices in an active market, where applicable.

The assets, in respect of UUPS, included in the table above, have been allocated to each asset class based on the return the assets are expected to achieve as UUPS has entered into a variety of derivative transactions to change the return characteristics of the physical assets held in order to reduce undesirable market and liability risks. As such, the breakdown shown separates the assets of the schemes to illustrate the underlying risk characteristics of the assets held.

Both of the schemes employ a strategy where the asset portfolio is made up of a growth element and a defensive element. Assets in the growth portfolio are shown as equities and other non-equity growth assets above, while assets held in the defensive portfolio represent the remainder of the schemes' assets.

The defensive element of the portfolio contains a proportion of assets set aside for collateral purposes linked to the derivative contracts entered into, as described above. The collateral portfolio, comprising cash and eligible securities readily convertible to cash, provides sufficient liquidity to manage the derivative transactions and is expected to achieve a return in excess of LIBOR.

Movements in the fair value of the schemes' assets were as follows:

Group2016
£m
2015
£m
At the start of the year3,133.72,377.0
Interest income on schemes' assets96.3101.0
The return on plan assets, excluding amounts included in interest56.0705.2
Member contributions5.86.3
Benefits paid(102.4)(92.5)
Administrative expenses(2.7)(2.6)
Company contributions58.939.3
At the end of the year3,245.63,133.7

The group's actual return on the schemes' assets was a gain of £152.3 million (2015: £806.2 million), principally due to gains on derivatives hedging the schemes' liabilities.

Movements in the present value of the defined benefit obligations are as follows:

Group2016
£m
2015
£m
At the start of the year(3,054.5)(2,554.4)
Interest cost on schemes' obligations(93.2)(108.0)
Actuarial gains/(losses) arising from changes in financial assumptions98.1(500.8)
Actuarial (losses)/gains arising from changes in demographic assumptions(46.6)10.2
Actuarial gains arising from experience52.635.9
Curtailments/settlements(1.1)(5.5)
Member contributions(5.8)(6.3)
Benefits paid102.492.5
Current service cost(22.3)(18.1)
At the end of the year(2,970.4)(3,054.5)

A contingent liability exists in relation to the equalisation of Guaranteed Minimum Pension (GMP). The UK Government intends to implement legislation which could result in an increase in the value of GMP for males. This would increase the defined benefit obligation of the schemes. At this stage, until the Government develops its proposals and publishes guidance, it is not possible to quantify the impact of this change.