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 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 latest actuarial valuations of UUPS and ESPS were carried out as at 31 March 2013. The results of these valuations have been adjusted to take account of the requirements of IAS 19 'Employee Benefits' in order to assess the position at 31 March 2014 by projecting forward from the valuation date by the independent actuary, Aon Hewitt Limited.

Funding requirements

The latest funding valuations of the schemes as at 31 March 2013 reported a deficit. The basis on which liabilities are valued for funding purposes differs to 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 which perform in line with the liabilities so as to hedge against changes in swap yields. For ESPS, a partial hedge is in place to protect against changes in swap 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 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.

The group expects to make contributions of £29.3 million in the year ending 31 March 2015, comprising £5.5 million to UUPS in respect of the inflation funding mechanism and £22.5 million and £1.3 million in respect of regular contributions to UUPS and ESPS respectively.

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, 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.

In contrast, the schemes' specific funding basis, which forms the basis for regular (non-IFM) deficit repair contributions, is unlikely to suffer from 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 IAS 19 assessment of financial position at 31 March 2014, although the discount rate has fallen by 0.3 per cent this masks a rise in underlying interest rates offset by a credit spread reduction of 0.5 per cent. This credit spread reduction results in substantially all of the reported £192.5 million deterioration. During the year ended 31 March 2014, there has not been any material change in the deficits on a scheme specific funding basis and therefore the level of deficit repair contributions.

Sensitivity of the key scheme assumptions

The measurement of the group's defined benefit obligation is sensitive to changes in key assumptions, which are described below. 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 interrelationship 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 £49.1 million decrease/increase in the schemes' liabilities at 31 March 2014, 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 £47.0 million increase/decrease in the schemes' liabilities at 31 March 2014, 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 improvement rate of 0.25 per cent would have resulted in a £37.3 million increase/decrease in the schemes' liabilities at 31 March 2014. 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.

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, it is not possible to quantify the impact of this change.

Reporting

The results of the latest funding valuations at 31 March 2013 have been adjusted in order to assess the position at 31 March 2014, 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.

The main financial and demographic assumptions used by the actuary to calculate the defined benefit (obligations)/surplus of UUPS and ESPS were as follows:

Group2014
% pa
2013
% pa
Discount rate4.34.6
Pensionable salary growth and pension increases3.33.3
Price inflation3.33.3

In assessing the financial assumptions, the group has taken into account the average duration of the schemes' liabilities.

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, reflecting actual mortality experience; and CMI 2013 long-term improvement factors, with a long-term annual rate of improvement of 1.5 per cent per annum. The current life expectancies at age 60 underlying the value of the accrued liabilities for the schemes are:

2014
years
2013
years
Retired member – male26.626.7
Non-retired member – male28.428.5
Retired member – female30.030.0
Non-retired member – female31.931.9

Further reporting analysis

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

Schemes'
assets
%
2014
£m
Schemes'
assets
%
2013
£m
Equities6.6157.014.9363.9
Other non-equity growth assets10.0238.310.6259.0
Gilts11.9283.92.150.7
Bonds52.21,240.760.51,477.4
Other19.3457.111.9291.0
Total fair value of schemes' assets100.02,377.0100.02,442.0
Present value of defined benefit obligations(2,554.4)(2,426.9)
Net retirement benefit (obligations)/surplus(177.4)15.1

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 'other' element of the portfolio is set aside for collateral purposes linked to the derivative contracts entered into, as described above. The collateral portfolio, comprising cash and eligible securities which are readily converted 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:

2014
£m
Restated*
2013
£m
At the start of the year2,442.02,113.0
Interest income on schemes' assets111.3106.8
The (loss)/return on plan assets, excluding amounts included in interest(125.1)205.6
Member contributions6.66.8
Benefits paid(83.7)(80.3)
Administrative expenses(2.2)(2.9)
Company contributions28.193.0
At the end of the year2,377.02,442.0

* The comparatives have been restated to reflect the requirements of IAS 19 (Revised) 'Employee Benefits'. See accounting policies for details.

The group's actual return on the schemes' assets was a loss of £13.8 million (2013: £312.4 million gain), principally due to losses on derivatives hedging the schemes' liabilities.

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

2014
£m
Restated*
2013
£m
At the start of the year(2,426.9)(2,205.0)
Interest cost on schemes' obligations(110.0)(108.3)
Actuarial losses arising from changes in financial assumptions(108.3)(176.9)
Actuarial gains arising from changes in demographic assumptions34.4
Actuarial (losses)/gains arising from experience(1.8)6.3
Curtailments/settlements arising on reorganisation(1.7)(0.6)
Member contributions(6.6)(6.8)
Benefits paid83.780.3
Current service cost(17.2)(15.9)
At the end of the year(2,554.4)(2,426.9)

* The comparatives have been restated to reflect the requirements of IAS 19 (Revised) 'Employee Benefits'. See accounting policies for details.