20 July 2017
The Royal Mail Marshmallow
The outcome of the Royal Mail pension dispute may set a key precedent.
by Frank O’Nomics
Nearly 50 years ago researchers in Stanford conducted a series of delayed gratification studies. Children were offered the choice between one marshmallow immediately, or 2 if they were prepared to wait for 15 minutes. Follow-up studies showed that those children who were prepared to wait tended to have better life outcomes on a number of different measures, including educational attainment and body mass. Interestingly this is exactly the kind of option that the rather more grown-up employees of the Royal Mail are being offered concerning their defined benefit pensions. What is interesting is that, if they decide to accept the option of a lump sum sooner, as an alternative to the current final salary scheme later, the ramifications are not only important for the future of the Royal Mail, but potentially for a great many other cash-strapped pension funds. For the Royal Mail Group the difference is between committing £400mn a year and over £1bn a year into the pension fund. Spread across other similar corporate schemes this could add up to something very significant that will benefit the corporate profitability of the UK.
So just what are the options? For some time the Royal Mail has been trying to replace its existing £9.8bn defined benefit scheme, which offered a guaranteed income in retirement. This scheme they see as unaffordable and so they initially announced that the current plan would close to future accrual next March. They first proposed a switch to a defined contribution scheme, where employees build up a pension pot over their employment. This effectively transfers the investment risk from the employer to the employee. The problem here is that such a change would almost certainly leave employees significantly poorer in retirement. Not surprisingly, the Communications Workers Union threatened strike action, although they did make an alternative suggestion – a continued DB scheme that does not offer inflation protection – indicative of some acceptance that the current state is unsustainable.
Now the Royal Mail has introduced the marshmallow dilemma. Instead of replacing the existing DB scheme with a DC scheme, as has happened with many corporate pensions over the past twenty years, they have proposed a variation on the DB model. Under the new proposals employees will get a choice between receiving a “new DB” of a cash lump sum linked to their final salary and length of service, but at a rate below the existing scheme, or an improved DC scheme, the company making the point that, under the existing scheme, most opt for a lump sum at the outset anyway. Of the 2 relevant unions, Unite is not making a recommendation to its 6,000 members, but will hold a consultative ballot (not a strike ballot), while the CWU (who represent the vast majority of employees) has already rejected the proposals, arguing that it represents a “significant shortfall in the pensions promise”.
Whether the CWU can be persuaded to accept these terms, or a further revision, is crucial for a number of reasons. First, it will matter for the future of the Royal Mail. Their business model is already seriously challenged by electronic communication and other parcel providers and their future may be in question if it has to sustain potential pension liabilities. Results on Tuesday showed revenue from letters down 4%, although this was more than offset by volume growth in parcels. The company’s share price has fallen over 20% over the past year, underperforming the market by around 30%. For investors, one of the key attractions has been the high yield of Royal Mail shares, which on current valuation is close to 6%. However, this dividend is only 1.2 times covered by profits and hence would be called into question if larger sums have to be pumped into the pension scheme. The current dividend costs £230mn, and so would be easily eradicated by a tripling of the current “affordable” £400mn of contributions to the pension scheme. Second, it is of serious consideration for current and past Royal Mail employees. If the scheme were to fall on the Pension Protection Fund, they would face a potential fall in their pension income, which could be as much as 20% based on previous experience. Once a shortfall in a pension scheme develops it becomes very difficult to repair. Punter Southall has come up with a new “risk of ruin” measure of the possibility of a scheme failing, and puts the likes of Tesco at 51%. They estimate that 1 in 3 defined benefit pension schemes will deliver benefits in full to members. Thirdly, it matters for other corporates who face the same dilemma. This is a rapidly reducing number but there are still some 5,800 companies that offer DB schemes, most of whom would almost certainly rather not.
The Royal Mail is of course ultimately offering a variation on the marshmallow choice. The rational choice of taking the old defined benefit is not currently on offer, and if the unions insist on its preservation the company’s very existence could be called into question. The choice then is of one marshmallow (new DB scheme), an indeterminate amount of marshmallows in the future, which may or may not be less depending on an individuals length of service (new DC scheme), or a bet on whether the unions can persuade the company to persist with the old scheme – really a bet on whether you will live longer than the company – to still receive two marshmallows (old DB scheme). The Royal Mail and many companies like them will be hoping that union members have a sweet tooth – but the shorter odds would seem to be on a rejection of the proposals and a threat of strike action.
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