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:

Group

2017
£m
2016
£m
Total value of current employees benefits917.5831.6
Deferred members benefits798.9624.1
Pensioner members benefits1,899.11,514.7
Total defined benefit obligation3,615.52,970.4

The duration of the combined schemes is around 21 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 finalised funding valuations of the schemes were carried out by independent qualified actuaries as at 31 March 2013 (UUPS) and 31 March 2016 (ESPS) and determined that the schemes were both in a deficit position on a funding basis. The basis on which scheme liabilities are valued for funding purposes differs from the basis required under IAS 19, with liabilities on a funding basis being subject to assumptions at the valuation date that are not updated between revaluations. Funding deficits vary significantly from company to company, but neither the deficits, the assumptions on which they are based, the associated sensitivities, nor the risk exposures are disclosed by many companies and therefore meaningful cross-company comparisons are not possible. Conversely, scheme liabilities are valued on a consistent basis between companies under IAS 19 and are subject to assumptions and sensitivities that are required to be disclosed. Consequently, the relative economic positions of companies are comparable only on an IAS 19 basis, subject to normalisation of assumptions used between companies.

A retirement benefit surplus was recognised as an asset at both 31 March 2017 and 31 March 2016 as, under both the UUPS and ESPS scheme rules, the group has an unconditional right to a refund of the surplus assuming the full settlement of the plans' liabilities in a single event, such as a scheme wind-up.

Under UK legislation there is a requirement that pension schemes are funded prudently, and that funding plans are agreed by pension scheme trustees. The group has plans in place with the schemes' trustees to address the funding deficits by 31 December 2020 for the UUPS and 30 September 2024 for the ESPS, through a series of 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. Further details of the derivatives used in reducing investment risk are disclosed in the 'Further reporting analysis' section of this appendix.

In addition, the group has had an Inflation Funding Mechanism (IFM) in place since 2010 for the UUPS, which was extended to the ESPS in 2013. Under the IFM, additional contributions may be payable annually, calculated with reference to a notional amount of liabilities and the difference between outturn inflation and a fixed inflation assumption, currently set at 3.0 per cent per annum. To the extent that outturn inflation exceeds the fixed inflation assumption, additional contributions are payable in the following year and the base on which future payments are calculated increases, resulting in the smoothing of inflation effects over future years. If outturn inflation is less than the fixed inflation assumption, no additional contributions are payable. The IFM does not have an accounting impact except to the extent that resulting cash contributions increase the level of scheme assets.

The group expects to make contributions of £62.5 million in the year ending 31 March 2018, comprising £38.9 million to the UUPS and £4.1 million to the ESPS in respect of deficit repair contributions, £18.2 million and £0.7 million in respect of regular contributions to UUPS and ESPS respectively, and £0.6 million in respect of expenses to the ESPS; no additional contributions are expected to be made under the IFM.

The schemes' funding plans are reviewed every three years. The UUPS funding valuation at 31 March 2016 is currently ongoing and the next funding valuation for the ESPS is due no later than 31 March 2019.

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 a high quality 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 contributions, and through external market hedges.

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, at the current time, 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 2017, the discount rate has fallen by 0.85 per cent, which includes a 0.6 per cent decrease in credit spreads and a 0.25 per cent decrease in swap yields over the year. The IAS 19 remeasurement loss of £76.7 million reported in note 18 has largely resulted from the impact of the decrease in credit spreads during the year, partially offset by growth asset gains, the reduction in swap yields and the favourable impact of changes in mortality during the year.

Reporting and assumptions

The results of the latest funding valuations at 31 March 2016 for ESPS, and 31 March 2013 for UUPS, have been adjusted for IAS 19 in order to assess the position at 31 March 2017, 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.

Member data used in arriving at the liability figure included within the overall IAS 19 surplus has been based on the finalised actuarial valuation as at 31 March 2016 for ESPS and the preliminary results of the actuarial valuation as at 31 March 2016 for UUPS.

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:

Group

2017
% p.a.
2016
% p.a.
Discount rate2.553.40
Pensionable salary growth and pension increases3.403.20
Price inflation3.403.20

Demographic assumptions

Mortality in retirement is assumed to be in line with the Continuous Mortality Investigation's (CMI) S2PA (2016: S1NA) year of birth tables, with scaling factor of 108 per cent for males and 102 per cent for females (2016: one-year age rating for males in the UUPS only), reflecting actual mortality experience; and CMI 2015 (2016: CMI 2014) long-term improvement factors, with a long-term annual rate of improvement of 1.75 per cent (2016: 1.75 per cent). The current life expectancies at age 60 underlying the value of the accrued liabilities for the schemes are:

Group

2017
years
2016
years
Retired member – male27.027.1
Non-retired member – male29.029.2
Retired member – female29.830.7
Non-retired member – female31.932.9

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 £74.8 million (2016: £58.4 million) decrease/increase in the schemes' liabilities at 31 March 2017, 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 high quality 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 £70.0 million (2016: £55.3 million) increase/decrease in the schemes' liabilities at 31 March 2017, as a significant proportion of the schemes' benefit obligations are linked to inflation. However, around half of the schemes' liabilities were hedged for RPI in the external market at 31 March 2017, meaning that this sensitivity is likely to be halved as a result. In addition, around half of the schemes' liabilities were hedged through the IFM, with any change in inflation outturn resulting in a change to cash contributions provided under this mechanism. Any change in inflation outturn results in a change to the cash contributions provided under the IFM. As assumptions for pensionable salary growth and pension increases are in line with those for price inflation, sensitivities are also in line.
  • Life expectancy – an increase/decrease in life expectancy of one year would have resulted in a £135.3 million (2016: £92.5 million) increase/decrease in the schemes' liabilities at 31 March 2017. 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 values of the schemes' assets recognised in the statement of financial position were as follows:

Group

Schemes' assets %2017
£m
Schemes' assets %2016
£m
Equities9.1350.49.8318.3
Other non-equity growth assets4.8185.69.4304.3
Gilts44.81,729.336.91,196.2
Bonds39.81,537.341.01,332.7
Other1.560.42.994.1
Total fair value of schemes' assets100.03,863.0100.03,245.6
Present value of defined benefit obligations(3,615.5)(2,970.4)
Net retirement benefit surplus247.5275.2

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.

The fair value derivatives included within pension scheme asset classification are analysed as follows:

Group

Underlying assets
£m
Fair value of derivatives
£m
Combined
£m
At 31 March 2017
Equities320.629.8350.4
Other non-equity growth assets185.6185.6
Gilts1,729.31,729.3
Bonds1,547.6(10.3)1,537.3
Other250.5(190.1)60.4
Total fair value of schemes' assets4,033.6(170.6)3,863.0
At 31 March 2016
Equities317.11.2318.3
Other non-equity growth assets304.3304.3
Gilts1,196.21,196.2
Bonds1,347.2(14.5)1,332.7
Other53.540.694.1
Total fair value of schemes' assets3,218.327.33,245.6

The derivative values in the table above represent the net market value of derivatives held within each of these asset categories as follows:

  • derivatives are held within the UUPS equity portfolio to gain economic exposure equivalent to around 4.0 per cent of that scheme's assets, and comprise total return swaps on equity indices with a value of £18.2 million (2016: £1.0 million) and currency forwards with a value of £11.6 million (2016: £0.2 million);
  • derivatives are used within the UUPS bond portfolio to hedge non-sterling exposure back to sterling, and comprise credit default swaps with a value of £(10.3) million (2016: £0.4 million), interest rate swaps with a value of £nil (2016: £(15.4) million) and currency forwards with a value of £nil (2016: £0.5 million);
  • derivatives are used within both the UUPS and ESPS 'other' portfolios to manage liability risks, and comprise £(227.8) million (2016: £(9.0) million) in the UUPS and £37.7 million (2016: £49.6 million) in the ESPS. These are further broken down as follows:
    • the UUPS has a liability hedging strategy in place, which uses a wide range of derivatives to target a high level of interest rate and inflation hedging. The net value of £(227.8) million (2016: £(9.0) million) comprises asset swaps with a value of £(132.9) million (2016: £(250.7) million), interest rate swaps with a value of £522.0 million (2016: £631.7 million), gilt repurchase agreements with a value of £(655.8) million (2016: £(377.6) million) and RPI inflation swaps with a value of £38.9 million (2016: £(12.4) million); and
    • the ESPS has a liability hedging strategy in place, implemented using pooled funds which make use of derivatives. The value of £37.7 million (2016: £49.6 million) represents the total value of these pooled funds, i.e. underlying assets plus the value of the derivatives within these funds.

The derivatives shown in the tables only cover those expressly held for the purpose of reducing certain undesirable asset and liability risks. The schemes also invest in a number of other pooled funds that make use of derivatives. No allowance is made in the figures above for any derivatives held within these, as these are not held expressly for the purpose of managing risk. The total fair value of pooled funds held within the schemes' assets was £1,179.5 million (2016: £1,521.8 million).

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

Group

2017
£m
2016
£m
At the start of the year3,245.63,133.7
Interest income on schemes' assets109.496.3
The return on plan assets, excluding amounts included in interest555.556.0
Member contributions5.25.8
Benefits paid(114.3)(102.4)
Administrative expenses(2.7)(2.7)
Company contributions64.358.9
At the end of the year3,863.03,245.6

The group's actual return on the schemes' assets was a gain of £664.9 million (2016: £152.3 million), principally due to gains on derivatives hedging the schemes' liabilities.

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

Group

2017
£m
2016
£m
At the start of the year(2,970.4)(3,054.5)
Interest cost on schemes' obligations(99.2)(93.2)
Actuarial (losses)/gains arising from changes in financial assumptions(721.4)98.1
Actuarial gains/(losses) arising from changes in demographic assumptions52.7(46.6)
Actuarial gains arising from experience36.552.6
Curtailments/settlements(3.1)(1.1)
Member contributions(5.2)(5.8)
Benefits paid114.3102.4
Current service cost(19.7)(22.3)
At the end of the year(3,615.5)(2,970.4)

A contingent liability exists in relation to the equalisation of Guaranteed Minimum Pension (GMP), which is expected to have a widespread impact for defined benefit schemes operating in the UK. 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 has further developed its proposals, it is not possible to quantify the impact of this change.