British Airways clears new pension scheme for April take-off

British Airways, the old joke has it, is a gigantic pension fund with an airline attached to it.

Like all jokes, the humour works because there is an element of truth to it.

The assets in the two main active British Airways pension schemes totalled almost £24bn at the end of last year, while International Consolidated Airlines Group, the parent company of BA, currently has a stock market value of just under £13bn.

That becomes problematic when the pension scheme has a deficit.

BA is not alone in this regard. Like many formerly state-owned companies, such as BT and BAE Systems (LSE: BA.L - news) , it has made very generous pension promises to past employees that must now be met.

BA and BAE have bigger pension liabilities as a proportion of the market capitalisation than any other companies in the FTSE-100.

The airline today came up with its response: it confirmed it will open a new 'defined contribution' pension scheme - where the pension payable is based on contributions to the scheme made by the employee and employer - next April.

The new scheme will replace two existing schemes. The first is the New Airways Pension Scheme (NAPS), which is a 'defined benefit' scheme, where the pension payable is based on the employee's earnings at the time of their retirement.

Such schemes, typically referred to as 'final salary' schemes and routinely described as 'gold-plated', are dangerous for employers. With (Other OTC: WWTH - news) defined contribution schemes, the risk of the employee outliving their retirement savings resides with the employee.

:: BA faces union turbulence over pension plan

With defined benefit schemes, all of the risk resides with the employer, making them open-ended promises.

Such arrangements are not only risky to employers, they are also more costly, because an employee's earnings typically tend to peak at the end of their career. The employer has to mitigate that risk as best they can by employing actuaries to estimate how long the employee will live and then put aside sufficient funds to pay their pension.

Yet that too can be unpredictable due to the nature of investment returns.

To add to the expense, most defined benefit pensions are index-linked, in order to inflation-proof the pension received by the retiree. Typically, pensions payments are linked to the Retail Prices Index, rather than the lower Consumer Prices Index.

Some companies, such as BT, have sought to reduce the expense by seeking to change indexation from the RPI to the CPI.

Exacerbating the problem is the fact that pension liabilities are calculated according to the yield on UK government bonds (gilts), which have been depressed as a result of ultra-low interest rates, causing deficits to widen.

NAPS, which opened in April 1984 and closed to new joiners at the end of March 2003, has an estimated 17,000 active members - representing around 47% of BA's current workforce.

As proof of the risk to employers posed by defined benefit schemes, it had a deficit of £2.8bn at the time of its last valuation in March 2015. The chances are that the deficit has widened since then.

Once NAPS has closed, deferred pension rights built up in the scheme will - as with BT's proposals - be indexed in future according to the CPI, not the RPI.

The second scheme is the British Airways Retirement Plan (BARP) which, like the new scheme, is a defined contribution scheme. Some 52% of current employees, around 20,000, are members.

BA explained: "These changes are aimed at addressing the rising cost of future pensions provision and the volatility in the NAPS scheme."

The airline has been grappling for years with the cost of its pension schemes.

An earlier scheme, the Airways Pension Scheme (APS), dates back to 1948 and closed when NAPS opened in 1984.

This £9bn scheme's most recent review revealed that it has a deficit of £409m, which was costing BA more than £4m each month to make good.

In September, BA entered a 'reinsurance agreement' with two insurers - Canada Life Reinsurance and Partner Reinsurance - where the latter agreed to take on the risk that members of APS will outlive the money set aside by the airline to fund their pensions.

Significantly, BA's statement today points out that the decision has been taken "following consultation with trade unions and employees". This is crucial because, when BA first announced plans to close NAPS in early September, the Unite and GMB unions both reacted angrily and demanded talks with BA.

As has been seen elsewhere, pensions are increasingly the cause of industrial disputes, with university lecturers recently indicating they are prepared to take industrial action to protect their pensions.

Meanwhile, over at BT, the Communication Workers Union last month threatened strike action over plans to move 11,000 managers from a defined benefit to a defined contribution scheme.

BA is not alone among airlines in seeking to reduce the risk posed to it by its pension schemes.

Air France KLM struck a deal in October with pilots and cabin staff at KLM (Shanghai: 600686.SS - news) , the carrier previously owned by the Dutch state, in which they agreed to see their pensions switched from a defined benefit scheme to a defined contribution scheme.

German carrier Lufthansa (Xetra: LHAB.DE - news) , whose pension deficit stood at a stonking €8.1bn at the end of June this year, is also trying to reduce its liabilities.

If BA can resolve this issue without having to face strike action, it will be quite an achievement for a company that has had more than its fair share of industrial disputes down the years.