18 Post-retirement benefits

As described in the Finance Director's review, during 2007, the trustees of the UK defined benefit schemes, in consultation with the Group, have undertaken a review of their investment strategies. As a result, revised investment strategies have been adopted that aim to hedge, on an economic basis, the majority of the interest rate and inflation risks associated with pension liabilities by investing a significant proportion of each schemes' assets in swap contracts, backed by short-term money market deposits (the liability-driven investment or LDI portfolio). Following the agreement of this revised strategy, new entrants are no longer able to join the schemes and the Group has paid additional contributions of £500m to the main UK pensions schemes.

As described in note 1, for accounting purposes, the defined benefit schemes are valued in accordance with IAS 19 Employee Benefits. In particular, IAS 19 requires the discount rate used for the valuation of forecast liabilities to be determined by reference to the market yield on high quality corporate bonds. In contrast, for funding purposes, the discount rate is determined by reference to the expected rate of return on the scheme's assets, taking account of the specific investment strategy in place. As a result of this difference in valuation methodologies, the amounts recognised in the balance sheet will differ from those that would have been recognised if the valuation had been undertaken using the assumptions used for funding purposes.

Accordingly, although the investment strategy aims to hedge interest rate and inflation risk on an economic basis, the net position recognised in the balance sheet for UK defined benefit schemes may vary over time as a result of actuarial gains and losses that arise due to this difference in valuation methodologies.

In December 2007, PaySave was introduced in the UK. This a salary sacrifice scheme under which employees elect to stop making employee contributions and the Group makes additional contributions in return for a reduction in gross contractual pay. As a result, there has been a decrease in wages and salaries and a corresponding increase in pension costs of £3m in the year.

The discount rates are determined by reference to the market yields on AA rated corporate bonds. For the main UK schemes, the rate is determined by using the profile of forecast benefit payments to derive a weighted average discount rate from the yield curve. For less significant UK schemes and overseas schemes, the rate is determined as the market yield at the average duration of the forecast benefit payments. The discount rates above are the weighted average of those for each scheme, based on the value of their respective liabilities.

The overall expected rate of return is calculated by weighting the individual returns expected from each asset class (see below) in accordance with the actual asset balance in the schemes' investment portfolios.

The mortality assumptions adopted for the UK pension schemes are derived from the PA92 actuarial tables, with medium cohort, published by the Institute of Actuaries, projected forward and, where appropriate, adjusted to take account of the relevant scheme's actual experience. The resulting range of life expectancies in the principal UK schemes are as follows:

Other demographic assumptions have been set on advice from the relevant actuary, having regard to the latest trends in scheme experience and other relevant data. The assumptions are reviewed and updated as necessary as part of the periodic actuarial valuation of the schemes.

Assumptions in respect of overseas schemes are also set in accordance with advice from local actuaries.

The future costs of healthcare benefits are based on an assumed healthcare costs trend rate of nine per cent grading down to five per cent over seven years.

Future contributions

The Group expects to contribute approximately £271m to its defined benefit schemes in 2008.

Sensitivities

As described above, the revised investment strategies are designed to hedge the risks from interest rates and inflation. The principle remaining risks relate to the assumptions for mortality and increases in salaries. If the age ratings in respect of the principal UK defined benefit schemes were increased by one year, the scheme liabilities would increase by £164m. If the rate of increase in salaries were 0.5 per cent higher, scheme liabilities would increase by £112m.

The defined benefit obligation relating to post-retirement medical benefits would increase by £33m if the healthcare trend rate increases by one per cent, and reduce by £27m if it decreases by one per cent. The pension expense relating to post-retirement medical benefits, comprising service cost and interest cost, would increase by £4m if the healthcare trend increases by one per cent, and reduce by £3m if it decreases by one per cent.

In accordance with the transitional provision amendments to IAS 19 Employee Benefits in December 2004, the disclosures above are determined prospectively from 2004.