European Pensions: The Debate Continues

Summary

In the six months since the publication of Fitch’s initial report on defined benefit pensions in Europe, outlining the methodology that has been adopted by the agency, the debate has continued with renewed strength. This paper highlights the developments that have taken place over that period and illustrates some case studies from the Fitch portfolio of companies most affected by defined benefit pension deficits, explaining how these events have affected their credit ratings.

Fitch’s initial view on the extent to which the pension methodology would affect corporate credit ratings has been confirmed by this portfolio review. It was found that the pensions issue has been incorporated into rating Outlook changes, rather than of itself resulting in widespread rating action. Imperial Chemical Industries plc (“ICI”) recently created an asset-backed pensions guarantee. Fitch views the dedication of assets in this way as negative from a senior unsecured bondholder’s perspective. Whether this results in downgrades will depend on the whole credit profile of the particular case under consideration. Recent defined benefit pension scheme developments that are significant in terms of corporate credit ratings include:

• Pensions-related issuance/asset allocation.
• Continued closure of defined benefit schemes.
• Minimal incentive to create fund surplus.
• Continued mismatch between actuarial and funding calculations.
• Increased regulatory scrutiny.

In short, the issue remains very much an area of focus for investors. The implementation of pension-adjusted ratios by Fitch has increased transparency in this area.

Recent Developments

Since Fitch’s initial publication, “The European Pensions Debate”, in March 2003 (available from www.fitchratings.com), a number of further developments have taken place. Recent events have affected the landscape for European corporates managing defined benefit pension schemes, and have had an impact on their relationship to individual company credit ratings.

Pensions-Related Issuance/Asset Allocation

US Sets a Precedent for Issuance

In the US, General Motors Inc (“GM”) issued USD13.2bn of bonds to finance its pension deficit. This was the first company to take such a step, and may be followed in Europe at some point. However, Fitch notes that to some extent GM’s position is unique in terms of scale: other issuers may prefer to rely on the flexibility that variations in contributions can bring, provided of course that they are sufficiently cash-generative.

In the case of funded schemes, Fitch notes that pension-related issuance would have no effect on the credit rating since the Fitch adjusted leverage remains constant in these circumstances (see worked example above). The additional leverage and coverage ratios are devised to track such changes over time.

For unfunded schemes:

1. Partial funding of the scheme will not have as severe an effect on the adjusted credit ratios as in the case of funded schemes. This is because only part of the provision is treated as debt-like (see worked example on next page).
2. In the case of full funding of the scheme, there is likely to be a cross-over point between the treatment of the scheme as funded or unfunded.

   Funding of such a scheme should be viewed in the context of the regulatory environment, which does not require funding at this time.

Subordination of Bondholders Through Allocation of Balance Sheet Assets to Pension Creditors

ICI recently announced the outcome of the triennial valuation of its UK pension scheme. The increased actuarial deficit has led the company to make top-up contributions of GBP62m (previously GBP30m) to the fund for nine years from 2004. This will effectively increase the fixed cost base of the company, reducing the already strained free cash flows. The other, more radical step was to create an asset-backed guarantee for GBP250m to support the fund in case of corporate insolvency. The assets are trade receivables that have been placed in a subsidiary, of which the pension fund is the only creditor. The bondholders’ position has become structurally subordinated as a result of this action. This step sets a precedent that may be followed by other large corporate entities facing substantial pension liabilities, which in turn is likely to stimulate credit rating actions.

Such a step effectively creates a “conditional” contribution whereby the “guarantee” is available to the scheme should the creditworthiness of the company decline; however, it is not as definitive as a formal contribution to the scheme, since if the scheme enters surplus at some point in the future the guarantee remains unused or is reduced, rather than the company clawing back the surplus through reduced contributions over a number of years. In addition, Fitch believes that such a “guarantee” may be called upon by trustees where the corporate sponsor of the pension scheme is encouraging them to take on a certain level of risk in relation to investments that they may not select for themselves. In these circumstances the company would be called upon to underwrite the risk. In this context, such guarantees could become more common. Such a step has to be balanced against the interests of the bondholders, shareholders and pensioners.

Continued Closure of Schemes to New Members

Further closure of defined benefit schemes to new members has taken place as companies seek to limit their overall exposure to pensions. This trend has been particularly pronounced in the UK. The Retirement Financial Management Statistics published by Mercer as at 31 December 2002 (publication date July 2003) indicated that the number of companies offering defined benefit pension schemes to UK employees had fallen to 25% of FTSE350 companies from 45% in the prior year. In Fitch’s view, companies are most likely to continue to operate such schemes rather than closing them entirely, since the government’s defined benefit pension reform proposals (11 June 2003) require companies to meet the full cost of securing the benefits with an insurance company. The cost of such an exit is thought likely to be in excess of the deficit measured under FRS17, thereby increasing the incentive for companies to deal with the issue internally.

Creation of Fund Surplus

In general, companies in Europe are not encouraged to create a fund surplus, since such sums are difficult to extract subsequently from the trust and also because there is generally some pressure from beneficiaries to increase or share the benefits. One course of action would be to take a pension holiday, something which many companies did in the 1990s: this gives improved cash flows for the company for a short period while the fund is in surplus. However, given the accounting valuation method based on market prices, the fund’s status is dependent on the volatility of the stock market, and companies would be well advised to continue contributions to avoid a repeat of the current situation in future years, should the market turn down to the same extent once more. It is possible that some schemes will return to surplus positions at FYE03. As noted above, Fitch does not net the surplus in one scheme against a deficit in another. In certain circumstances, disclosure on specific schemes is limited and an amalgamated number is disclosed. In these situations, as part of its analysis, Fitch conducts more detailed discussions with the issuer in order to understand the component parts.

Continued Mismatch Between Funding and Accounting Valuations

Particularly in the UK, where pension obligations are required to be backed by assets, there is a mismatch between the accounting and funding valuation methods, which creates a degree of confusion. Funding calculations are based on the long-term assumptions used by the scheme’s actuary in his valuation and also take into account the risk tolerance of the company to some degree. Contributions are calculated on this basis rather than using the more volatile mark-to-market valuations created by the accounting rules. As a result there can often be an apparent divergence between actual contributions and the accounting deficit (see case study on BT Group plc for further detail).

Regulatory Scrutiny

Regulatory regimes have sharpened their focus on this area and it has also increased in importance on the political agenda, for example with regard to the proposed defined benefit pension insurance scheme in the UK. Fitch considers it likely that this pressure will continue over the short to medium term and may even result in some widespread changes in the regulatory framework.

A number of companies have made voluntary contributions to close the pension gap despite a lack of regulatory pressure. In Germany, a number of companies have selected to build up pension assets e.g. BASF, Volkswagen.

In view of the current review being undertaken by Ofgem of the way in which pensions/ pension deficits should be treated and how best to assess what can be passed through to customers, ratios have not been compiled for the Fitch Energy Group. However, Fitch would expect to see the majority of pension deficit costs being allowable by Ofgem, with the treatment of pensions holidays and their subsequent impact on deficit positions coming under close scrutiny.

Fitch Portfolio Review

Following the reporting season, Fitch undertook a review of all the European corporate entities within its rating universe in order to monitor the effect of the pension methodology in terms of credit ratings. In the initial report, Fitch indicated that rating Outlooks were most likely to be affected by pension issues in the absence of regulatory intervention. This has been borne out by the review, which covered both the supplemental ratios as well as the qualitative aspects of corporate pension provision in Europe.

A number of the most severely affected companies within the Fitch corporate portfolio have been selected for case study analysis below:

BAE Systems plc

Earlier in 2003 BAE Systems (“BAE”) announced that it would deal with its substantial pension deficit (GBP2.16bn) by scaling back the benefits provided to members. This caused outrage from the unions and workers threatened to strike in response to the company’s proposal that workers increase their contributions by 2% per annum, as well as the closure of the plan to new workers. The proposals were combined with expected company top-ups of GBP30m for 2003 and GBP60m in 2004.

A compromise was reached after lengthy negotiations whereby the company agreed to cover 60% of the additional costs over a period of three years to close the shortfall, with a commitment to reducing employee contributions once the plans enter surplus. This means that the company will boost its contribution rate to 18% from 12% over the period and employees will increase their rate to 9.3% from 5% over the period. In addition, new employees were offered a hybrid combining elements of both defined benefit and defined contribution schemes.

BAE was one of those companies that took advantage of a pension contribution holiday from 1987 to 1993. This decision meant that it benefited from improved cash flows over that period, as it had ceased to make payments to the scheme. Some of the surplus was used to top up benefits. However, this early benefit has contributed in part to the increased cash flow burdens that the company is now experiencing. The additional burden has come at a point in the economic cycle when the majority of companies are at their lowest point of flexibility. The provision of improved benefits to members has contributed to an increased long-term burden on the company, which has been shared with employees who now bear a portion of the cost through the increases in their contribution rate.

The current rating and Outlook incorporate the pension issues for BAE.

ThyssenKrupp AG

ThyssenKrupp AG (“Thyssen”) represents a topical example of the unfunded pension provisions that are typical in Germany. The Fitch methodology takes into account the regulatory environment and effectively capitalises the proportion of the deficit in line with the proportion of debt to total assets. Since there is no immediate funding requirement, it is assumed that the company will replicate its capital structure over time.

Fitch discussions with management on the pension provision focused on peak cash payments and the state of maturity of the scheme. In this case the scheme is very mature, with the majority of members already retired, which means that the peak cash flow demand is only EUR20m higher than the FYE02 level.

The pension commitment is fully built into the Fitch rating and Outlook for this company published in May 2003.

Whitbread plc

Whitbread runs a large deficit in its pension scheme relative to the size of the company after its demerger (scheme is 60% of balance sheet size measured as the larger of assets and liabilities). It has taken steps to tackle the issue, increasing its contribution by GBP15m in FY03 and intending to maintain these additional contributions.

The defined benefit scheme was closed to new entrants from January 2002 in an attempt to mitigate the issue over the long term. The current rating level takes the pensions issue into account.

BT Group plc

BT is perhaps the highest-profile company in terms of the magnitude of its pensions deficit. Despite the high absolute deficit, Fitch was able to affirm the rating in view of the reducing trend for net leverage and lease-adjusted net leverage predicted over the medium term.

In its work with BT on this subject, Fitch reviewed the actuarial funding assumptions and the profile of the scheme to gain an understanding of the qualitative aspects. This is an important step in fully incorporating the pension methodology into credit ratings, since there are a number of non-quantitative issues that should be considered, as outlined in the prior report on the subject.

For further details, see Fitch press release on BT’s pension deficit dated 22 May 2003 (available from www.fitchratings.com).

RATP

Although RATP suffers a significant increase in leverage as a result of adjusting for pension liabilities, this is not reflected in the rating level, which is primarily based on its status as an EPIC. The company remains heavily subsidised and without such subsidies, EBITDA would be deeply negative. In the pension calculation the service cost is actually the net amount (gross service cost less the state subsidy). As a result, the ratios calculated are “polluted” to some extent by State subsidies.

Deutsche Post World Net

This company has also been a centre of attention for the press and investment community in recent months.

In analysing this group’s own pension obligations, Fitch continues to distinguish between:

1. the bulk of the annual pension cost for the civil servants at this postal operator – a sum proportionate to the staff costs of a closed (since 1995) number of employees, a fixed percentage rather than one changing with pension plan valuations, and a sum that, for these employees, becomes an obligation of the state once retirement or early retirement occurs; and
2. the group’s own defined benefit schemes.

   Fitch’s evaluation of the predominantly unfunded liability is that it has little long-term effect on the cash generation ability of the company at a cash cost of about EUR400m per annum.

Carlton Communications Plc

The company continues to operate a defined benefit pension scheme for its employees, who become eligible following an initial period of service. Given that the company operates in a cyclical industry dependent to a significant degree on advertising revenues, leverage rises substantially at the low point in the cycle. This, combined with the fall in the equity markets, thereby increasing the accounting deficit in the pension scheme, has a double effect on the company in terms of the adjusted ratio.

The current rating incorporates the pension deficit and the RatingWatch designation reflects the potential for ratings action in the light of the proposed merger with Granada.

Conclusion

Fitch continues to monitor corporate ratings in the context of pension scheme liabilities and regulatory developments in this area:

• Credit rating Outlooks are most likely to be affected by weak pension-adjusted ratios.
• Structural subordination of bondholders may occur where the company restricts their access to assets upon insolvency, e.g. ICI. This may have an effect on the rating of those instruments.

Fitch anticipates that this area will remain significant during 2004 as companies across Europe take action to address mounting defined benefit pension liabilities.

Note: Co-authors of this report were Susan Hunter and Wolfgang Wiehe. This report was first poublished by Fitch on 11 November 2003.