UK Pensions: Influencing Corporate Flexibility
Defined benefit pension scheme deficits continued to grab the headlines throughout 2004 for a variety of reasons. Fitch believes that there is now increasing pressure on UK corporates to channel incremental funds into their pension schemes, which may constrain their operating and financial flexibility to some extent. These developments can be summarised as follows:
These developments are likely to lead to increased rating volatility at the time of merger and acquisition activity as pension trustees wake-up to their new powers and ability to place onerous obligations upon sponsors to the disadvantage of the predators. What is clear is that there is an increasing trend for trustees to call for further funding from the corporate sponsor into the pensions scheme. Examples to date have been notable in constraining corporate merger and acquisition activity. Matters are far from transparent since the accounting position does not equate to the actuarial position nor the full buyout cost and, as highlighted in the actuaries’ paper, there is significant variation in practice and understanding of the implications of actuaries’ own valuations.
The pressure continued to mount during 2004 for UK corporate defined benefit (DB) pension schemes. Whilst some companies have attempted to address the issues raised by the financial community and scheme trustees by pledging additional contributions, it is clear that an increasing awareness of the issue on the part of trustees could result in further channelling of cash flows into the schemes.
In fact in 2003 FTSE100 companies contributed around £10bn to their defined benefit pension schemes, approximately double that of the previous year, according to Lane Clarke and Peacock’s Accounting for Pensions Annual Survey. Increased trustee activism is in part due to the increased awareness of the implications of the unfunded pension deficit. Fitch believes that further trustee pressure on the corporate sponsor could result in funding of the pension scheme so as not to constrain the operating profile of the company although in itself directing resources to the pension fund means less cash for other corporate purposes.
The actuarial profession is in the process of considering change to its own practices. A recent paper entitled ‘Funding Defined Benefit Pension Schemes’ by Charles Cowling, Tim Gordon and Cliff Speed puts forward an approach for actuaries which could result in an appreciation that pension scheme deficits are significantly larger than had previously been understood as a result of the potentially confusing terminology, in particular the funding descriptions.
Should the proposals put forward, in the paper mentioned above, to the Institute of Actuaries (25 October 2004) and the Faculty of Actuaries (17 January 2005) be accepted, this is likely to drive corporate bond issuance as a means of funding. By implication will affect traditional credit protection measures with the actuarial liability being crystallised by the company rather than existing as a longer term obligation which can be funded over the lifetime of the scheme.
Some key recommendations of the report
The argument pursued by the authors of the recent paper follows the line that the pension deficit is like an unsecured loan from the pension scheme members to the corporate sponsor. As a result the likelihood of payment is closely aligned to the credit profile of that corporate entity. This means that the pension scheme should take some account of the ability of the employer to service its obligations. The most effective method of doing this is to rely upon corporate credit ratings. This would then enable the trustees to put in place a risk management strategy, potentially requiring further cash contributions upon credit downgrades which may be used to purchase protection against the corporate sponsor’s insolvency. This type of solution is similar to ratings triggers which can exist in bank and bond documentation today.
It is proposed in the paper that schemes invest 100 per cent in bonds due to the tax advantages when compared to equities for shareholders of the corporate sponsor. Put simply, cash or bond investments are made gross of tax whilst equity dividends received by the scheme are net of tax and when passed to the shareholder of the sponsor are taxed again. In addition, the bond investment creates further certainty for scheme members. It is worth noting that upon insolvency bondholders have stronger rights than equity holders thereby reducing the risk of loss. In fact rating transition studies are well established along with recovery rates upon insolvency. See Fitch Ratings Corporate Finance 2003 Transition and Default Study dated August 2004.
It is the case that the increased funding paid to pension schemes to invest in bonds would in large part be funded by bond issuance by the corporate sponsors, thereby eliminating any severe long-term mismatch between supply and demand.
This recommendation represents a departure from current practice. As noted in Fitch’s earlier report in 2003 the average percentage of pension assets invested in equities was 67 per cent and this has not changed significantly since that date. The rationale for the asset allocation into equities was linked to the higher rates of return expected over the lifetime of the fund. However, the risk reward balance is under review given the reliance that scheme members place upon the schemes for their livelihood during retirement.
The paper highlights the inevitable tension between loyalties for trustees who are senior management of the sponsor. These trustees have a divided loyalty between the sponsor’s performance (i.e. contribution levels) and the well-being of the pension scheme. In extreme circumstances the trustees could use pension fund objections to achieve corporate aims e.g. blocking certain merger and acquisition transactions. Whilst governance concerns do not directly impact the credit profile of the corporate sponsor, a strengthened regime could result in increased funding requirements from trustees.
The actuaries point out that even where trustees have full power to set the corporate contribution level, pension schemes remain poorly funded which points to the fact that trustees have not been forceful to date in exercising their powers. Fitch believes that the appointment of independent parties similar to non-executive directors could in part address this issue. Many current trustees remain reliant upon the company for their current income in addition to their income in retirement.
The 2004 Act does require that 50 per cent of trustees are member nominated which represents an increase from the previous one third member nominated trustees. Below Fitch has listed the trustees of Diageo Plc for illustrative purposes. Limited information was publicly available on the composition of the board of trustees at the other companies mentioned in this report.
| Trustees Graeme Forrester Catherine James Brian Higgs Ray Joy Graham Logie Robert Moore Ian Shaw Roderick Sivewright Gareth Williams |
Corporate Function Retired Malt Distilling Director Group Investor Relations Director Finance Director Great Britain Site Operations Manager Finance Director Global Supply Retired Share Registration Administrator Human Resources Director |
Source: Company/Fitch
Fitch notes that a heightened level of trustee activism may not be limited to merger and acquisition activity but could occur in all cases where there is a potential for credit deterioration. This may result in further cash payments to pension schemes in advance of other uses of funds. In some examples the corporate sponsor has anticipated calls for funding from the pension scheme and contributed additional funds. The agency observes that, increasingly, companies with high pension deficits may become unattractive targets for acquisition.
Four examples are listed below which illustrate some different situations involving pension funds and their corporate sponsors that arose during 2004.
M&S issued a £400m bond in March 2004 and used the proceeds as a cash injection to the defined benefit pension scheme. This was viewed by the agency as credit neutral, following the methodology outlined earlier in this report.
More recently in July 2004 the pension scheme trustees used their powers to discourage a takeover bid by Philip Green, the retail entrepreneur. In a statement released by the company dated 10 July 2004 following a request from M&S the trustees called for a more conservative investment strategy to be implemented should there be a material weakening in the company’s creditworthiness. The statement illustrated a range of possible funding strategies, ongoing contribution rates and years over which the deficit could be spread. The existing funding plan for the Marks & Spencer pension scheme was for an initial payment of £400m in 2004 (funded by the bond issue mentioned above) together with nine payments of £33m a year from 2007 until 2015 to fund the remaining deficit, in addition to the regular annual contribution of £80m.
However, following a £2.3bn share buyback to defend itself from the bid, the company is now more leveraged than it was when the trustees commented on the increased leverage attached to the Green bid. The trustees’ response to the two situations is viewed as inconsistent by Fitch and may illustrate the tension between loyalties noted earlier. Fitch believes that there is likely to be an increasing number of cases where trustees are proactive and can effectively demand additional funding ahead of credit deterioration events – e.g. share buybacks. In these circumstances where the pension scheme trustees are impinging on management strategy it is possible that a decision will be taken to fully fund the scheme to increase management’s ability to make operational and financial decisions. Such a decision would have an effect upon the credit profile of the corporate sponsor.
In April 2004 discussions on a potential sale to Permira, a venture capital fund, were suspended by the company following a communication by the Chairman of the Trustees of the WH Smith Pension Trust that ‘a substantial cash contribution to the pension fund would be required in the context of an offer for the Company financed by a significant level of borrowings with security over the Company’s assets’.
In fact the company later disposed of its Hodder Headline subsidiary and contributed £120m to the pension fund as well as returning £207m cash to WH Smith shareholders. This was financed through the disposal proceeds and new banking facilities the company put in place. WH Smith stated that this step will lead to future cash contributions to the scheme being halved to £21m per annum over the next nine years. This was consistent with the earlier calls to make a cash contribution to the scheme under the Permira bid. The actual step of allocating the disposal proceeds to the scheme was viewed as credit neutral.
The current ‘BB-‘ rating encompasses the company’s ability to pay the reduced £21m of contributions.
In this example the company reacted to the pension deficit in an inventive way. Diageo recently transferred £100m worth of General Mills shares to the group’s pension scheme. This was an effective solution given that the scheme had a pre-tax deficit of £817m (June 2004), even though it had an actuarial valuation in excess of 100 per cent. The transfer does not affect the company’s cash flow profile and hence its credit quality in this instance.
In April 2003 the company entered into an agreement with the Whitbread Pension Trustees Limited to fund the pension deficit over a period of 15 years and has given the trustees undertakings similar to covenants provided in respect of banking agreements. The company’s net FRS17 deficit was £256m at FYE04. In this case it appears that the trustees have set themselves risk based criteria based upon a combination of limits similar to Whitbread’s banking covenants and actuarial advice.
The Pension Protection Fund (PPF) set up by the recent Pensions Act 2004 has attracted significant criticism from market commentators. In particular, the operation of the scheme has not been detailed. In the current highly publicised case of Turner and Newall, the company has been in administration for three years but the pension deficit is likely to be protected by the PPF, eligibility for which depends upon the date of the pension scheme wind-up rather than employer insolvency, according to the pensions minister. This means that the PPF could end up adopting the scheme’s assets, with the pensioners becoming PPF pensioners to the level provided by the legislation (PPF guarantee level).
Fitch observes that in the first year a flat-rate levy will be applied to pensions schemes prior to the introduction of the risk-related and scheme based levies in 2006. Fitch believes that in practice the levy will be pushed back on to the corporate sponsor of the pension scheme.
It is argued that well funded corporate schemes could purchase protection in the form of credit derivatives e.g. credit default swaps referenced to the corporate sponsor as a means of minimising PPF contributions. As a result it would appear that any dissociation of risk and contribution in the form of the levy could create a favourable arbitrage for pension schemes which may pay lower contributions to the PPF than the rate at which the market would price similar credit protection.
The PPF levy represents a real cash cost to pension schemes which is likely to be pushed back to their corporate sponsors. For strong credits it may be seen as a type of tax, whilst for weaker credits servicing the pension fund may become a lower priority since the employer has the knowledge that the PPF will step in at the guaranteed level. The NAPF (National Association of Pension Funds) has indicated that a number of companies are looking to move their pension schemes to Ireland which has less restrictive pension regulation than the UK.
The establishment of a pension regulator by the Act (the Regulator) appears likely to make predators increasingly cautious of taking over companies with sizeable defined benefit pension deficits. The regulator has a range of powers over a company’s pension funding in the event of a takeover. This may extend to requiring a contribution of the full buyout cost of the scheme, which is typically in excess of the actuarial deficit. It is feared that approval by the Regulator is likely to slow merger and acquisition activity since many participants will seek preapproval prior to completion of the transaction where substantial liabilities exist. Fitch believes that this will require both sides to quantify the obligation to a greater extent than was previously the case. This effectively crystallises the debt upon sale of a division or entity with significant pension obligations. It is considered likely that any reorganisation prior to a disposal without full funding would be considered avoidance by the Regulator.
The Act effectively prevents employers from obtaining refunds from pension schemes unless funded to the buyout level, which could be in excess of full actuarial funding. Fitch’s methodology excludes scheme surpluses since it assumes that these may not be refunded to scheme sponsors.
From 1 January 2005 EU domiciled companies will be required to implement IFRS. IFRS 1 enables a company to recognise the full deficit upon adoption and subsequently to measure movements. For example this is how Royal Dutch Shell intends to apply the standards. As a result the impact will amount to a $4.9bn reduction in opening net assets. Should the asset valuations recover in future years, this treatment would lead to the recognition of surpluses by the company.