Credit Crisis Impact on Retail Pension Schemes
During the run up to Christmas 2008, many of us will have snapped up bargain Christmas presents that had been heavily discounted by retailers struggling to liquidate their Christmas stockpiles. It was evident in the shop windows throughout the UK’s high streets that retailers were displaying symptoms of the unprecedented turbulence in global finance. In early January 2009, Pension Capital Strategies (PCS) produced a report investigating how the doom and gloom on the high street would affect the provision of defined benefit pension schemes in the UK retail industry.
The retail sector is often a bellwether for the UK economy. Consumer spending typically accounts for over half of the UK’s GDP. In the good times, we are all happy to spend and fuel a retail boom. In the bad times, spending is immediately cut back and shoppers demand savage price cuts before they will part with precious cash. Retail companies typically run on relatively tight margins. Reductions in spending can therefore have a significant impact on bottom-line results.
But where do pensions fit in? Increasingly, the luxury of a generous defined benefit (DB) pension scheme is something retailers can ill afford. Marks & Spencer is feeling the strain and, only days before PCS produced the report, the high street store announced plans to instigate significant cutbacks in its DB pension provision. Moreover, the legacy of a large DB pension scheme is increasingly seen as a millstone around the necks of company boards and a drain on precious cash flow. Particularly for treasurers driving cashflows, new demands for cash from the trustees of pension schemes may be an unexpected and unavoidable diversion of funds. When margins are tight, those companies that have not managed to deal with the burden of their DB pensions are increasingly finding themselves at a competitive disadvantage.
In order to appreciate the complex nature of the UK DB pensions environment, we need to consider three different viewpoints for looking at pension liabilities:
Trustees are being encouraged by the pensions regulator to act more like a corporate creditor when a pension scheme is in deficit. Under their fiduciary duty, the trustees produce a prudent valuation of the pension liabilities, known as the technical provisions.
The value of pension liabilities that affects the company balance sheet is determined under the International Accounting Standard 19 (IAS 19). The yields available on high-quality corporate bonds are used to derive the discount rates used to value pension liabilities under IAS 19.
The ultimate pill to remove the pensions headache is to transfer all the liabilities and assets of the scheme to an insurance company. The insurance company places its own value on the pension liabilities, commonly referred to as the buyout liability.
In December 2008, the pensions regulator issued its third annual edition of DB Pensions Universe Risk Profile (the Purple Book). This provides a comprehensive analysis of the state of pension scheme funding in the UK. In line with the regulator’s findings, Table 1 illustrates the variation in the value of pension liabilities under the each of the three viewpoints as of 31 March 2008.
| Technical Provisions | IAS 19 | Buyout | |
|---|---|---|---|
| Present value of pension liabilities | £116m | £100m | £159m |
There has been some serious turmoil in financial markets since March 2008, and the comparisons above are beyond their ‘best by’ date but they do illustrate two simple facts:
In its January report, PCS investigated 20 major UK retailers to see how they are affected by their DB pension schemes. To draw meaningful comparisons between the retailers, PCS posed two questions:
Increasingly prudent legislation and continuing evidence of people living longer have served to add significantly to the values of accrued pension liabilities. From the trustees’ viewpoint, increasing technical provisions leads to increasing demands for cash funding from trustees. But can companies afford more demands for cash at the present time? There are two other important considerations here. First, corporate bond spreads have been ravaged by the credit crisis and are now at levels not seen since the Great Depression of the 1930s. This means that due to the perverse accounting rules, pension liabilities under IAS 19 are at artificially low levels. A return to more normal levels of corporate bond spreads would see pension liabilities in company accounts increase by 30% or even more. Second, if a company does get into difficulties, it is not the accounting liabilities that the trustees will be looking at, but the full insurance company buyout liabilities, which since 2003 are a UK statutory debt on the company. These are typically 30-40% greater than the accounting liabilities (but can be even more).
Of course, a replacement benefit would have to be provided, but would typically be considerably cheaper. Summarised results of the PCS analysis are shown in Table 2.
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The analysis revealed a wide array of exposures to DB pension liabilities among the UK retail industry. Using IAS 19 liabilities, 13 retailers disclosed pension deficits in their annual accounts and, arguably, these IAS 19 liabilities underestimate the ‘true’ cost of DB pensions provision. For Jessops, Beales, WH Smith and Thorntons, recognition of an increase in pensions costs, possibly manifesting in trustee cash demands, threatens to restrict company finances. For Mothercare, Beales and Sainsbury, the ongoing provision of DBs is hitting pre-tax profits hardest.
Like for like, the outlook for the UK economy at the start of 2009 is significantly worse than a year ago. Confidence in UK companies is now at rock bottom as they face a toxic combination of limited credit availability, a weak pound, and reduced consumption. From a high of 99 in September 2007, the Nationwide Consumer Confidence Index has plummeted to a record low of 40 in January 2009. Consumers are feeling the credit crunch and are set to spend less on the UK high streets, which will heighten retailer sensitivities to increasing pension costs.
Pressure to cut costs continues to pile on. Much publicity has surrounded companies entering administration, including household names such as Woolworths. Even Marks & Spencer, a flagship UK retailer, has announced job cuts and store closures as a result of falling sales. The retail workforce may now more readily accept that sacrificing defined benefit pensions will help avoid further redundancies.
Corporate consolidations intensify in the prevailing economic environment, but for companies with significant pension liabilities, any deficit in the scheme can be the most poignant of poison pills that financial controllers will encounter. In 2004, a takeover of WH Smith by private equity house Permira was foiled primarily by WH Smith’s sizable pension deficit. Currently, in the aviation industry, the British Airways pension deficit is the fulcrum of merger negotiations with Iberia. The retailers most affected by their pension liabilities will be less attractive to potential suitors. Attracting other investment may also become more problematic. The credit ratings agency Moody’s has recently issued a warning on how significant pension liabilities can have a significant impact on credit ratings and hence on companies’ ability to borrow.
Over the next five years, PCS predicts a barrage of cost-cutting exercises will reduce corporate provision of DB pensions. We believe the large majority of private sector companies will close their DB pension schemes to all future benefit accrual. Indeed, a recent survey of pensions in smaller firms from the Association of Consulting Actuaries found that in those firms with DB schemes, nearly half of all such schemes are already closed to future accrual. Those that move first (and some already have, e.g. Debenhams and WH Smith) will gain competitive advantage. Furthermore, companies need a clear big picture end-game strategy for managing a reduction in their accrued pension liabilities, which ultimately leads to their complete removal. We believe that retailers will be at the front of the queue to escape from their pension schemes.