The Pension Fund Doesn't Affect My Company's Credit Rating... Right?
Pension deficits are considered as company debt (where pensions are guaranteed by the company) and this is also how credit rating agencies treat them, adding them into debt when calculating their key debt ratios. Even though they are usually further down the food chain than typical forms of debt the agencies rate, pension deficits can have a very real impact on a company’s credit rating.
The extent to which a pension fund’s accumulated assets fall short of the liabilities (the deficit), along with the rate of financing new liabilities being built up, can have a very material drain on profits and free cash flow. Where there is a significant deficit, it does not in itself usually trigger a credit event because legislation may be such that it can be amortised over a fairly long period. However, this continued drain on resources over an extended period means that debt holders do not build up a sufficient buffer against the vagaries of normal business activity. Even where there is no contractual pressure on the company to make good its pension deficits, the ‘real world’ pressure of reputation should not be underestimated.
Not only are the debt holders more exposed to business risk, the pension deficit in itself is very volatile, meaning that the debt holders have to build in one more layer of uncertainty. The pension deficit is so volatile because it is the difference between two big numbers, liability value and asset value. Even though some pension funds have started trying to make these elements move in unison via liability-driven investment strategies, there is still a long way to go on this front. For example, a company with a £1bn pension fund, but no pension deficit, could have a £100m deficit the next year via a 5% move in the liabilities upwards and a 5% move in the assets downwards. These are historically very ‘minor’ moves; indeed a typical pension fund could have a one in 20 chance of developing a deficit of £300m in one year.
Unfortunately, the actual position is even worse. This is because of the frequently strong correlation between financial strain in the company’s core business and the likelihood of a pension deficit arising. The credit crisis was just one example of this: as markets fell, not only did the company’s business suffer; the equities and corporate bonds in the pension fund also fell. There was a ‘flight to quality’, causing sharp increases in gilt prices, significantly increasing the pension funding liabilities. Companies were struggling to keep some free cash flow, and pension funds were coming to ask for more cash to pay for the extra deficits in the pension fund. It is this correlation risk that could be the difference between a normal economic cyclical downturn, and something that endangers the survival of the business itself.
The events of the past couple of years luckily only come along infrequently. However, the pension funds also cause significant difficulties in more conventional times. Companies will typically target a certain credit rating to, among other things, make the cost of their debt more predictable. Sometimes they also have agreements in place with their banks that certain financial ratios will be maintained or improved. Having a pension fund that exacerbates the ups and downs of the business requires management to hold more resources in reserve, resources that could otherwise have been used to generate business growth. If the resources are not enough, and a credit downgrade is threatened, raising additional capital via an equity rights issue is far from ideal; not only is equity capital expensive at the best of times, the share price will already be depressed due to the business situation.
Financial institutions are facing greater recognition of (unsmoothed) pension deficits and risks in pension funds in the capital adequacy frameworks for financial institutions (Solvency II and Basel III) that have long been considered by the rating agencies.
It is important to recognise the increasing influence from new financial vehicles such as credit default swaps (or proxies to it calculated from the level and volatility of the share price), especially after the problems credit rating agencies face as a fallout from the credit crunch. Discussion of this is beyond the scope of this article, but the continuous market pricing of these vehicles means that a company’s management has yet another metric to manage to.
Just cutting out all the risk from the pension fund causes seemingly perverse repercussions. The typical issue confronting the company when it raises this solution is that the pension fund will ask for more cash to make up for lower anticipated excess investment returns. Even though this cash call will now be predictable, few companies can afford it. It is important to note that there are frequently alternative sources of security that a company can give its pension fund instead of cash – such as contingent assets.
The following graphical representation shows the three dimensions of the holistic risk to the company from its pension fund. Reducing the overall risk can be done on one or more of the axes. For example, an overall high risk position can be improved by reducing the correlation between the company’s core business and the pension fund finances (the blue triangle in the medium risk scenario) – simplistically, the pension fund of a motor vehicle manufacturer should avoid pro-cyclical assets. The ‘pension risk’ component (when the pension fund is looked at in isolation) is unfortunately what funds solely focus on – it is only the company who can look at the overall position and act accordingly. This action will typically be in the interests of the pension fund as well because, given current deficit levels, it will require a healthy company for an extended period. Which dimension to tackle will vary over time, and will of course be constrained by other business demands.
To come to a solution, companies will therefore need to address the following: