Corporate Finance and Pension Funds
Many companies are struggling with substantial pension legacies. These legacies are an onerous drain on the financial resources of the companies, resources that could much more effectively be spent in growing the business. Even more worrying is that the pension funds still expose sponsoring companies to substantial risks.
Resolving the existing and potentially significant pressure on the business from these legacies clearly needs the attention of the company at the highest level. The key aspects the company needs to look at include:
The optimal approach is heavily influenced by the industry in which the company does business. Companies in certain industries are already putting a risk management process in place that is specific to the demands of their environment.
Having risk in the pension fund which is significantly correlated to the risks of the business means that a setback in the business is likely to coincide with a setback in the pension fund. The recent financial crisis brought this home to a painful extent for a large number of companies.
The economic factors affecting the financial position and changes in a pension fund also directly influence the industry in which the company operates. The industry, for its part, clearly has a very material influence on the business, i.e. studying the features of an industry frequently allows a more durable view of the underlying economics for risk and cost management, given that there are many possible idiosyncratic features affecting any company.
Take the example of a national publishing company, which has a natural exposure to advertising revenue. When there is an economic recession or stagnation, the sharp fall in advertising revenue causes a sharp drop-off in earnings and free-cashflow. This is in an industry already suffering very significant pressures from new technology and mature markets. Unfortunately an exposure to equity-like assets in their pension funds result in sharply higher deficits at the same time as the business pressure, leading to a demand for more cash to finance the extra shortfalls. Where the economic pressure is severe enough, it could result in lower interest rates, which causes even greater pension deficits and a higher demand for cash if the pension fund is not hedged.
It is not just the cyclicality of the business that needs to be fundamentally recognised in how the company sets its pension strategy, but also the degree to which it can absorb any setbacks given competitive pressures. If the publisher’s competitors had significantly smaller pension legacies, they would have less stress in a downturn, with the ability to improve their competitive position.
Another variation of this differentiation theme is where a company has a significant pension legacy but has employed a robust risk management strategy. When the downturn comes, they therefore have a relatively greater level of protection with consequent ability to improve their competitive position.
The presence of significant pension legacies is not uniform across geographies. A company with a greater presence in the UK (with its tradition of defined benefit plans; now typically poorly funded) will therefore suffer when competing against another company in its industry that does not have this exposure to the UK. This differential structure is frequently unavoidable, and the company with the pension legacy must therefore employ robust risk management to level the competitive playing field.
Then what if the economic conditions turn out very favourably – will the company with the pension legacy not then have a geared position leading to competitive advantage? This is unfortunately unlikely, as the trustees of the pension fund will most likely oppose reductions in cash contributions so as to reach full funding earlier – possibly engineering this via de-risking the investment strategy. Also, the pension fund is far from the company’s core competencies. An improvement in the financial markets will therefore most likely lead to lower gains than if the business instead had greater exposure to its own markets and operations. This strategy of greater focus of capital on its own industry rather than the pension fund should also lead to greater protection in a downturn because a company understands its own industry so much better and can take corrective steps. Quick action is something that the governance of a pension fund finds notoriously difficult.
A common theme above is the way the pension fund trustees are likely to react under different circumstances. A pension fund is in certain respects a joint venture a company has undertaken where it carries the financial risks but has patchy decision power. It is therefore very important that the company provides a deep understanding with the trustees about the nature of the industry the business is operating in, and consequently how the pension fund finances should be managed.
In the examples mentioned above, reaching an understanding that “taking risk to finance the deficit” actually endangers the company and therefore the members is imperative. That is, funding the deficit over a longer period is actually the safer course of action.
There is a range of industry awareness the company (and trustees) should bring to bear on the situatuon, which is usually less straightforward than the example given in the case study above.
Removing all the risk from a pension fund may well not be the most efficient solution. That is, being selective about the level and nature of the risk, given the company’s financial strength and industry, can add significant value.
For example, a utility company is likely to be able to pass on moderate volatility in its pension costs to its customers. Its focus should be on the severe risks that it cannot transfer due to probable regulatory limitations in such downside scenarios.
A company in a UK focused retail industry may look to concentrate the pension risk budget it has on carefully selected foreign exposures. Although it is very important to be wary of apparent diversification that turns out to be illusory in times of significant economic pressure, a robust deliberate risk allocation process can be very rewarding to both the company and the trustees.
‘Shrink-wrapped’ risk management solutions being pedalled in the market should be viewed with a healthy dose of scepticism. It is tempting to jump in and be seen to be doing something – however, without a thorough strategy around the issues, there is a real danger that the proper priorities are missed, or that resources are channelled in the wrong direction.
There are key risk management steps being taken in certain industries, driven by the particulars of their environment. For example, in utilities we are seeing increasing sensitivity to the exact risk framework discussed with the relevant regulator, while in the banking sector emerging capital requirements are being incorporated into risk management procedures. We expect this industry-specific approach to strengthen significantly over coming months and years.