As we all know, pensions are receiving substantial attention in the wider press, both in financial and non-financial publications. This has been triggered by a combination of factors: equity underperformance has eroded asset values, falling bond yields have driven up liability values and increased accounting transparency has made the resulting reduction in funding positions more visible.
One of the consequences is that various company stakeholders (investors, analysts and rating agencies) that traditionally have not paid much attention to pension costs and liabilities, are starting to look at pension positions as part of their analyses. The trend is towards adjusting income and balance sheet measures in line with the rules set out by the UK standard FRS 17, so that, although the implementation of FRS 17 has been delayed until 2005, it is already influencing company valuations.
This has presented corporate Europe with an additional issue to deal with on top of the direct business impact of the current downturn. The press stories include reports of pension funding deficits running into billions of Euros, suggesting a serious burden on company balance sheets. The question is to what extent pensions are really a problem for companies or whether the attention is nothing more than a hype that will disappear when markets recover and investors, analysts and journalists recognise that the new accounting standards are too focussed on the short term.
As always, the answer lies somewhere in the middle. Pension deficits are definitely a liability on the company and, therefore, similar to debt. Exhibit 1 describes the case study of Bethlehem Steel in the US, where the pension liabilities were a significant contributor to the company filing for Chapter 11 bankruptcy protection.
On the other hand, pension deficits generally do not have to be rectified immediately and therefore can be funded over a period of time, or might simply be reversed if equity markets recover strongly. The immediacy of the cash flow needs depends on the regulatory environment and the existence of funding requirements. In Germany, for example, pension liabilities do not have to be funded and are often carried on the company balance sheet. Therefore any funding is voluntary. On the other hand, in countries with funding requirements, the strictness of the tests differs. In the UK the Minimum Funding Requirement (MFR) requires deficits in excess of 10% of liabilities to be rectified in three years and deficits up to 10% within 10 years. The basis for valuing the MFR liabilities is relatively ‘weak’ in that the difference between the liability value and the money needed to buy-out the benefits with insurance contracts can be substantial. Consequently, a reported deficit in the company accounts does not necessarily mean additional contributions are necessary under MFR. In the Netherlands, on the other hand, the regulator recently stipulated explicitly that funds in deficit need to be 105% funded within 12 months. Again, the liability valuation basis is somewhat weaker than the basis used for accounting disclosures, but not to the same extent as MFR.
This shows that it is very difficult to make general statements about whether a funding deficit is a problem. Pension arrangements and regulations differ significantly between countries. Consequently, the company’s pension position critically depends on the country where its pension funds are located, ie, where its workforce is based. This means that for multinational companies with workforces in many different countries, the situation becomes even harder to evaluate.
However, I do not want to suggest that the reporting of aggregated pension funding positions is worthless. On the contrary, the ‘fair value’ accounting approaches (such as FRS 17) present the best estimate of the true underlying economic position, by taking assets at market value and using bond yields to discount the liabilities. Fair value approaches are often criticised for focussing too much on short-term volatility and only showing a snapshot of the funding position, but that is exactly what a balance sheet needs to reflect: a snapshot of the company’s assets and liabilities at a particular point in time. One of the elements of confusion in the discussion is that the economic funding position of the pension scheme is mixed up with the optimal way to finance it (both in terms of timing of contributions and allocation of assets between equities, bonds, real estate, etc).
Besides being theoretically sound, the reported funding positions are also predictors of future cash flows. Exhibit 2 shows a scatter diagram of the difference between contributions and service cost (the cost of annual pension accrual), as a percentage of service cost, versus the funding position in the previous year for 36 UK companies. We compare the contribution to the previous year’s funding position to allow for the time lag between calculation of the funding position and setting of the new contribution rate.
This shows that there is a negative relationship contributions tend to be relatively higher for lower funded schemes. This is a statistically relevant relationship with an R2 of 38%.
So, despite the above mentioned difficulties in comparing aggregate pension funding positions of European corporates, there are a few statistics we can focus on to get an idea of the company’s position.
First of all, the aggregate funding level as illustrated above. As mentioned before, the immediacy of the problem depends on the regulatory regime, but it is a reasonable predictor of cash flow. Second, the relative size of pension scheme: pension issues are more important the larger the pension scheme is in relation to the sponsoring company. We measure this as the ratio of pension liabilities to company market capitalisation. The higher this ratio, the more impact pension contributions are likely to have and the more exposed a company is to changes in the pension asset-liability position. For the companies in our sample, pension liabilities are, on average, about 40-50% of company market capitalisation at the end of 2001. However, the dispersion is large, ranging from a ratio of 0.4% for Vodafone to ratios of 390% and 777% for Corus and KLM respectively. Lastly, we look at pension scheme maturity. A pension scheme is said to be mature if there are many pensioners relative to active members. The more mature the scheme, the shorter the time horizon to make up deficits. Consequently, a mature pension scheme generally needs more careful management from the company perspective. Maturity is difficult to measure from publicly available data. We use the ratio of interest cost of pension liabilities to service cost (the annual cost of pension promises accrued during the year). This is a measure of the size of the total liabilities relative to the new accrual of service by active members and is higher if the scheme is more mature. In our sample, the average ratio is around 2, so pension schemes with a ratio above 2 are considered to be mature. This measure is particularly interesting for companies with unfunded liabilities (for which the funding level measure is less relevant), because the more mature the pension scheme the higher the pension payments. Monitoring and predicting maturity is therefore important as pensions are paid straight out of operating cash flows.
Exhibit 3 plots the funding position versus the relative pension fund size for a selection of European companies. This illustrates the widely different positions with which companies are faced. Note, many German companies have low funding positions as a result of German pension liabilities often being unfunded (balance sheet reserving). Consequently, a low funding level does not necessarily mean immediate cash requirements.
In summary, the importance of pension costs and liabilities differs from company to company depending on its history (how old is the company?, how generous are the benefits?), location of its operations, past pension funding and investment policy, etc. However, the recent drive for increased accounting transparency allows a better analysis of the position companies are in. There are a variety of statistics, such as those discussed above, that are useful in this regard.
Jeroen van Bezooyen is vice president in the European Pensions Group at Morgan Stanley International in London