Treasurers at UK companies may be aware of the call for matching assets to liabilities, but putting this into investment practice is another matter altogether.
According to a survey by Mercer Human Resource Consulting, nearly half of treasurers and CFOs at British companies believed investors would prefer them to follow a liability-matched investment policy, in spite of the detrimental effect on contributions and P&L in the short term.
“This is a fascinating response given that only a handful of companies have actually implemented such a policy,” Mercer commented in its ‘Survey of Pension Financial Risk’.
Over the summer, Mercer put questions to CFOs and treasurers of mainly FTSE 350 companies. The firm wanted to find out to what extent they saw pension schemes and their deficits as corporate risk issues, and how they perceived investor attitudes.
When asked what type of pension fund investment policy they believed investors preferred, 47% of participants believed they would prefer a matched investment policy, going along with a higher but stable P&L charge and cash contributions.
Mercer pointed out that in the FTSE350 as a whole, the median exposure to equities is around 67%, and 95% have equity exposures of at least 31%.
Pensions risk seems serious to a substantial minority of UK companies. More than a third of companies surveyed see pensions presenting a moderate or severe risk to major financial metrics such as credit ratings or profits. But for most companies, however, pensions present limited risk.
Participants in the survey were asked to rate their exposure to the pension scheme in four key areas – banking covenants, declared profits, liquidity and credit rating. “In terms of issue-specific exposures, 39% considered the pension scheme a source of moderate or high risk to the company’s credit rating, but only 16% saw this as extending to a breach of banking covenants,” Mercer said. The risks to profits and liquidity were judged similar to risks to credit rating.
Mercer said that although there are many large and high-profile deficit situations where the pension scheme’s performance can have a substantial impact on overall business performance, these are the exception rather than the rule. But individual situations can be critical. In an analysis of pension exposures for FTSE350 companies, Mercer found the median deficit to be only 3% of market capitalisation, but for 25% of companies it was more than 9%, and for 5% it exceeded 30%.
Increasing debt is one way to plug a pension deficit.
“If pension scheme deficits are considered to represent a special form of debt financing, it follows that a transaction which involves raising fresh loans and uses the proceeds to fund part of the deficit can be seen as a re-financing of existing debt rather than fresh borrowing,” said Mercer.
“As with other re-financings, the attractions of doing so will depend on a number of factors other than borrowing capacity – for example, the tax benefits of borrowing net and investing gross within the pension scheme.”
Mercer asked companies if they had specifically addressed the merits of issuing debt or bank borrowing to plug a pension deficit. It found that 18% of companies have considered this, and gone on to do it. This is a higher number than expected, the firm commented, given the relatively small number of cases where this type of strategy has been mentioned in public. A further 31% said they had considered issuing debt or bank borrowing to fill the pensions deficit, but had decided not to do it.
So 49% had addressed the issue of taking on debt. “It was less clear why most of the other 51% had not given active consideration,” said Mercer. “Whilst some did not have the necessary access to the capital markets, it seems likely that a more common reason is that the possibility has yet to be formally identified and studied.”
On the issue of whether investors fully allow for pension deficits when they assess a company’s value, around half of companies believe investors differ on this. Some do and some don’t, said 47% of participants in the survey. Thirty-seven per cent of CFOs and treasurers believe investors do make full allowance, but most of them thought they had no consistent methodology for doing so.
“If analysts and investors do not take account of pension funding when analysing company accounts, and therefore do not translate its impact across to the share price, it will understandably be given less attention by key decision-makers,” said Mercer. Even though credit rating agencies take deficits into account, when they are material, whether and how equity analysts do this is less clear, it said.
Even though the participants perceived this lack of consistency among investors for judging the effect of pension deficits, the picture was different when it came to assessing how they would judge companies they wanted to buy. Some 61% of companies would use a ‘fair value’ method, such as FRS17 or solvency, for assessing the deficit of a target, rather than a traditional ‘ongoing’ assessment of the shortfall.
This is against 31% who would use the ‘ongoing funding liability’, ie, the shortfall assessed on the assumptions used to determine contributions.
“Ongoing measures are increasingly seen as arbitrary and open to manipulation,” Mercer noted. “Although to the extent they reflect existing agreements with the trustees on contributions, they can give an indication of cash flow commitments.”
Mercer asked how far the companies actively gave trustees input into their decisions on investment policy and the degree of mismatching. It said: “One of the practical issues around investment strategy is that control rests in the hands of the scheme trustees not the sponsor, although it is generally the sponsor which benefits from success or picks up the tab for underperformance, not the scheme members.”
It found that 37% of companies take their own advice independently of the trustees, against 47% considering the advice provided by trustees, and 6% saying they simply rubber-stamped trustees decisions.
The fact that more than a third are taking their own advice, said Mercer, provides the mechanism for the investors’ perspective to be recognised. “Of equal importance with the increasing focus on risk within the Operating and Financial Review, is that this is seen to be recognised,” it said.
“There would still appear to be a disconnect in outcomes in spite of this, ie, a significant group of companies believe investors would prefer matching, but this is not reflected in the strategies adopted,” Mercer commented.
On the question of whether companies benchmarked their pension funding position against others in their sector, the firm noted that a competitor focus can be important for the sponsor. “Whilst members and trustees will be interested in general pension industry practice and overall security, sponsors must concern themselves with practice in their industry sector,” it said.
Some 43% of companies said they did benchmark their position against competitors, and 31% said they did not. In the report, Mercer looked into whether attitudes were different for companies which had rated their pension deficit as a moderate or severe risk to risk metrics.
“It might be thought that they would demonstrate higher sensitivity when it came to identifying and addressing these risks,” it said. “In fact this was not the case – breaking down the data across all these metrics there was little significant difference of attitude we could detect.”
The results of the survey, said Mercer, would be “food for thought for those pondering the increasing weight of opinion which points to treating the pension scheme as part of the company’s debt structure in corporate financial planning”.