Across the globe, CEOs and CFOs have been ‘feeling the heat’ for some time. The corporate and personal implications and repercussions of the prolonged slowing of the world economy, the Enron scandal and other stories, the Sarbanes Oxley Act and the sustained decline in equity prices over the past three years have – put euphemistically – been hard to get used to. To add to these woes, the ‘double whammy’ of the declining equity markets and rock-bottom interest rates has moved pension liabilities to centre stage focus for both equity (Morgan Stanley, DKW) and rating agency (S&P, Moody’s, Fitch) analysts .
In early March, S&P caused quite a stir, in particular among German multinationals, when it announced a downgrading of ThyssenKrupp, Linde and Deutsche Post, largely on the grounds of its reassessment of the unfunded pension liabilities of these German flagships. Although some in Germany suspected that the highly publicised image tarnishing might perhaps have been orchestrated with a hidden agenda, the issue is a world-wide one and not focused against German corporations alone.
Essentially, the deteriorating funding deficits of most global corporate pension funds have taken on such proportions and have been so sustained that the issue has become too big for the rating agencies to ignore. So a review of the treatment of corporate pensions in their rating methodology was overdue and reassess it they did.
Initially, an analyst will typically take the numbers reported in the financial statements and with these calculate the financial ratios the agency considers relevant for rating the creditworthiness of a business. Those ratios relevant to pensions are typically:
o profitability to interest expense;
o debt to total capital employed, and
o cash flow to debt.
In the following, I shall only consider the second, the debt to total capital employed ratio. This is of particular interest to analysts because it gives an indication of whether a company is unduly burdened by debt or not. In view of the funding deficits the logical question to ask is whether and to what extent such underfunding should be treated as explicit debt. Then, depending on how this question is answered, the rating analysts will make adjustments to the ratios calculated on the basis of the numbers reported in the financial statements of the enterprise being analysed.
Where all three agencies seem to be in broad agreement
In a flurry of research papers issued in the space of the past four months, all three of the big rating agencies have published papers on the (re)assessment of their methodology as it relates to pensions.
Put in a nutshell, the reasoning of the rating analysts is as follows:
o First, defined benefit (DB) pension liabilities are considered to be liabilities of the sponsoring company, whether pre-financed by assets segregated from the company in a dedicated trust fund or not.
o Likewise, segregated assets will be considered as assets of the company too, albeit earmarked for discharging part or all of the liability. The difference between the two, ie, gross pension liability minus market value of assets, is considered to be a net liability of the company, even though this amount is typically not recognised to its full extent on the face of the balance sheet. This is because financial statements prepared under both US- and international GAAP accounting standards generally make use of the so-called ‘deferred recognition’ of unanticipated movements in both pension fund assets and the associated liabilities, thus, for example, not recognising most of the market value losses suffered by the declining equity markets.
Since current wisdom considers this procedure as ‘arbitrary smoothing’ and thus not representative of the underlying truth, analysts nowadays will – and do – adjust the reported balance sheet and income statement amounts to reflect the full net liability. This, broadly, is the state of analytical wisdom today.
I hold against this wisdom that the smoothing mechanism has its
justification not so much in smoothing earnings from year to year by ‘arbitrarily deferring recognition’ but rather in the underlying acknowledgement that both the calculated accrued liability amounts as well as the fair value of the assets held in the trust fund are no more than rough estimates. Smoothing therefore recognises the significant measurement error inherent in the full net liability. Put in another way: It is better being approximately correct than exactly wrong.
Where S&P seems to be going it alone
Compared with its peers Moody’s and Fitch, S&P has resolutely gone one big step further by classifying all net liabilities (without qualification) as explicit external debt, in the same way as borrowings are. In contrast, I understand that Moody’s and Fitch take a more differentiated view. For example, they make a difference between ‘underfunded’ and ‘unfunded’ pension obligations. The term ‘underfunded’ refers to arrangements that are not adequately financed by the assets held in a trust fund, where adequacy here is measured by what the accounting standards require (PBO/DBO and market value of assets). In contrast, the term ‘unfunded’ refers to arrangements that are not financed via trust funds holding assets legally and practically segregated from the company but rather financed by internally held general assets of the sponsoring employer. Moody’s and Fitch, consider these two cases as being different, arguing that for underfunded arrangements the local supervisory authorities may require significant cash funding in the short term whereas the unfunded variety will require cash flow from the company only to the extent that benefit payments are due. All three rating agencies then reason that the net liabilities of underfunded plans are attributable to explicit debt. S&P treats unfunded plans likewise while its peers, Moody’s and Fitch, consider unfunded liabilities as attributable to explicit debt only to the extent that they deem management would decide on financing such liabilities by explicit debt.
Now this difference might sound like splitting hairs, but it is extremely important for a large number of German corporations with largely unfunded plans. The sudden reappraisal of the unfunded liabilities as explicit debt can increase their gearing ratio (debt to total capital employed) significantly, thereby justifying a painful reduction in its credit rating.
S&P’s classification of all unfunded and underfunded liabilities as explicit debt is quite emphatic and – in response to extensive questions we have posed to the responsible S&P analysts – quite adamant. This inflexibility seems all the more surprising considering that the research paper published by S&P in December of last year under the heading of ‘Occupational Pension Schemes Rise to Prominence in Germany’ is riddled with fundamental misrepresentations and errors. It is clear that S&P requires a significant amount of help in understanding at least the German pensions world.
Because of these two points, we hereby declare that S&P is in danger of being rated down two notches in our credibility rating, unless it reviews its research papers and makes appropriate adjustments.
In respect of not classifying unfunded liabilites in Germany in their entirety to explicit debt, we can only agree with the reasoning of Moody’s and Fitch. Apart from the financing considerations put forward by them, I would add the following aspects:
o future cash flow required to meet pension liabilities generally has a duration that is significantly longer than that of corporate debt;
o an extraordinary and unanticipated repayment of the capital cannot be claimed by the creditors (no sudden acceleration);
o both the beneficiaries and the Pension Benefit Guarantee Corporation are not preferred but ordinary creditors;
o the capital accumulated has been accrued from generated profits and not injected by an outside third party as would typically be the case with explicit debt;
o the amount of interest due is independent of the economic situation of the company and the interest due is not due in cash.
It is probably too much to hope that the agencies will review their methodology in respect of the measurement of the net pension liability, whether unfunded, underfunded or overfunded and come to significantly different answers, in particular because all of them seem to share more or less the same ground and almost all available disclosures in financial statements provide numbers prepared on a comparable methodology.
Considering the measures that the SEC is in the process of implementing in view of holding analysts accountable for their opinions, one can only hope and expect that S&P will review its position towards unfunded plans the content of its research paper on Germany. The first is out of line with the opinions of its peers, the second is a shame. If S&P undertakes such a review we shall consider not to downgrade the agency to junk status after all.
Alf Gohdes is a managing partner at
Buck Heissmann in Wiesbaden