M&S issues bond to bridge gap
The debate over how to plug the huge funding gap faced by British company pensions was kicked into touch by Marks & Spencer recently after the blue-chip retailer launched an unprecedented £400m (E598m) bond to address the problem.
The move has enabled Marks & Spencer to bridge a large part of an estimated £585m shortfall between the market value of assets held by its UK pension scheme and the fund’s estimated long term liabilities.
But tapping debt markets for the specific aim of injecting new capital into pensions is something of a novelty among UK companies, let alone European ones. This is not the case in the US, where major corporations such as General Motors have issued bonds worth billions of dollars over the past year to boost their pension assets.
As a result, M&S has attracted attention from other companies looking for a solution to their own pensions headache, according to leading pension consultants. “It’s been looked at by a number of companies but there is more interest in finding out if M&S pension fund will be changing its asset allocations,” says Anthony Ashton at Hewitt Bacon & Woodrow in London.
Some experts even argue that there is little need to plug these shortfalls in the short term as expected pensions bills will be spread out over many years, perhaps decades. That gives pension providers ample time for contributions to grow and investment returns to compound over the long term.
Moreover, in other European countries, pension fund deficits have been treated differently. In Germany, the most popular way of financing occupational pensions is through on-balance sheet book reserves, where future liabilities at met from future company profits. This means pension liabilities are recorded in a company books but are left unfunded.
Even within Britain, where the FRS17 accounting rule forces companies to reflect any swings in the market value of pension assets in their annual results, different strategies have been adopted to address the problem. Last autumn, ICI, the British chemicals giant, sought to address concern by guaranteeing £250m in company assets to shore up its UK pension scheme in the event of the group’s financial collapse. The assets underpinning the guarantee were in the form of receivables – payments owed to the company by customers.
In contrast M&S turned to debt markets in March this year to underpin its defined benefit pension scheme by issuing 10-year bonds yielding about 5.6%. The yield spread amounted to just 0.93% over the equivalent 10-year UK government bond, reflecting M&S’ high credit profile. The issue, handled by HSBC and Morgan Stanley, was oversubscribed thanks to strong demand from institutional investors for good quality corporate paper.
Sue Harris, head of treasury at M&S said that the group wanted to make a big cash injection as a prudent measure, although it also considered alternatives to a bond issue. The group hired Watson Wyatt, the pensions consultants, to advise it on how to deal with the shortfall.
“There was a big shortfall in our scheme both from an FRS17 basis and on an actuarial assessment. So it was unrealistic to expect equity markets would recover versus the bond market . Therefore we felt it was prudent to inject new funds. Although we are still left with a shortfall, we hope that the residual amount will be bridged by rising markets,” she says.
Another major reason for the fund raising was that the group wanted to maintain staff morale. “It was an extremely important consideration as pensions are at the core of our group values,” she says.
However, some experts such as Jon Exley, senior consultant at Mercer Investment Consulting, believe that fears over the deficits have been overstated. “There has been a lot of misleading comment from investors and analysts about shortfalls. It doesn’t really matter if a company has a big deficit, the pensions can be fulfilled with contributions over the years,” he says.
He funding deficits is really about accounting issues and can offer tax advantages. The extra funds also provide added security to employees over their pensions. “There are accounting issues involved as a pension fund can get a gross return over its funds while debts cost can be set aside against company profits,” he says. By topping up a fund and investing in low-risk bonds, a company’s managers can also concentrate on running the business rather than worry about the pension fund.
Over at Hewitt Bacon & Woodrow, Ashton agrees that accounting issues can flatter a company’s financial situation. However, he says there is no “right or wrong” way to addressing deficits with new capital injections. Much will also depend on the financial strategy of the company issuing the bonds. If the proceeds are invested by the pension fund in bonds it will enhance returns as interest is tax free, where as interest from equities is not, though capital gains are exempt.
However, the disadvantages are that debt is not as flexible in meeting pension liabilities as corporate cashflows are as payment become due to workers. Debt has to be paid according to strict conditions and timetables. It could also affect a company’s ability to raise more money in the future, he pointed out.
Much of the controversy over funding deficits has also been driven by the attitude of equity analysts and institutional investors during the bear market over the past three years. High pension deficits at companies such BT, the telecoms giant, Invensys, the engineering group and British Airways have often become key factors in valuing such businesses. Such companies with pension funds highly exposed to stock markets have been seen as an added liability as markets plunged. This has given short-sellers – who profit from falling shares – the opportunity to drive the shares such companies even lower.
Ashton says that it is still unclear whether more companies will follow Mark & Spencer’s example. “It will depend on the attitude of the markets and equity analysts, whether they view it as a positive or not. But such measure do enhance the security of pension funds so members should feel good about it.”