Trustees: The right balance
The collapse of Carillion highlights just how difficult it is for pension fund trustees to influence the sponsoring company
- A breakdown of the governance framework allowed Carillion to pay dividends and make acquisitions right until the end
- Powerless trustees repeatedly asked for larger contributions over the years
- Covenant downgrades are not considered as serious as credit downgrades
The chairmen of defined benefit (DB) pension trustee boards have to tread an unenviably delicate line. The collapse of UK construction and facilities management firm Carillion in January again demonstrates that, compared with banks, shareholders and bondholders, trustees are in a weak position to influence the strategy and behaviour of their sponsoring companies.
No doubt much will be revealed about the exact goings-on between the trustees of the pension funds and the management of Carillion in the coming months. We can already see where the governance framework broke down and relative bargaining positions impeded an optimum outcome for the pension funds and the company. We can only wonder how such a weak ‘covenant’ as Carillion was allowed to continue to make acquisitions and pay dividends for such a long time.
The testimony of the chairman of Carillion’s pension trustees, Robin Ellison, to the parliamentary Work and Pensions Select Committee, at the end of January was revealing. Over the years, powerless Carillion trustees asked repeatedly for larger contributions from the firm but were rebuffed, despite the involvement of UK watchdog The Pensions Regulator (TPR) and the opinion of covenant experts that the company had the capacity to do so (until a few years ago).
Ellison is right, of course, when he commented on the “balance” that is required in trustees’ actions. On the one hand, trustees aim to maximise benefits to pensioners but, on the other hand, they should be careful not to starve the sponsoring company of capital and cashflow. What seems to make no difference in this ‘balancing’ act is the covenant quality of the sponsoring company, and that can’t be right.
In a previous article (Inadequacies in the covenant assessment process, IPE September 2017), I argued that a covenant quality review resulting in a lower covenant grade (of which the lowest is 4 on TPR’s scale) would not necessarily provide the same sense of urgency to trustees that a credit rating downgrade would give bondholders.
A drastic credit downgrade to, for example, B- or CCC is an indication that the probability of default has increased significantly – to 25-50%, depending on the circumstances. At that point, there would be no question of the company making acquisitions or paying dividends to shareholders. Its lenders, bondholders and probably pension trustees would all object. The trigger effect of such a downgrade would, in practice, preclude directors from attempting to do any of these things for fear of being accused of leading the company even faster towards bankruptcy.
Dividends continued to be paid
What seems so odd in the case of Carillion is that its fragility was known for a long time, and yet it continued to pay out dividends it could ill afford until the end.
Sources in the infrastructure finance world confirm that the construction firm, which was never rated publicly to my knowledge, was considered for a number of years as a mid-single B credit at best.
It is not known publicly what Carillion’s covenant grade was, only that it was reviewed regularly, and that pensions and covenants advisory firm Gazelle argued that the company had the ability to increase its contributions to the scheme in 2012. Recommendations by Gazelle in a letter made public through the parliamentary enquiry refer to Carillion’s tendency to “historically prioritise other demands on capital ahead of [pension] deficit reduction”.
Gazelle also suggested that the company increase pension contributions as its cashflows improved, which it never did. It would be interesting to know if the advice became more strident as the situation deteriorated.
So what power do trustees really have?
“When the company is approaching a phase of financial distress, the trustees face very difficult choices. Should they assume the downturn is temporary?”
Let’s assume that the trustees were given the correct advice. What could they have done once they realised that the probability of a Carillion default was increasing? Could they have forced the company to reduce executive pay or cut dividends? Could they have reduced their exposure by selling down their positions in the market? Or could they have declined to renew existing credit lines as they came to maturity? In each case the answer is that there is very little they could have done, as confirmed by Ellison to the select committee.
There is a conundrum at the heart of this relationship.
When the company (or sponsor of the pension fund) is in good financial health, the position of the pension fund is quite different from any of the other ‘lenders’, in that it can benefit from the upside by enjoying a longer-term investment horizon. It can afford a more aggressive investment strategy and, of course, can try to negotiate higher contributions.
When the company is approaching a phase of financial distress, the trustees face very difficult choices. Should they assume the downturn is temporary? Should they immediately change their investment strategy, which can be costly, in an attempt to derisk the pension fund? Often the temptation is to look ‘through the cycle’ and hope that things will improve.
Lack of power
Trustees lack real power to influence management, apart from threatening to call in the Pension Regulator, a threat that is ineffective until it is too late. In the case of Carillion, TPR was involved actively throughout. Its objectives are as complex as those of trustees in that it has a duty to the pensioners, to the company and to the PPF. Is this a recipe for inaction?
Reducing risk exposure when the situation becomes acute is never easy, and investors and lenders often lose out in a liquidation. In the case of pension funds, the downside is actually quite limited, thanks to the Pension Protection Fund (PPF) guarantee. Think about it: in the case of Carillion, which creditor would not wish to change place with the pension fund and be given a 90% face-value bail-out?
In short, when the sponsor is in good financial health, the trustees have an incentive to intervene, to obtain a better deal for the pension fund, but little power to achieve that durably.
When things start to get worrying, there is an incentive to wait as long as possible to avoid painful decisions, and when things are truly dire, there is nothing trustees can do and the PPF guarantee will bail out the pensioners anyway.
Who mentioned moral hazard? Or put another way, the pension fund is in a hybrid position where it is neither a traditional lender (no flexibility to reduce exposure), nor an equity holder (cannot effectively participate in upside, no influence over management). And yet, right until the last moment the pension fund’s interests are much more closely aligned with the sponsoring company than with the lenders: success for the company in getting out of temporary difficulty is also a success for the pension trust.
This status – which leaves the pension fund so exposed – should come with special privileges to influence management to achieve long-term stability and restraint
Olivier Beroud is visiting professor at the London Institute of Banking and Finance, founder of Beroud Consulting and formerly head of EMEA at Moody’s