Where trustees are coming from
The structure of pension provision in the UK has changed dramatically over the past five years. New roles and responsibilities for sponsors and trustees and the transition to a principles based framework for decision taking, combined with a sharp reversal in the solvency of many pension schemes, have created tension and in some cases a polarisation of sponsor and trustee interests.
Managing the sponsor-trustee relationship throughout this period has proved challenging to both sides as avoiding unproductive confrontation and deadlock requires recognition and appreciation of the regulatory requirements facing trustees, as well as the need to reach balanced decisions which reflect realistically the operating conditions of the business.
Clearly, the majority of UK defined benefit pension schemes are in deficit. The most vexatious issue facing the sponsors and trustees of such schemes is reaching agreement on a deficit funding schedule. This must satisfy the regulatory requirement for trustees to “negotiate robustly” with the sponsor. Furthermore, in exercising these responsibilities trustees are obliged to “form a view on the ability of the employer to fund benefits” and to understand “the nature and strength of the employer covenant and its ability and willingness to meet the cost of members’ benefits”. Although these duties are taken from “voluntary” codes of practice the need for compliance is effectively absolute.
The codes of practice of The Pensions Regulator reflect its responsibility to protect scheme members’ benefits and to limit calls on the Pension Protection Fund. As the sponsor is obliged to meet the liabilities of the scheme, and as the scheme is wholly dependent upon the sponsor to meet members’ benefits, it may seem obvious that the sponsor’s ability to underwrite the risks arising within the scheme be considered. However, a study we published` earlier this year showed that this has not been common practice in the industry. In fact, there is no correlation between the size of scheme deficits and the sponsor’s financial strength. Similarly, there is no correlation between investment risk, as indicated by equity exposure, and sponsor financial strength.
This is significant. The probability of default over 10 years of an AAA rated company is less than 1 in 200. The same figure for a B rated company is greater than 1 in 3. To run the same funding and investment risk irrespective of the sponsor’s ability to make good any shortfall represents a material compounding of the risk to members’ benefits, the Pension Protection Fund and the sponsor itself.
The sums involved are not trivial. FRS 17 deficits for the 340 schemes in the S&P research paper were £85bn and the median deficit was 20% of liabilities. This raises some uncomfortable issues. If it is reasonable for a pension scheme with an AAA rated sponsor to effectively extend credit equal to 10% of scheme assets to its sponsor, can it also be right that a scheme with a much riskier B rated sponsor has a credit exposure of 25% of its assets to its sponsor? How can this be reconciled with the Pensions Act 1995 restrictions on employer-related investments which state, “none of the resources of a scheme may at any time be invested in any employer-related loan”?
From the sponsor’s perspective, having to “negotiate robustly” a payment over which it previously had a considerable degree of discretion, may at first be difficult to accept. However, the need to engage with a more independent trustee board over funding and investment decisions became unavoidable once the sponsor’s obligation to meet the pension scheme’s liabilities became contractual (June 2003 for solvent sponsors). From this point unfunded pension obligations began to resemble more closely an unsecured loan from the scheme to the sponsor. And, as is clear from the quotes above, The Pensions Regulator has been explicit about the trustees’ responsibilities in this regard.
How then can sponsors’ financial strength be objectively incorporated in funding and investment decisions? Credit ratings have for many years been used in financial markets to assess the ability of companies to meet their financial obligations. The fundamental credit dependency relationship between a borrower or sponsor and a lender or pension scheme is very similar. Lenders and underfunded pension schemes are both creditors to the company. Certainly there are differences; bond investors may have greater security and enforceability as well as the assurance of a finite life and a steady stream of interest income. Nevertheless, they are both commitments that the employer must eventually meet.
As an unsecured creditor, the pension scheme and its trustees can apply credit analysis to assess the ability of the sponsor to underwrite scheme risk in the same way that other creditors and lenders use credit analysis to assess the risk of a sponsor failing to meet its interest and principal payments.
By combining the credit rating with the actual historic default experience of rated entities it is possible to estimate sponsor covenant strength when making funding and investment decisions. For example the default probability of BBB rated companies over 10 years is 5.4% on average. In other words, to be 95% confident that a BBB rated company will complete the funding programme, trustees should seek funding over no more than 10 years. Similarly, to be 99% confident of completing the programme it is clear that funding must be achieved over a shorter period, in this case three years. This framework enables trustees and sponsors to objectively quantify risk across a range of possible funding outcomes.
The distinction between default and insolvency is important. Default is defined as being a penny short or a day late in the payment of any interest or principal. In the UK, default would normally trigger the company being put into administration at which point regular contributions to the scheme would typically cease. Companies can default and remain in administration for many years before being liquidated or recapitalised.
In contrast, the insolvency measure provided by the Pension Protection Fund’s (PPF) risk-based levy banding, is based on the one-year probability that a company “ceases operation without paying creditors”. As it is normal for companies to continue operating while in administration this period may extend long after payments to the pension scheme have stopped. In other words, a default measure is more appropriate than an insolvency measure when viewed from the perspective of being able to pay pension contributions.
For trustees faced with the need to consider sponsor financial risk on one hand while being provided with a sponsor insolvency risk measure by the PPF on the other, there may be a temptation to use the latter to satisfy the former. As explained above, this could lead to the extension of credit (unfunded deficit) over a longer period than is justified due to the difference between the event that the PPF is concerned with (insolvency) and that of greatest concern to trustees (earlier default).
Using PPF risk bands could also lead to erroneous conclusions simply because the one-year probability of insolvency cannot accurately be extrapolated over the typically much longer funding periods to achieve full solvency. This is because financial risk is not constant. The result is that simply extrapolating the one-year PPF insolvency risk may significantly misrepresent the actual risk.
As well as reflecting the strength of the sponsor covenant in their funding and investment decisions, trustees are also expected to understand “the effect of pension liabilities on the sponsoring employers”. Here, credit ratings can be used to demonstrate, on an objective and independent basis, the impact that a change in the scheme funding level, or the capital structure of the business, can have on employer financial strength. Broadly speaking, the substitution of conventional borrowing for an unfunded pension obligation is credit neutral for well-capitalised companies. This is because the FRS17 deficit has already been factored into the sponsor’s balance sheet as a “debt-like” obligation. For weaker companies, however, this may not be the case as the fixed nature of conventional borrowing can put additional demands on the cash flow of the business and restrict management flexibility.
The rapid pace and broad spectrum of change facing the pensions industry has forced trustees to take on new and demanding responsibilities. To some extent these reflect the statutory change to the pensions promise that is now hard-wired into The Pension Regulator’s codes of practice. As uncomfortable as this may be for trustees, it is possibly even more uncomfortable for employers who must now accept that once passive trustee boards are now obliged to negotiate scheme decisions on the basis of being very large (often the largest) unsecured creditor to the business. To resolve the inevitable conflicting demands for scarce capital resources will require judgement and informed debate as well as an understanding of the regulatory pressures faced by trustees.
Jim MacLachlan is director of Standard & Poor’s pension services, based in London