Pension financing and risk management have become business priorities for most multinational companies, and German-based multinationals are no exception. However, a recent analysis by our firm of pension liabilities in top European companies showed that the largest German-owned firms have almost 20% more exposure to pension risk than top UK and Dutch firms and over three times more than French-owned organisations.

The study - designed to help investors assess pensions risk in the major European financial markets - defines pension risk as the relation of a company's pension liabilities to its market capitalisation. The combined value of pension liabilities in the biggest German-based companies (the DAX 30) is equivalent to 31% of the organisations' market capitalisation. This pension risk exposure is around a fifth higher than for the top UK (FTSE 100) and Dutch (AEX 25) companies, which have liabilities equating to 26% of their market capitalisation.

The analysis of pension scheme funding shows a similar trend.

According to the research, German-owned companies have the lowest level of scheme funding, with just 61% of pension liabilities covered by dedicated assets. As a result, they have an average pension deficit of 12% of their market capitalisation.

While these figures are far from pleasing, they are less alarming if the characteristics of the German company pension system and its history are taken into account. Germany has traditionally been known to have many unfunded pension liabilities. Even today, most German companies back their pension commitments with company assets, and benefits are paid to pensioners directly from the company. German tax legislation has historically favoured this "direct pension commitment" approach, in contrast to the separate funding found in most other countries.

Far more than half of all pension obligations of German employers are in the form of these direct commitments. Although not required by law, many employers in recent years have moved to match pension obligations with external investments. Today, roughly 40% of direct commitments have been matched with external investments, either in the form of insurance policies or mixed bond and equity portfolios. These investments are still treated as company assets and are shown as such on the balance sheet. In most cases, they may also be used for other purposes than paying pensions.

This concept of matching assets to pension liabilities has gained traction in recent years, driven by several external pressures.


Increased visibility of pension risks

With the adoption of US-GAAP and IAS/IFRS, new opportunities have become available to transform existing company assets into pension plan assets without negative tax implications.

DaimlerChrysler and Siemens were the first big German companies to set up pension trusts for their existing defined benefit (DB) plans in 1999/2000. Additionally, some companies have taken the opportunity to fund pensions through qualified insurance policies.

US-GAAP and international accounting standards have made pension risks more visible than the former German GAAP, which calculated liabilities with a fixed annual discount rate of 6%. This rate typically understated plan liabilities in today's market conditions and also failed to value mandatory pension indexation required under German law.

Along with the accounting issues noted above, the decline in interest rates over the past few years has greatly increased pension liabilities, creating concern for plan sponsors. Finally, improvements in retiree longevity continue to place additional strain on pension liabilities, which some plan sponsors are backing with assets to help reduce risk.


Advantages of prefunding liabilities

There are several advantages to creating an asset vehicle that qualifies as plan assets under IAS 19 or US GAAP. The transfer of existing company assets to the new vehicle may lead to the immediate recognition of capital gains (or losses) that have not previously passed through the profit-and-loss account. There may also be a positive effect on company earnings, where the expected return on plan assets lowers pension expense and enhances operating income. However, financial income reduces in exchange because the former assets are now plan assets and no longer generate financial income.

The pension trust provides additional protection against insolvency for benefits not covered by the state protection limits because these benefits are too high or the vesting period has not expired.


CTAs: A potential solution?

In Germany, a contractual trust arrangement (CTA) is a reliable and relatively quick and easy way to convert existing company assets into pension plan assets that are recognised under FAS 87 and IAS 19.

This is a (complex) legal framework that can usually be created without changing the investment structure or tax treatment of those assets. More than half of the companies listed in the DAX 30, and many German subsidiaries of foreign corporations, already have such a CTA in place. Contributions to CTAs are considered company assets and do not represent taxable income to employees.

There are signs that the trend toward CTAs is likely to continue among the larger companies and could spread to smaller and medium-sized organisations. While one can see the advantages of clearer accounting and additional benefit security for driving the change, there are other downsides. The main disadvantage of CTAs is that the transferred assets may no longer be used for other purposes, such as capital expenditures or acquisitions.

The new "Pensionsfonds", introduced in 2002, made it possible to make tax-favourable asset transfers to unfunded pension commitments without creating a tax liability for the employees concerned.

Companies can extinguish their past service pension liability by making a transfer to a
Pensionsfonds. We have also seen some organisations with small liabilities use the
Pensionsfonds approach in merger and acquisition situations when the buyer is highly resistant to taking on any pension obligations.

Unfortunately, Pensionsfonds were required to calculate their liabilities on a very conservative basis, similar to that used by insurance companies when pricing annuity business. Therefore, the amount that would need to be transferred to buy out plan liabilities was far more than companies would typically hold on their accounting books for those liabilities. Recently this has changed. Now Pensionsfonds may use discount rates "in line with IAS 19", which lessens the need for such a large contribution to finance the past-service liability and can make these transfers more attractive. But any advantage of this approach must be weighed against the fact that if transferred assets plus future returns prove to be insufficient to pay promised benefits, the company would need to make up any shortfall.


Proactive pension risk management

Most German companies are aware that they need to manage their pension risks proactively in order to be able to offer attractive benefits to their employees and achieve business results. The strong trend towards CTAs (and maybe in future also to Pensionsfonds) shows that German firms are taking the initiative and looking at ways to improve both accounting treatment and insolvency protection.

In addition, companies are exploring their options to control pension risk through plan design, with defined contribution plans becoming an increasingly favoured option.

Funding and asset management strategies based on asset liability studies are another strong pensions risk management instrument that more German companies are beginning to make use of.

However, they do not appear to be exploring the full range of tools that allow companies to project risk and return of their asset strategies.

For large German-based multinationals with different pension plans around the world, the biggest challenge is to know where the risks are that need to be managed.

A benefit audit can be a very valuable tool to assess the pension commitments around the world. It can also represent a first step towards the implementation of a pension governance framework that is integrated into the overall risk management system.

Raimund Rhiel is worldwide partner at Mercer Human Resource Consulting