Sponsors are increasingly seeking the help of custodians as they feel the pressure, along with trustees, to manage risk and achieve service quality, writes Iain Morse

The interest of pension fund sponsors in their pension liabilities is now greater than ever and having a major impact on the custody market. “We increasingly interact with both the pension fund and the sponsor,” says Penny Biggs, head of EMEA business development at Northern Trust. Other global custodians agree: “This is not to say that sponsors are in any way acting improperly or seeking to take over responsibility from trustees and boards. But the funding positions and risks in scheme portfolios have direct consequences for sponsors’ balance sheets,” adds Wade McDonald, head of customer management and sales in the UK and Middle East for State Street.

It is not hard to see why this should be the case. At the beginning of May, FTSE350 pension deficits for UK defined benefit pension schemes stood at €68bn. Funding levels fell to 85%. Even if company contributions treble compared with their 2007 levels, the average period of recovery for UK pension schemes will extend beyond 15 years. Deficits calculated on a scheme-specific basis are likely to be larger, perhaps far larger, than those shown in the accounts of their sponsoring companies. Indeed, the median deficit among FTSE350 companies is estimated to have increased from €45m at 31 March 2007 to no less than €252m now.

This depressing picture gets much worse on closer examination. Company balance sheets, particularly their profit and loss accounts, are under severe pressure. With banks unwilling to lend, every penny of cash flow is needed to patch and mend. From the point of view of both trustees and members, there is a growing risk of sudden deterioration in the strength of the sponsoring employer’s covenant. If an employer goes into administration at a time when funding levels are below their target levels the trustees might have little recourse to company assets to fill any resulting funding gap. There have been a number of high profile insolvencies in recent months where large pension liabilities will not be met.

Meanwhile, the rating agencies have warned that pension scheme deficits can and will result in credit downgrades for some sponsors. Consider BT, which declared a massive deficit at the end of June. This stood at £5.8bn (€5.6bn) net of tax, or £8bn gross of tax under IAS accounting rules. BT said that the dramatic increase in the deficit was a result of it being forced to change its accounting practices to take into account a higher inflation rate, rather than any fall in the value of the scheme’s investments. City analysts are warning that such deficits will be factored into their view on sponsors’ long-term share values.

“This environment has brought about huge changes in attitude on pensions matters,” judges Biggs. Any distance between the sponsors main board of directors and the trustees is now likely to be as short as possible, by common consent. “The fall in funding levels is likely to prompt trustees to issue demands for increased funding at exactly the time when cash is short,” warns Matt Collinson, leader of the Integrated Retirement Financial Management Group at Mercer (UK). But the Pensions Regulator has already stated a desire to reduce the length of recovery for underfunded defined benefit schemes. As a result, both trustees and sponsors now must learn to walk a tightrope between funding the scheme and weakening the sponsor’s balance sheet. The question is whether they walk the same tightrope or separate ones.

Custodians are being asked to help close this gap. Global custodians are recording an upturn in interest from sponsors now as as trustees and boards are concerned about risk measurement. But there are different perspectives on risk between the sponsor or trustees, depending on regulatory standards set by international accounting standards on the one hand and national pension regulators on the other. Credit spreads on AA-bonds are at historically wide levels, making it difficult to predict what approach sponsors will take when setting their quarterly accounting figures, so it becomes hard to estimate the value of their IAS19 liabilities.

These IAS19 liabilities will be of interest to shareholders but trustees will be more concerned about the funding levels on their technical provisions or scheme-specific basis. Best estimates suggest that in the average scheme, the technical provisions funding level has declined far more than IAS19 basis for the same period. This is because the calculation of the technical basis is driven by gilt rather than bond yields. By the end of March this year the average IAS19 funding level was estimated at around 85%, while that calculated on a technical provisions basis was much lower at just over 60%.

Many trustees and sponsors will now also be calculating their scheme funding position on a buy-out or solvency basis. This is hard to estimate accurately as it is always scheme-specific; reaching a hypothetical value is costly and time consuming. If a large number of schemes were to go to buy-out more or less simultaneously this could push up the cost to trustees and sponsors.

This is focusing ever more interest on the measurement of each scheme’s portfolio risk.

“Cost saving is not the only or main driver in a sponsor’s decision to consolidate its custody services with one provider,” says Sonia Spinner, senior consultant at Mercer in the UK. Ease of accounting at the tax year end, receiving all relevant data from a single, standardised source, are of growing importance to both trustees and sponsors. But beyond this there is ever-growing demand for real-time portfolio valuations and the real-time analysis of this valuation data via screen-based risk management tools. “What is the impact of a pensions deficit if the sponsor suddenly loses a major contract?” asks Spinner. “This can impact immediately on the sponsor’s share price, credit rating and capacity to increase or even maintain current pension contributions.”

The change in attitude among sponsors and trustees can be seen in a widely felt softening of the pressure on custodians to compete by reducing their fees and charges.”The balance is tipping to an emphasis on the effective management of risk via the custodian relationship,” argues McDonald. “Cash and assets need to be safe, counterparty risk cut to an absolute minimum, and service quality right.” If this trend continues it will bring relief to the custodians who have faced years of cost pressure. “You can see the modern custody market as driven by risk management. Even when the recession ends this will not change,” adds McDonald.

The closure of defined benefit schemes to new members and, in a growing number of cases, to future member contributions and accruals, will exacerbate this situation. Once closed, a defined benefit pension scheme ceases to be useful to sponsors as a means of attracting or even retaining employees. “At this stage the sponsor will become very focused on the cost and risk of managing a closed scheme,” comments Biggs. Many might decide on wind-up as a long-term objective. Minimising the cost of this will become a policy goal for both sponsors and trustees.

Meanwhile, custodians with the capacity to manage both defined benefit and defined contribution schemes side by side might also see greater demand.