Tackling the DB deficits
Globally an increasing number of companies are taking action to reduce pension deficits. Both Marconi and BAE Systems in the UK have made headlines in recent weeks whilst, looking back over the past two years, there have been many high profile cases, headed by GM in the US. However, this trend is not restricted to the Anglo Saxon countries - in Germany, for example, the move to fund using contractual trust arrangements (CTAs) continues to gain momentum.
So what are these companies doing and why?
Let’s deal with the ‘why’ first. There are several reasons why funding a deficit can make sense:
q Tax efficiency – This does not apply universally and, indeed, the arguments are largely similar to those when deciding whether to fund pension liabilities in the first place. Where there are strong tax incentives, it usually makes sense to maximise the benefit by making contributions sooner rather than later. Companies can issue debt (on which coupon payments are usually tax deductible), and put the proceeds in the pension fund, where they will earn tax-free investment returns. The UK is a good example of where this tax arbitrage can work very effectively. Conversely, in Germany, where CTAs do not enjoy the same tax advantages, this argument doesn’t apply;
q Earnings – A feature of many accounting standards (including IAS19) is that once contributions are paid into the pension fund, they are assumed to generate a return that gives credit for the equity risk premium, even though this risk premium has not yet been earned. The extent to which companies have been optimistic in this assumption has been well documented - especially in the US under FAS 87 - and it is widely perceived to be a major weakness in accounting methodology. Whilst the smoothing mechanisms under IAS19 make it difficult to generalise about the exact impact, it is clear that putting money into the pension fund tends to have a positive impact on reported earnings;
q Employee relations – Putting money into the pension fund enhances member security. Of course, if there is a central insurance arrangement (such as the PSV in Germany) which guarantees pension liabilities when companies become insolvent, this argument becomes weaker. Nevertheless, some of these insurance arrangements only cover a proportion of the accrued benefits – the UK’s pension protection fund is an example. Marks & Spencer quoted employee relations as an important factor in their decision to fund their deficit;
q Rating agencies – Standard & Poor’s, Moody’s and Fitch argue that pension deficits are similar to other forms of company debt, although Moody’s and Fitch treat unfunded plans (such as book reserve approaches in Germany) somewhat differently. As a consequence, rating agencies tend to be broadly neutral about companies funding pension deficits; indeed, they will sometimes attribute a net positive impact since it demonstrates a company’s recognition of the issue and often implies a focus on better risk management with regard to pensions and the corporate balance sheet.
q Regulation – Denmark, the Netherlands, Sweden and the UK are all cases where regulation has become, or is becoming, more demanding. In the first three, this is because of new insurance-type regulation, featuring mark-to-market valuations of assets and liabilities and stress tests.
In the UK, the period over which it is acceptable to repair deficits
is shortening and The Pensions Regulator is examining M&A
transactions to determine whether cash needs to be injected into the pension fund as part of each deal. The recent Ericsson / Marconi case is a good example – Marconi was required to inject £185m (e272.1m) into the pension fund with an additional £490m in a separate escrow account, available for the benefit of the fund should future circumstances require.
While the arguments for funding the deficit are often strong, they are not necessarily overwhelming. In some countries it makes sense to avoid “overfunding”, since it is difficult for companies to get the benefit of any future surplus, which might go to members in the form of benefit improvements or be heavily taxed on being taken out of the fund. Further, some companies will feel that they can generate higher returns by re-investing in their main businesses, even allowing for the tax and other advantages outlined above.
There are several ways in which pension liabilities can be funded:
q Cash injection (using cash held on balance sheet);
q Issue debt in order to raise cash which is then injected into the pension fund. Several companies have gone down this route, including GM’s issuance of over $17bn of debt and convertibles in 2003. In Germany, Henkel recently announced a €1bn hybrid issue to finance its pension obligations through a CTA;
q Inject other assets. Contributions need not necessarily be in the form of cash - other assets such as equity, bonds or property can also be contributed. In 2004 Diageo made a contribution to its UK pension fund in the form of equity in General Mills, which the company had previously acquired.
There are also several possibilities which can be implemented on a contingent basis. The benefit of these arrangements kicks in if the company defaults or other specific events are triggered:
q Escrow account. The Marconi case mentioned above is a good example. Assets are set aside in an account remote from the company;
q Securitisation. Future company income streams can be securitised and the proceeds pledged to the pension fund, on a contingent basis. ICI announced that they were implementing an approach similar to this in 2004, based on receivables from various business units;
q Letters of credit – These are provided by a bank. In return for a premium the bank will pay a pre-agreed amount in the event of company default;
q Credit derivatives – Trustees can buy protection against company default using credit default swaps;
q Short company stock/put options: The pension fund could buy put options on the company or even take a short position in the stock of the sponsoring company.
The question of whether to fund rarely occurs in a vacuum. In almost all cases, companies are willing to fund a deficit only in conjunction with further discussion on risk management – they want to avoid the worst case scenario of addressing the problem now only to see it recur within a few years. Consequently, the funding decision is often tied to a review of investment strategy, including the role of LDI-based approaches.
Fundamentally, pension funds should concentrate on taking risks only where they expect to be rewarded in the long term. These might include equity market risk, alternative investments and active management, but exclude interest rate and inflation risks.
Mortality risk is also unrewarded but is difficult to eliminate at a reasonable price. In addition to eliminating these ‘unrewarded’ risks, it often makes sense for there to be better diversification of ‘rewarded’ risk, rather than have this concentrated in equity market exposure, as is so often the case.
It may be that what we’ve seen so far is just the tip of the iceberg. Regulators continue to focus on risk management and the need for assets to adequately cover liabilities. If pension risks are not better managed going forward, the danger is that companies enter a downward spiral of funding their deficits, suffering worsening funding levels and having to repeat the process a few years later. Whilst there may be strong tax (and other) incentives for funding a deficit, it is better for all if this possibility can be avoided at the outset.
Gareth Derbyshire is a managing director of Merrill Lynch’s Insurance & Pensions Solutions Group, based in London