Quis custodes custodiet – who guards the guards? This month’s Off the Record looks at the power and influence of credit rating agencies and – in passing – investment analysts. Has their power increased, is increasing and ought to be diminished?
The power of rating agencies was illustrated dramatically recently when leading player Standard & Poor’s (S&P) downgraded the rating of German industrialist Thyssen Krupp two notches to BB+ because of the size of its pension fund liabilities. This pushed its bonds into non-investment grade status, forcing other institutional investors to sell.
ThyssenKrupp clearly felt that the problem was not its pension fund liabilities but the way that S & P perceived them. In a statement, it said stiffly: “ThyssenKrupp have not changed – the only thing that has changed is S&P’s view of the way it assesses pension obligations.”
Are credit rating agencies infallible? They have been criticised by the capital markets in the past for sins of omission rather than commission. They failed to spot the symptoms of various country and corporate crises – notably the Asian contagion and the Enron collapse.
However, there is now a growing feeling the power of rating agencies should be scrutinised more closely, if not curbed. The International Organisation of Securities Commission (IOSCO) is currently considering the regulation of rating agencies. Earlier this year the US Securities & Exchange Commission (SEC) issued a report on the role and function of credit rating agencies, in the wake of the Sarbanes-Oxley investor protection legislation.
In one sense, rating agencies are merely the latest in a lengthening line of people that have started to take note of company pension funds. First, the accountants began to warn about the impact of new accounting standards like IAS 19 on companies with pension fund liabilities. Then the equity analysts employed by investment banks began to warn investors to avoid companies with large pension liabilities.
Is this scrutiny reasonable? Or are accountants, investment analysts and now rating agencies taking a short term view of what are essentially long term liabilities?
Should pension fund liabilities be viewed as merely another form of debt on a company’s balance sheet? Agencies tend to regard pension liabilities differently from bonds, treating them as ‘soft’ rather than ‘hard’ liabilities with a flexible rather than fixed payment schedule. But some companies are arguing that pension fund debt should not be held against the company at all. In the UK, for instance, the glass manufacturer Pilkington is trying to persuade the rating agencies that its pensioners shoulder the risk of falling investment returns, rather than the company.
This poses the question: do rating agencies and investment analysts understand the significance of different types of pension scheme, in particular defined benefit (DB) and defined contribution (DC)? More important, do agencies make allowances for the different legal structures and business cultures that in Europe? In other words, are agencies and analysts taking an inappropriately Anglo-Saxon view of pension funds in Continental Europe?
There is a strong feeling in Germany that they are. Rainer Wend, a senior member of Chancellor Gerhard Schroeder’s Social Democrat Party said recently: “We have to ask ourselves whether the ratings agencies are really sensitive to German business practices, or whether they operate only on the basis of Anglo-Saxon business principles.”
His concerns were echoed by Joachim Poss, the SPD’s parliamentary finance spokesman, who said the “significant influence” rating agencies exercised in Germany was a problem. “They don’t understand our business culture.”
That seems to be the nub of the problem. Credit rating agencies and investment analysts do not appear to understand or acknowledge that European pension funds may be structured very differently from the UK and US models.
This is certainly the overwhelming view of the managers and administrators who responded to our survey. Three in four (72%) agree with the proposition that the main credit rating agencies do not understand the legal structures that underpin European pension plans.
Investment analysts get even shorter shrift. Four out of five of respondents (81%) agree with the suggestion that investment analysts do not understand how European pension funds operate.
However, there is no doubt that credit rating agencies should take pension fund liabilities into account when assessing a company’s creditworthiness. Nor is there any doubt that investment analysts should factor in pension fund liabilities when giving advice to investors. A large majority (90%) say that investors should consider a company’s pension fund liabilities when deciding whether to invest in a company.
Equally, there is little doubt that this advice can have an effect on the share price of the company. Most respondents (79%) agree that a company’s share price can be damaged by its pension fund liabilities.
One way of avoiding this is not to classify pension fund liabilities as debt. But this gets little support. A substantial majority (86%) agree that pension liabilities should be regarded as a form of debt – whether soft or hard – on a company’s balance sheet. However, one manager of a Swiss pension fund made a distinction between said existing legal obligations and constructive obligations. Legal obligations belong on the balance sheet; constructive obligations do not.
There is also little doubt that, because of their long time horizons, pension fund liabilities should be regarded differently from other balance sheet liabilities. A large majority (84%) agree that they should be treated differently.
Rating agencies could perhaps overcome the suspicion that they make arbitrary and inexplicable decisions about companies’ creditworthiness could be overcome if they explained more fully how they had arrived at their decisions. A large majority of managers (all but 5%) say that agencies should explain the methodologies they use.
Opinion is evenly spread on the question of whether rating agencies are too big for their boots. Slightly under half (49%) feel that rating agencies have too much power. One UK pension fund manager suggest that the real problem is their concentration rather than the influence they exert: “The power is concentrated in too few agencies”.
This is largely a problem created by the procedures of the rating system itself. Companies complain that the business of regularly providing data to the various agencies is so onerous and time-consuming that they can only deal with a maximum of two or three agencies.
Companies could solve the problem of the drag of their future pension fund liabilities by removing them from their balance sheets altogether; for example, by closing their DB scheme and switching to a DC scheme. A number of UK companies have taken this route. Yet there is only lukewarm support for such a strategy, with only 45% agreeing and 55% disagreeing.
Anyway, merely switching plan types does not get to the root of the problem, the manager of a pension fund in the Netherlands points out: “This is a matter of accounting standards not individual company decisions. The IAS 19 should be re-drafted to be geared towards the European situation. IAS 19 is drafted on the assumption that pension funds are transparent vehicles rather than independent entities with their own decision making bodies – the board of trustees.
In other words, accounting standards bodies – like credit rating agencies – should take proper account of the way that European pension funds function. Which is where we came in.