In Germany at present the dominant way of financing occupational pensions is still represented by so called Pensionsrückstellung (pension provision), through on-balance sheet book reserves.
Annual additions to pension provisions are tax deductible, and need not to be asset backed. Both advantages explain why this way of financing has been so popular in Germany, especially in the post world war era when German companies obtained access to a new financing source. In the mean time company workforces have been aging, thus increasing pension payments have lead to high cash outflows that are not offset by pension assets since no asset backing had been implemented in the past. The substantial and rising unfunded pension liabilities from German firms are considered as a non-transparent and hidden risk factor by the public as well as the finance sector.
The German economy has been turning away from the traditional standpoint of creditor’s protection towards shareholders as in the UK or other capital market oriented countries. To be compliant not only with international accounting standards but also with international business practices, German firms have to adjust their businesses in terms of accounting and financing and that also comprises pension liabilities. US and UK firms are used to financing their occupational pensions externally by the means of pension funds. The on-balance sheet Pensionsrückstellung without asset backing is not known by the international community forcing German companies to look for alternative ways of financing.
Finally, S&P came into play last year by downgrading Thyssen Krupp because of its unfunded pension liabilities and by putting sound firms like Deutsche Post on its watch list due to the same issue.
What can a German firm do in order to solve the pension problem? It might transfer its pension provisions to external funds that are in line with the German law. Among other even more expensive options there are two potential funding vehicles: Unter-stützungskasse (support fund) as well as the newly established Pensionsfonds (a German style pension fund). If a German firm transfers its pension provisions – the underlying pension scheme with active pension claimants – to one of these funds, the present value of expected contributions to these external funds is likely to be much higher than the present value of the pension provisions under German GAAP. As the off balance sheet pension provisions are discounted by a rate of 6%, both Unterstützungskasse and Pensionsfonds apply a discount rate of 2.75%. The value of expected contributions becomes even higher because trend factors and longer life expectancy are considered in sharp contrast to the pension provision that does not take these into account. Even though contributions to these external funds are spread over a long future period of time, they represent substantial costs.
A solution becoming popular in Germany is the Contractual Trust Agreement (CTA). Many of Germany’s international companies – Daimler Chrysler, Volkswagen, Deutsche Bank and Schering – have already reacted. They have started to fund their pension liabilities off-balance sheet under IFRS/FAS by the means of a CTA.
Basically, a transfer of pension liabilities (German provisions) to a CTA means cash outflow. If a firm wants to maximise the benefits of the CTA arrangements that are subject to book values, at first sight, with balance sheet contraction and EBIT increase, a negative enterprise value is likely in the majority of cases due to high cash requirement. If a firm wants to maximise the CTA benefits but is also focused on enterprise/shareholder value, the target function must be ‘transfer of pension liabilities to a CTA with minimum cash outflow’. Since no investment requirements exist concerning the CTA plan assets neither under IFRS/FAS nor under German GAAP, a German firm would be able to map out its own financing strategy. This flexibility would help to gradually finance the CTA assets, and hence to maintain enterprise/shareholder value.
Obviously a trade-off exists preventing many German companies from funding their pension liabilities. But here is the good news: ratios like return on capital, EBIT interest coverage, and debt ratio can be enhanced significantly while maintaining enterprise value by thorough planning of the key financials. The impacts on enterprise value can be properly measured by forecasting a CTA funding plan as well as the future course of pension liabilities together with the underlying corporate finance strategy. Applying fundamental evaluation models, the results on free cash flow as well as the capital costs can be quantified for each single future period, and therefore any change of enterprise value can be measured. And, much more important, a very positive message is sent to the market. The company starts to separate the pension issue from its core businesses and increases its ability to meet future obligations significantly. In addition to this, the company complies with international business standards, and allows a much better comparability for international investors.
It must be highlighted that each company faces a specific situation in terms of its pension scheme. Thus, different maturity stages of pension schemes as well as different financing structures lead to different outcomes. So a firm running a mature pension scheme – substantial pension payments are already being made – starts to finance a CTA by debt. The firm literally substitutes the ‘pension debt’ by other sources of debt. As a result, total assets remain the same (no balance sheet contraction) but the effects on corporate cash flows are powerful. First, the redemption structure (note that the firm has already paid high pension payments) is shifted into the future associated with positive impact on present values of cash flows. Second, two tax shields are used. Under German GAAP the taxation does not change as stated above: even though the company has established a CTA, it still accounts as tax-deductible pension provisions. Additionally, the company has created a second tax shield due to the “substituting” of debt associated with tax-deductible interest. Hence real value can be created under certain premises with an artificial leverage but without increasing the debt level of the firm.
Looked at the other way round, if a company with a new pension scheme starts to transfer its pension liabilities to a CTA, the enterprise value can be hurt massively: “repayments” of the future pension obligations in terms of pension payments are pulled into present associated with negative impact on present value of cash flows.
In order to summarise the very complex decision whether to fund or not to fund German occupational pensions, it is important to be familiar with one of the commonly used counter arguments against external pension arrangements like the CTA: “…in order to evaluate the funding of pension liabilities, one has to compare the return on pension assets, respectively the market, to the return on company assets. If firm assets generate a higher return, one must not invest the money elsewhere”. That’s actually not right because we don’t live in a risk-free world. Every smart investor has learnt to evaluate risk-adjusted returns, hence a corporate manager facing the decision whether to fund or not to fund pension liabilities has to compare the risk-adjusted return on firm’s assets to the risk-adjusted return of the market. Applying the principles of the capital market theory, it becomes clear that a higher return of the company will be associated with higher risk.
Thus, the funding decision cannot be made by a simple comparison of the nominal returns. The general answer must be: it depends… and can be defined by means of a thorough CTA enterprise valuation.
Oliver Bilal is an investment consultant at Pension Consult in Munich