Pension commitments are not inconsiderable and can often be a major burden on companies. UK corporate sponsors have, since March 2009 for instance, put more than £150bn of corporate cash and assets into their pension programmes in an effort to close deficits and put their plans on a sustainable footing. Yet, despite this colossal sum, until May of this year, deficits had barely begun to move downwards. Corporate pension sponsors are running harder and harder merely to stand still. The factor which changed things recently was an upward spike in gilt yields, but the need to be aware of and mitigate against pension risk is now firmly in the minds of many treasurers, chief financial officers (CFOs) and other boardroom executives.
Real gilt yields are perhaps the biggest single factor impacting pension scheme liabilities – every 1% drop in real yields adds approximately 25-30% to scheme liabilities. At the end of April, the yield available on a 15 year gilt was about 2.5%, when 15 year inflation expectations stood at 3.24%, considerably above the Bank of England’s (BoE) 2% target. This means that the real yield – which factors in the impact of inflation – was minus 0.73%, even with a slight rise over the month. This figure is roughly 200 basis points lower than yields were at the start of the BoE Quantitative Easing (QE) programme, which started in early 2009. Combined with safe haven buying of UK gilts by foreign investors, the effect has been catastrophic for pension scheme sponsors in the UK.
The upward spike in yields seen in May brought deficits down by about £70bn, according to the UK Pension Protection Fund (PPF). However, it would take a sustained improvement in real yields and a continued rise in the value of risk assets, leaving aside the thorny question of the impact of unwinding QE on the markets, to significantly improve schemes’ funding positions.
Looking at the wider economic picture, it is difficult to see how a ‘goldilocks’ growth scenario – where growth is just good enough to help asset values, but not quite strong enough to start the unwinding of QE – might happen. Combine sub-par economic growth with the likely effects of a loosening of the BoE’s exclusive focus on inflation targeting, which might mean higher than expected inflation for longer, and it is possible that real yields will remain depressed for some time.
This should be concerning for corporate pension sponsors for several reasons; not least because investors seem to be taking more notice of pension liabilities. Last year, one law firm, Freshfields Bruckhaus Deringer produced some research into the effect of de-risking pension schemes on FTSE 350 companies, which found that on average their share price rose by 1.7%, compared to a fall in the index of 0.2%. The experiences and customer cases seen at the Pension Insurance Corporation (PIC) seem to bear this out. In 2008, for example, PIC worked with Delta plc, an engineering company based in the West Midlands, UK, to complete a £453m pension insurance buyout of their pensioners-in-payment.
The transaction was specifically structured to ensure maximum shareholder value by removing completely the liabilities from Delta’s balance sheet and financial reporting (unlike a ‘buy-in’ where the liabilities and assets remain on the balance sheet). The positive impact on Delta shareholder value of removing pension risk was demonstrated by the favourable reaction of the markets to the partial buyout. Delta’s share price rose 8% on the day the deal was announced.
One factor which makes pension liabilities particularly difficult to handle is the impact of economic stress. This is because low interest rates, low equity values and potentially rising inflation combine at just the worst moment to create the perfect storm, in that deficits get bigger as the corporate sponsor itself declines in value, perhaps in-line with wider stock market valuations. When the sponsor weakens, trustees of the pension scheme have to assume that they should take less risk, thus reducing their reliance on investment returns and requiring more, and perhaps greater, contributions from the sponsor.
By way of a simple example, a strong company in a weakening economy may only need to have £100m in assets to fund its pension scheme, whereas a very weak company, with the same pension liabilities, may need to have in excess of £140m. A potentially fatal difference for the weaker company, as the executives and shareholders of the Scottish woollen manufacturer Dawson International found to their cost last year, when the weight of their pension obligations forced the company into administration.
Other key pension risks facing corporate CFOs are rising longevity expectations, when each additional year’s life expectancy for scheme members – much as it is good news for them – causes liabilities to rise by 4%.
Legislation can further add to the burden too. Surprisingly, 30 years of UK pension legislation, including making increases guaranteed rather than an intention, requiring prefunding of technical provisions with a prudent margin, removing advance corporate tax (ACT) for equity dividends, and the PPF levy and compliance demands, have all potentially increased the cost of providing a pension benefit by around 50%. The new rules have also perhaps killed the defined benefit (DB) pension scheme system off in the process.
As the problem worsens, increasing numbers of corporate sponsors have sought imaginative solutions to help them deal with an increasingly urgent problem. Some have sought to defer the issue by spreading the cost of deficits over 10 years or even longer, hoping that things will get better. But for any business transaction such as short or medium term borrowing, M&A, or other restructuring, the full pension scheme deficit will be taken into account, and will be a negative factor pushing up the cost of borrowing or making restructuring difficult.
Sponsors can encourage trustees to help put their pension schemes in a better position to maximise funding positions over time, in spite of a poor macroeconomic context. Best practice suggests that they might run assets and liabilities together; remove all unwanted or unrewarded risks wherever possible; and avoid catastrophic losses via the taking of unintended risks.
Other solutions have included transferring company assets into SPV structures, including Whiskey (Diageo) and maturing cheese (Dairy Crest), and going down the de-risking route. The latter may be painful to do in one go (buyout) but making a start will gradually lock down the issue.
Derisking options include Liability Driven Investment (LDI), prior to a buy-in or buyout. And there are ways to make pension insurance less painful up front, for example one recent UK buyout was notable for the use of a deferred premium over five years, representing a significant portion of the total premium. In this transaction the full level of member benefits was insured at outset and the payment mechanism reflected the structure of the deficit recovery contributions agreed by the Trustees and sponsor after the previous valuation, which was designed to make good the pension deficit by 2015. Other transactions have made use of company assets, including the sale and leaseback of commercial property as part payment of the premium to avoid having to divert further company funds.
So while pension funds can represent a significant drain on company cash flow and even, in some instances, a real threat to the continued existence of the sponsor, there are actions that can – and should – be taken to mitigate pension risk.
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