The headache of defined benefit pension schemes is nothing new – but the Eurozone debt crisis has heaped further pressure upon an already challenging matter. As corporate treasurers take an increasingly active role in the area of company pension schemes, they are being confronted with a wide range of issues from lower yielding assets to the impact of pensions on M&A activity.
Defined benefit pension schemes – also known as final salary schemes – have become an increasingly rare breed. The announcement in January that Shell is planning to close its final salary scheme to new members was noteworthy because it was the last FTSE 100 company to make this move. Meanwhile, other corporates are taking the more drastic step of closing their schemes to existing members.
Although such actions limit the size of defined benefit schemes, they do not take away the problems entirely. Even companies that have long since closed their schemes still face the challenge of funding them, and in the current climate many are seeing the value of their liabilities balloon while returns decline. At the same time, corporate treasurers are increasingly being called upon to take a more active role in this area.
The story so far
Defined benefit pension schemes – which have historically been commonplace in the UK as well as in Germany, Ireland and the Netherlands – were already in turmoil before the financial crisis arrived. Increased life expectancy meant that companies were paying out for many years longer than originally anticipated, while underperforming equities had failed to deliver the expected returns, leaving many funds out of pocket. Even ahead of the events of 2008, the number of funds facing a deficit as a result of these conditions was huge.
“Low long-term interest rates have hit pension funds with the double whammy of higher liability values and lower returns on their assets.”
The events of the last few years have done nothing to improve the situation. Low long-term interest rates have hit pension funds with the double whammy of higher liability values and lower returns on their assets. Combined with continuing increases in life expectancy, the overall impact on pension schemes is significant.
Faced with these problems, many companies have moved to avert disaster by closing their defined benefit schemes to new members, instead typically offering employees access to a defined contribution scheme (where the amount received by employees upon retirement is based on the amount paid into the scheme rather than the employee’s final salary). Today, only 19% of the UK’s private sector final salary schemes are still open to new joiners, according to the NAPF annual survey released in December 2011.
Closing schemes to new members might once have been seen as a solution to the problem – but it has become increasingly clear that this course of action may not be enough. With funding pressures mounting, a number of companies are going one step further to limit their pension liabilities. The announcement in 2011 that Unilever was planning to close its final salary scheme to existing members was widely reported (and resulted in 2,500 staff walking out), but the company was not alone in taking this decision. The 2011 NAPF survey revealed that 23% of pension schemes are now closed to new accrual by existing members, as well as to new members: dramatically more than the 2008 figure of 3%. And more companies are likely to follow suit: the survey also found that 30% of those still open to existing staff expect to close the pension within five years.
“Until fairly recently, closing schemes to future accrual by existing members was regarded as quite a draconian step, because it impacted existing employees – but I think more and more companies are willing to take that step,” comments Robert Hayes, Managing Director, Head of Strategic Advice at BlackRock. “From the moment you do that, the scheme is very much a legacy issue – albeit a large and ongoing legacy issue.”
That companies are closing their defined benefit schemes altogether is not surprising, given the pressures these schemes are facing in current market conditions. Volatile markets can have a disastrous effect on pension schemes, as Mark Ashley, Director, Institutional Business Development, Insight Investment outlines: “For a large number of companies, one of the largest risks they have in terms of volatility in their balance sheet is through a defined benefit pension scheme.
What can get lost is that on their balance sheet, it’s purely either the net deficit or net surplus that’s reported. If you break down the net position into its assets and liabilities, some companies are reporting a small net deficit, whereas the assets and the liabilities are far larger and the sheer change in value of liabilities can be significant for relatively small moves in interest rate and inflation expectations because of the duration of the liabilities.
These sorts of moves can have a significant impact on pension scheme funding positions, which is why it’s key that treasurers look at the underlying position and not necessarily just the deficit or surplus position.”
Furthermore, the Eurozone debt crisis has impacted pension schemes in a number of ways. “We’re running into another period of disappointing returns, which is putting pressure on the recovery plans that a lot of pension plans had in place,” explains Hayes. “Long-term interest rates have gone down, so yields have gone down in less risky markets and liability values have gone up. On the other side, funds have failed to generate the returns that people might have hoped for, so it’s led to an overall deterioration in many pension funds’ balance sheets.”
“For a large number of companies, one of the largest risks they have in terms of volatility in their balance sheet is through a defined benefit pension scheme.”
The Eurozone debt crisis is also challenging the definition of a low-risk asset. “As a treasurer, or indeed as a trustee, you might want to manage on a low-risk basis,” says Hayes. “So you say, let’s buy matching assets – but if a government bond is no longer low risk, then where do you go?
This has led to a number of questions and challenges for clients, particularly in northern European pension schemes, who would typically have their bond assets invested in a pan-European bond index. They are faced with the question of whether to move to an index that excludes Spain and Italy, or whether to buy German government bonds – but the problem is that yields on those are very low, so the position of the fund weakens.”
“At Insight, we’ve been obtaining unfunded exposure to government bonds on behalf of our clients through repos, or to a lesser extent through total return swaps,” adds Ashley. “In order to minimise as far as possible the counterparty risk with investment banks, we daily cash collateralise the mark-to-market value of swaps with cash or government bonds. So it’s reducing the risk and exposure to those investment banks.
This is key as one of the impacts of the Eurozone crisis has been to affect European government credit ratings, and off the back of that, European bank credit ratings, given the large amounts of PIIGS government bonds that they are holding, and the associated write-downs they’ve had to take on these.”
Playing by the rules
Regulatory issues have also impacted on pensions in recent years. “In the last 15 years or so, there has been a continual and gradual increase in the regulatory pressure around pension funds in two ways,” says Hayes. “The first is in terms of discretionary benefits being made contractual. In the UK that’s particularly around inflation linking, while in other countries pensions for widows have increasingly been hard coded in.
The second element has been in terms of the accounting and actuarial view of pensions moving much more onto a mark-to-market basis. So whereas in days gone by you could assume a long-term rate of return, with a more mark-to-market driven focus on what these things are actually worth, corporate treasurers are having to become increasingly focused on the balance sheet and cash flow implications.”
Meanwhile, increased longevity continues to be a problem. A report published by Mercer in October shows that life expectancy assumptions by FTSE 100 companies have increased by 2.5 years since 2005, equating to a 6% increase in liabilities in the same period.
Last year broadcaster ITV and power systems provider Rolls-Royce became the latest companies to opt for longevity swap deals in order to limit this risk.
Impact on M&A
The problems associated with company pension schemes are not limited to funding and cash flow requirements. “Pension schemes have also periodically been a barrier to corporate activity,” says Hayes. “We have seen that in many sectors, particularly in the private equity sector where legacy pension issues can have a major bearing on corporate transactions and how those get dealt with.
For example, if a subsidiary gets sold in a leveraged buyout, then the pension trustees, and the pensions regulator, may take the view that the quality of the covenant has deteriorated and therefore a higher level of funding is required to compensate for that.”
Ashley agrees that pensions can represent a significant obstacle in M&A deals and points out that trustees can block potential acquisitions in certain instances by insisting that any potential buyer will have to make whole a deficit position – which could amount to paying hundreds of millions of pounds.
“There’s a much greater focus in M&A transactions on the pension scheme and what the funding position is in that scheme,” Ashley says. “Certainly we have been talking to a large number of UK pension schemes which are relatively immature due to the fact the pension liabilities have been left behind with the previous employer because the new owner simply does not want to take on that liability and the sheer volatility of the risk associated with it.”
Such a challenge was encountered by Virgin Media when the company sold its broadcast division to Macquarie Communications Infrastructure Group in 2005. “At the time, a number of associates were participating in final salary schemes,” says Rick Martin, Group Director, Treasury and Investor Relations at Virgin Media. “Those issues had to be quite carefully negotiated with the ultimate purchaser.
On the one hand, trustees of the scheme were understandably quite keen and under deed had every expectation of preserving their benefits. On the other hand, the prospective purchasers of the division were not minded to take on unnecessary – from their perspective – risks.
“Accordingly, the deal we cut with Macquarie Communications Infrastructure was that they would establish a so-called mirror-image plan; however we retained the legacy assets and liabilities. So that’s why, even though we’ve had no new entrants to defined benefit schemes for some time, I still get involved with DB schemes.”
Interaction with trustees
In the UK, companies are not permitted to dictate the investment policy that trustees should follow, which makes the relationship between the trustees and the company particularly delicate. “Understandably, and hopefully correctly, the treasury area is looked to as a source of input as to how the portfolio of assets in the fund can best be allocated,” says Martin. “Clearly, I would rush to add, it is ultimately the responsibility of the trustees – however, they look to us to provide a degree of input before they make their investment allocation decisions.”
The importance of this input is growing. “We are finding that corporate treasurers are getting much more involved in the area of pensions,” observes Ashley. “They are one of the natural parties within the sponsoring employer to look at these sorts of risk.
“In the UK, companies are not permitted to dictate the investment policy that trustees should follow, which makes the relationship between the trustees and the company particularly delicate.”
They understand the financial markets; they understand the use of derivative instruments that can be used to remove interest rate and inflation risks from within the liabilities. And they report to the CFO, who is ultimately responsible for the financial condition of the company.”
Ashley points out that the CFO is in a conflicted position where pension schemes are concerned: a scheme that is in deficit will be putting pressure on the sponsor to provide extra funds to remove the deficit – but the CFO will be looking to keep those payments to a minimum. “The CFO would potentially have been a trustee ten years ago but very few CFOs remain as trustees now,” says Ashley. “This is increasingly being delegated to treasurers, who are getting much more involved in pension scheme risk management.”
Treasurers taking on a more active role with pension trustees may also face a conflict of interest. Their knowledge of the company’s funding plan for the years ahead means that they have a good idea of how much surplus cash the company is likely to generate. “Nonetheless, some treasurers are trustees, and when discussions move to the negotiation between the trustees and the company the corporate treasurer will step back so there isn’t that conflict,” says Ashley.
While the relationship between the company and the trustees is usually cordial, relationships can sometimes become fractious. Trustees may believe that the corporation is not looking after the scheme members’ interests, while the company may be looking to restrict the amount paid into the scheme.
Meanwhile, frustrations can arise from the fact that while the pension scheme is a big exposure for the company, in technical terms the company has limited control over how it is managed. Ensuring good communication and developing a strong, mutual relationship is time well invested.
“Trustees may believe that the corporation is not looking after the scheme members’ interests, while the company may be looking to restrict the amount paid into the scheme.”
In addition to sensitivities regarding the sometimes conflicting goals of the company and the trustee board, treasurers managing this interface can encounter other frustrations.
Trustee boards, which tend to meet quarterly and which include members with varying degrees of financial knowledge, can be slow to reach decisions. Such delays can mean that market opportunities are missed which can lead to higher costs.
In order to address this, many pension schemes have moved to set up a smaller investment sub-committee which typically includes the treasurer.
“To a lesser or greater extent, the trustee board will delegate some authority to that investment sub-committee to investigate strategies and fund managers and go back to the board with the recommendation that certain strategies, particularly relating to risk management, are implemented,” says Ashley.
The year ahead
Pensions have a unique place in the treasurer’s area of responsibility – while the ultimate responsibility for investment decisions lies with the board of trustees, the treasurer’ s involvement in this area is significant. Indeed, Martin estimates that managing the company’s pension schemes will take up 10-15% of his time in 2012.
In the current climate, however, tackling the multiple challenges associated with pensions needs to be done with care. Hedging inflation and interest rate risks is becoming a greater focus for a number of funds, but with some caution. “Given the low yield environment, it doesn’t make sense to hedge out a lot of these liability risks at the moment, so pension schemes are looking at how much worse can it get versus how much better is it likely to get,” comments Ashley.
“Some schemes are taking the decision now that they ought to be hedging out some of those risks to at least get some of them off the table – but they are not going to do a significant amount of that because it’s so costly at the moment.”
Consequently, more companies are looking at the use of pre-set triggers for investment actions, so that hedging takes place at a specified interest rate or inflation rate.
There is plenty that can be done to address pension pain points – but above all, focusing on building a mutually beneficial relationship between the sponsoring employer and the board of trustees can only be positive at a time when the challenges facing pensions have never been greater.