In recent years, pensions have not only caused a headache for many corporates but have left a large hole in their balance sheets. Various companies worldwide are now burdened with significant pension deficits, made even more challenging by market volatility and regulatory changes. As a result, the treasury department has been called upon to take a more ‘hands-on’ role in this space.
Without doubt, corporate pensions are a burden – not least Defined Benefit (DB) schemes. In fact, legal firm Lane Clark & Peacock (LCP) calculated this burden to be close to $500 billion for FTSE 100 companies in 2013. Meanwhile, across the Atlantic, Mercer estimated that S&P 1500 companies’ pension liabilities totalled $2.14 trillion in the same year. What is more, both UK and US schemes are largely underfunded, with assets covering 91% and 95% of liabilities respectively.
Understandably, the vastness of these commitments and their impact on the balance sheet means that corporate pensions have largely moved away from their traditional home in the HR department and are creeping up the priority list for corporate treasurers. And with life expectancy increasing in many developed countries, such as the UK, the US and Canada, (all of which carry large DB scheme liabilities) the management of corporate pensions, and their deficits, is a genuine cause for concern. But this has not always been the case.
How we got here
“Up until 2007, pension schemes, especially in the UK, were in a healthy position in terms of their funding levels,” says Chris Coulston, Director, Tax at Deloitte. “Then the financial crisis hit and funding levels across the board deteriorated.” For example, in June 2009, FTSE 100 schemes faced a deficit of £90 billion, a loss of £82 billion on the previous year’s £8 billion deficit, he explains.
Since then corporates have invested billions into their schemes to cover these shortfalls. However, economic conditions have continued to be largely unkind, with market volatility, low interest rates and inflation compounding funding issues. Liabilities have also been increasing, not helped by falling bond yields.
Regulatory changes, such as IAS 19 accounting standards, have further emphasised the challenge for corporates, seeing the complexity as well as the cost of managing DB schemes increase. Corporates are now required to account for the whole value of the deficit on their balance sheet, which last year saw Royal Dutch Shell’s previous retirement benefit surplus of £4 billion sink to a deficit of £8.3 billion. “Overall, corporate focus has dramatically increased on pensions and their risk,” adds Ward. “Schemes have been hit so badly in the past decade that now corporates are making the management of these a high priority.”
As the treasurer’s evolving role highlights, since the financial crisis, companies have become more aware of the vulnerability of DB pension schemes and the assortment of risks they are exposed to. One such threat is financial risk – more specifically deficit instability. Over recent years companies have ploughed cash into their schemes to tackle shortfalls in funding; however, deficits often increase. For example, Mercer research shows that between March 2011 and March 2012 UK FTSE 350 companies contributed £20 billion to their schemes, although during that time the deficit increased by £17 billion. This trend was replicated in the United States.
“This is primarily due to volatile growth asset performance, interest rate risk, inflation risk and longevity risk,” says Mercer’s Ward. “In recent years these risks have often contrived to go against companies and their plans.” For a corporate sponsor, this affects the cash position and the funding position of the company. A larger deficit also causes the costs of the schemes to increase. For example, in the UK a larger deficit can mean that additional payments need to be made, such as the Pension Protection Fund (PPF) levy. “Overall, the deficit can be a key concern and may require large amounts of cash to be pumped into the scheme, which could otherwise be used for the business,” says Ward.
Of course, general market and economic activity also affects corporate pension liabilities. Quantitative easing (QE), for example, has resulted in a reduction in UK gilt yields, which in turn has caused an increase in pension liabilities. The National Association of Pension Funds indicates that UK schemes’ deficits increased by £90 billion in 2012 on the back of this. On the other hand, Deloitte estimates that a 1% increase in gilt yields could see funding liabilities reduce by 15% to 20%, which would then also raise the risk of overfunding the scheme and trapping cash.
Once the corporate sponsor has handed over the cash to the pension scheme, they are then exposed to the investment decisions of the trustees. If investment decisions are poor and return on assets low, further cash injections will be required. “It is because of this that we are seeing treasurers increasingly sitting on trustee boards,” says Coulston. “They can then apply their expertise and provide greater input to the investment of the funds.” Some treasurers are also employing independent actuarial advisors to highlight the risks of the schemes and ensure that the trustee board are making the best decisions.
Finally, the complexity of DB schemes means that corporates are also exposed to regulatory and operational risk. An eye must be kept on the ever-evolving regulatory landscape which may bring tougher funding requirements for corporate sponsors. One such example of this is the Solvency II Directive, which, if passed in its current form, will require corporates to fund and reserve their pensions in the same way as insurance companies. This will dramatically increase the impact of pensions on the balance sheet and at worst could add £600 billion to the liabilities of UK company pensions.
“When it comes to the management of pensions, it is primarily about being two steps ahead, and thinking two steps ahead of that,” says Renold’s Hawes. “We need to be aware of what is around the corner to ensure that we can continue to pay the pensions and also ensure the company has sufficient cash.”
The role of the treasurer
Not only has corporate focus on pensions increased, but the treasury department’s role has intensified in this area too. “As soon as cash becomes a key objective for the corporate, the treasury becomes more integral to the process,” says Deloitte’s Coulston.
Nevertheless, the role of the treasurer in corporate pensions is not set in stone and will vary from company to company. In some cases treasurers may take an active role managing the scheme, while in others they may serve just as advisors to pension managers and trustees. Whichever path they take, Mercer’s Ward believes that “treasurers can add a lot to the mix, but what they really bring to the table is their skillset, in terms of understanding risk.” Treasury professionals will be well-versed in many of the tools which are key to managing the risks surrounding pensions, such as interest rate swaps and inflation swaps, to name a few. “Corporate treasurers are therefore well placed to bring pensions into the overall risk management framework,” says Ward.
UK-based manufacturing company Renold introduced its treasury into the management of the company’s pension scheme in 2007. “The reason for this,” says Andy Hawes, Pensions and Treasury Analyst at Renold, “is that we already had a deficit at this point which had existed for around five years. It therefore became much more important to manage the liquidity of the pension scheme alongside the group.”
It is Hawes’ belief that the management of the group’s and the pension fund’s liquidity work hand in hand. “At Renold, we have a substantial pension payroll each month,” he says. “The majority of this is funded through the deficit repair contributions and also from the income from the assets of the scheme.” Funding for the business, however, cannot be neglected. “Treasury is therefore well positioned to take a more hands-on role in the balancing act of ensuring there is enough money to fund the scheme and also the business,” says Hawes.
It is not only the funding side of pension management which treasurers are finding themselves more involved in but also the liabilities side. “The financial crisis put a lot of emphasis on the management of pension assets,” says Rando Bruns, Head of Group Treasury at pharmaceutical and chemical giant Merck, which has large pension schemes across Europe and in the US. “However, I think treasurers now have a more holistic approach to pensions overall and are increasingly focusing on the liabilities. At Merck for example, the treasury takes an active role in looking at the impact of both sides through sensitivity analysis and forecasting future scenarios, thus allowing us to know where risks are and what impacts these will have, not only on the pension schemes but also the company’s overall balance sheet.”
Getting involved in the company’s pension scheme can also help to raise the treasury function’s profile with other departments, and highlights treasury’s ability to add value to the organisation. “For example, we have regular meetings with HR and accounting in order to discuss any changes to the pension plans,” says Bruns. “Together, we can then evaluate the impact on all areas of the business.
The balancing act
As such, the treasurer’s role in managing corporate pensions is truly a balancing act between risk and return. “The trade-off between the two is really the million-dollar question, especially in volatile markets,” admits Merck’s Bruns. There is no single right answer as each company will be in a unique funding position. “There is also the balancing act of knowing when to carry the risk and when to reduce it,” says Mercer’s Ward. “If treasurers look to close off the risk too quickly the apparent funding levels would appear to decline and the deficit would increase, seeing more cash required from the company.” When it comes to pensions there are balances within balances.
All pension experts agree, however, that a long-term strategy is needed for managing corporate pensions. Bruns advises that this should include funding and investment strategies which can stand the test of time. “Schemes can’t be ultra-safe and see no return on investments, but on the other hand, they cannot be highly aggressive and leave huge risk on the balance sheet,” he says. “There needs to be something in between.” The strategy also has to have the flexibility to cope with shifts in economic conditions and be able to make the most of opportunities when they arise. For Bruns, “Managing pensions is a lot about looking into the future and carefully waiting for the opportunities – it’s a long-term task.”
With no silver bullet to hand, companies are of course looking for methods which can increase their assets, reduce their liabilities, and ultimately remove any deficit. These can be small incremental changes to reduce their pension fund’s risk, or they could be larger, more advanced strategies, depending on the company’s position and needs. There are a number of options available.
Asset-backed funding (ABF) is one such method, offering an alternative to cash funding. ABF sees the corporate sponsor provide an income stream to the pension scheme from a special purpose vehicle, backed by collateral assets such as property, stock, or more imaginative items such as alcohol, made famous by Diageo, which promised £400m of funds to its pension scheme with a structure using maturing whiskey stock. The pension receives a series of cash flows from this asset over a set period of time. This income stream is often given a net present value and treated as an asset by the trustees. “This delivers a more cash-efficient way of funding for the company and helps reduce the deficit,” says Deloitte’s Coulston, “which is exactly what the treasury is looking for.”
Companies can also look to de-risk by offering transfer incentives and increase exchange options to its employees. For example, employees can be offered the option to take money at retirement as a lump sum. “This is a method which Renold has employed and it has helped reduce long-term liabilities substantially and has also created savings on our short-term monthly cash flow,” says Hawes. Other options in this area include offering enhanced transfer values (ETVs), whereby non-retired DB scheme members are offered a certain amount of cash in advance and then the rest is moved to a more flexible pension vehicle, potentially offering greater value for the employee. ETVs have been popular in recent years and allow the corporate sponsor to reduce their liabilities and cost.
Many companies offer multiple pension schemes which are all separately managed. If this is the case, asset pooling can increase control, improve risk management and governance, while also delivering cost savings through economies of scale. “This is something which we carried out at Renold,” says Hawes. “We historically had four or five pension schemes and combined them into one. To have the assets all in one large pot meant the returns became higher. We have also saved in areas such as administration costs.” It must be noted however that there can be barriers to this method, including trustees being unwilling to relinquish control, as well as tax issues.
The future for the treasury and pensions
With the majority of DB schemes now closed to new entrants and DC schemes fast becoming the norm, can we expect the treasurer’s role in corporate pensions to decline? “If we look very long-term and assume there isn’t going to be a shift back to DB schemes then the role of the treasurer in pensions should in theory decrease and become easier,” says Mercer’s Ward. “The tail of the DB, however, is very long and currently is not shrinking. So the management of these will continue to be challenging for a prolonged period.”
Hawes agrees: “As the DB schemes decrease, management of the assets will be required as contributions will decline. Treasurers will therefore find themselves managing assets which are either static or decreasing, requiring further involvement in following and reporting where the investments are going and how they are behaving.”
There is a light at the end of the tunnel, however. “The closer we get to D-Day, which may be 20 to 30 years away,” says Hawes, “the management of DB schemes will become easier. “With many schemes closed there will be no new entrants and also liabilities will decrease. Once the DB schemes are finished, we can certainly put our feet up as we will know what our contributions will be each month and there will be no pensions deficit to manage,” he says.