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An astonishing pension u-turn. Wednesday, November 12, 2008

Image via WikipediaThe current economic downturn is forcing business to look at all options for weathering the downturn, including corporate restructuring. However, many companies and potential acquirers of companies face the challenge of fully funding pension scheme liabilities under "Section 75" if they wish to enact changes that may imperil schems.

Introduced in 2004, it directly tackled a loophole highlighted by Maersk, the Danish shipping line, which tried to walk away from the pension liabilities of its UK subsidiary even though it remained solvent. The scenario at the time was one of plunging stock markets and falling bond yields unmasked which created huge pension deficits that were transparent to investors. Unsurprisingly, companies sought to restructure to avoid their pension responsibility and, at the time, it was estimated that about 125,000 UK pension scheme members had been affected by such moves.

Now in a bizarre about-turn by the UK Government, at a time when pension deficits are to balloon again after huge falls in stock markets, the Pensions Minister has announced a consultation process with a view to watering down the scheme. It apparently reflects concerns that Section 75 is impeding "necessary" restructuring.

For clarity, I do have considerable sympathy with companies who are impeded from introducing restructuring measures on the basis that they simply cannot fund deficits at this time - corporate borrowing is difficult enough right now, and so to be forced to use scarce funding for "non-business" purposes is a massive issue. Moreover, since Section 75 was introduced, there have been a number of examples of high profile takeovers that have fallen through because of the need to fund a pension deficit upfront e.g. Sainsbury's.

Similarly I recognise the difficult balance that exists between allowing companies to implement measures to keep a company afloat to the benefit of current stakeholders and the protection that needs to be afforded to current and future pensioners.

Nonetheless, I'd be astounded if Unions don't express their fury at such a move and it will be an interesting spectacle to see the Government defending any weakening in employee protection at a time when workers are increasingly fearful about their jobs.

Worryingly, if measures did backfire and companies exploited any changes to the detriment of pensioners as is likely, it may actually lead to more Pension schemes having to turn for funding to the Pension Protection Fund, which is funded by pension schemes via a levy.

Labels: Pension, Pension Protection Fund

posted by John Wilson @ 10:57 AM Permanent Link ,

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The market in pension fund liabilities Thursday, May 08, 2008

FT Alphaville had a report recently on companies offloading their pension obligations

More of the UK’s 100 biggest listed companies are looking to get rid of pension liabilities as the price of offloading their risk has fallen. At least 10 FTSE100 companies are seeking bids from insurance firms that specialise in taking on retirement obligations, including seven that have schemes with assets of £1bn or more, according to a report by Lane Clark & Peacock, the actuarial consultants. The report, issued Wednesday, said the £4.1bn that companies offloaded to insurers in the six months to March 31 was seven times the figure in the preceding six months.

This is a fascinating area, since the big attraction to a company of selling it's pension fund is that their existing liability to fund a scheme can be capped/fixed. With depressed markets and changes to tax in relation to pension schemes, many schemes were pushed into deficit [forecast liabilities to pensioners exceeded forecast pension fund assets]. Legislative and regulatory changes in the UK meant that companies had to address how these deficits would be funded, but

a) the deficits in some mature schemes represented a substantial proportion of the market value of the company; and
b) depressed market meant raising finance to fund such deficits was problematic, especially since such fund raising did nothing to grow the underlying business

A growing number of companies were facing this issue and it began to overshadow their normal activities. Indeed, one joke in the City was that British Airways, via its pension fund, was a hedge fund with a struggling airline attached. The greatest concern was that companies had no easy way of capping their liabilities and, perversely, these liabilities could drive the companies into insolvency if they continued to grow. In this scenario, pensioners interest would be materially harmed.

For companies, their risk falls into two broad areas, namely

investment risk [pension assets won't grow sufficiently to fund liabilities]; and
mortality risk [pensioners will live longer than expected and hence draw a pensions for longer thus draining the fund]

When referring to such deals, we are specifically looking at defined benefit schemes [final salary schemes as they are commonly known] where the employer undertook to fund a scheme to enable a pension to be paid equivalent to a proportion of an employee's salary at retirement, adjusted for number of years of service. As such, the employer bore all of the investment risk associated with the performance of the pension scheme. As markets deteriorated, so the difference between the required fund size [as foreseen by actuaries] and actual ballooned leaving companies to fund large deficits, whereas they had enjoyed large surpluses for many years in the 80s and 90s.

As consequence of this, there has been an enormous shift in the UK from defined benefit to defined contribution pension schemes under which employers agree to pay defined contributions into a scheme but the employee bears the investment risk related to what the pension fund will be worth at retirement. Many existing defined benefit schemes have been closed to new members, with pressure placed on employees to switch into defined contribution schemes.

To obviate their ongoing investment risk on existing funds, companies have been presented with opportunities to fix/cap existing pension deficits by insurance-like firms who offer to assume the ongoing risk.

Firms such as Paternoster set up ready to benefit from the resultant opportunities, but few deals actually materialised. As the FT mentions, the main deterrent up until now has been the high cost to a company of offloading its pension fund since acquirers need to be compensated for the risks they are assuming. However, rising bond market yields have caused forecast deficits to shrink thus encouraging firms to sell.

For the buyers, the main appeal of the deal is to widen the gap between the assets of the pension funds and the liabilities in their favour. Several things can assist this process

improved investment returns via more aggressive management of the funds
encouraging pensioners to cash-in early at a net present value that is less than the payout foreseen were the pension run its lifetime. Many pensioners value cash now rather than a delayed payout, as it seems many people expect to die sooner than they actually do and hence they believe it to be a better deal.
hedging mortality risk so that that increased costs of extended lifetimes are covered/capped

For the buyers there will also continue to be opportunities to on-sell these "books" of business subsequently or parcel them up and sell them in tranches. As bond yields and markets change, so the value of the liability/asset will vary and hence create P&L opportunities.