Introduction
For any company considering whether to offer (or continue to offer) a traditional defined benefit (DB) pension scheme, the fundamental issue is whether the benefit of doing so justifies the cost. The rationale is clear: in providing a desirable benefit for employees, the company hopes to attract and then retain the calibre of staff it requires. The main costs are twofold: the direct cost of the employer’s contributions to the scheme, and the contingent risk that the scheme will need “topping up” if the fund financing it runs into deficit.
The recent spate of closures of DB schemes suggests that many companies have decided that the costs now outweigh the benefits. Two causes of the increase in costs have been widely discussed and are accepted by almost all commentators: greater life expectancy for beneficiaries means that expected payouts will continue for longer, and the substantial falls in equity markets in recent years have left many scheme sponsors needing to increase their contributions to cover deficits.
This article will highlight a third reason for closures, the increasing imbalance of risk for pension scheme providers. This imbalance will continue to affect companies’ decisions and the attractiveness of providing a DB pension scheme even if equity markets were to recover their buoyancy, and therefore needs a new solution. The article concludes by suggesting that bond issuance by sponsoring companies to repair pension fund deficits may be one way forward.
The traditional risk balance
Traditionally, pension funds were kept very separate from the sponsoring company’s balance sheet. This insulation of the fund from the company was two-way. Any surplus in the fund could not be withdrawn directly by the sponsoring company, though it could in effect be withdrawn over time by the sponsor taking a “contributions holiday” and reducing or even ceasing its payments to the fund. Equally, although any deficit in the fund did impact upon the sponsoring company, here too the effect was drawn out, as the company was given time to correct the position.
This had the merit of being balanced: both surpluses and deficits did eventually affect the sponsor, but in both cases only over the long term. In this way the day-to-day (or quarter-to-quarter) net position of the pension fund did not impact directly on the company’s balance sheet. As a consequence of this, it also meant that the company could afford a relatively “hands-off” approach to the management of the fund, leaving fund trustees to pursue their own strategies. One side-effect of this, though, was that few companies (or trustees) resolved what the true objective was for the pension fund, i.e. whether to maximise the absolute return on the fund (regardless of risk), or maximise the probability of the fund meeting its liabilities (which is not the same), or minimise the risk/volatility for the company’s balance sheet.
Changes in the risk balance
Recent legislative and accounting change have affected one side of this balance. Scheme sponsors can still only withdraw surpluses over the long term, but they face increasingly frequent and short-horizon valuations, and increasingly short periods in which they have to make up deficits. In short, if the pension fund does well the surplus remains largely out of the reach of the sponsor, but if the fund runs into a deficit, the sponsor has a shorter time to make it good, and the deficit feeds through faster to the company’s own profit and loss account and balance sheet.
Not surprisingly, this imbalance of risk has affected the attractiveness of pension schemes to sponsors. In a nutshell, they bear the losses but cannot benefit (in the same timescale) from the gains, and this is yet another reason for sponsors to view traditional final salary pension schemes unfavourably.
The position is even more stark for closed schemes, because as a scheme becomes increasingly mature, and dominated by beneficiaries, the role of contributions falls. This reduces yet further the ability of the sponsor to benefit from investment surpluses by taking a contributions holiday, and further imbalances the equation. Indeed, once a scheme has no active members and so no contributions, companies face a situation where they must meet any shortfalls in the fund but may be totally unable to benefit from any surpluses. And this may not even be resolved as a closed scheme reduces to its last few surviving beneficiaries: if there is still a surplus in the fund at this stage, do they share it? does it all go to the last survivor? or does it return to the (possibly no longer extant) sponsoring company?
The pension fund as an on-balance sheet liability
As the recent legislative changes increasingly force companies to consider their whole balance sheet, including their pension fund liabilities, there are growing attractions in seeking to manage the company’s financial affairs accordingly. This introduces new dynamics into the question of how best to finance companies. It provides new incentives to minimise volatility and risk on the whole company balance sheet, including that derived from changes in the net position of the pension fund. And it changes the question of the optimum gearing for a company, and the combination of debt and equity financing.
Under this “whole balance sheet” approach, many companies will find that there are significant advantages to be derived from the pension fund matching its liabilities more with bonds. The main argument in favour of such a move is that it produces less volatility for the company’s finances, for whom the pension fund ceases to be a leveraged play on equities. But in fact the advantages go beyond this, and almost everyone benefits. Pensioners are clear beneficiaries, as their pensions are more secure. The company benefits, because it faces reduced balance sheet risk, and this should also increase its value for shareholders. Alternatively, the company can utilise the reduction in risk on the balance sheet to gear up, selling bonds to buy back its shares. In this way, if the stock market subsequently rallies, there should be no regret from not investing the pension plan in equities. Finally, there may even be tax advantages from such a move, as the pension fund may be able to reclaim the tax on bond coupons, while the company benefits from coupon payments on debt being a taxable expense.
One of the arguments used against moving pension funds into bonds is that, with many funds now in deficit, this would simply crystallise the losses that have occurred in the last three years and ensure that funds will never recover without sizeable new contributions. But this confuses two issues: how best to restore the damage to the fund that has already occurred (the deficit), and how best to position the fund for the future welfare of the fund and the sponsoring company. In fact, the answer to the second question is independent of the first question. Immunisation and risk minimisation through liability matching, as proposed above, remains an attractive course, whatever the current net position of the fund.
Bond issuance to refinance pension funds
How best, then, to handle deficits if companies wish to take the matching liabilities route? For companies with pension funds facing a deficit, they should consider issuing long bonds which match their net pension fund liabilities, and then investing the cash thus raised in their pension fund. Not only will this make the pension fund whole, but the company will have replaced a liability which it has the obligation to cover in short time period (the pension fund deficit) with one which it does not (the long bond issue).
But there are wider benefits from bond issuance to cover pension scheme deficits. Such moves should also be welcomed by the Government, as they seek to encourage actions to resolve the issue of pension fund deficits and improve the financial position of pension schemes. And increased bond issuance in the capital markets creates more supply for other pension funds to buy if they wish to reweight towards bonds. In short, this appears to be a genuine win-win situation. It is interesting to observe that, on the other side of the Atlantic, such bond issues are already happening, with a recent £11 billion bond issue by General Motors specifically designated to make whole their pension scheme.
Wider consequences of matching pension fund liabilities
As well as protecting companies and their balance sheets, immunisation of pension funds in this way also has major advantages for investors. Once a company’s pension fund is market- and risk-neutral, rather than a leveraged play on equities, investors are more able to assess what they are buying when they buy a company’s shares. There is no reason why an investor in a company would want that company’s pension fund to buy equities, because if he likes equities he can buy them himself directly. Following this reasoning, companies with matched and fully hedged pension funds should command a premium in their share price, both because of the more secure balance sheet and because of the greater transparency as to what the investor was buying.
Secondly, a proper analysis of the interaction between the company and its pension fund may help to clarify for the various stakeholders – the company (and its shareholders), the pension fund trustees and the pension fund beneficiaries – what the true objectives of the combined entity should be.
Finally, the accounting ramifications of a major move to balanced pension funds are also beginning to engender discussion. Given that pension fund liabilities are ever more seen as direct liabilities of the sponsoring company – not least by the credit agencies – some are beginning to ask why they are not treated as such. Other long-term liabilities of a company (eg a bond borrowing) do not have to be backed with cash assets so far in advance of their maturity, and the argument is growing that it would be more logical to treat long pension liabilities in the same accounting way as other long liabilities. This would enable companies to utilise the funds otherwise set aside in pension fund assets in earnings-generating investments instead.
On this last point, however, those who put forward these arguments need to be realistic. Although not uncommon practice on the Continent, at the moment such a radical move is unlikely to be acceptable politically in the UK, due to past experiences when companies have “raided” pension funds (i.e. used pension fund assets elsewhere in the company) and then failed. And as always, pensions and their accounting arrangements are in the ultimate resort too important for the politicians to leave alone!