As recently as the 1990s, Britain’s corporate-sponsored pension plans were the envy of the world. Schemes were flush with abundance. Only the rare fund had a shortfall, and life was good. But now this pension paradise has been turned upside down.
Today, a staggering 94 percent of final salary pension schemes at FTSE 350 companies report pension deficits. Six FTSE 100 companies have shortfalls larger than 30 percent of their market capitalization. Underfunding estimates reach as high as £150 bn ($262 bn) for UK companies.
In Europe, the overall pension deficit was Ä116 bn ($138 bn) for the 50 companies on the Dow Jones Stoxx index, with companies in Germany, Spain, the UK and the Netherlands reporting the largest average pension deficits. ‘We’re talking some big numbers,’ says Marc Hommel, an actuary with PricewaterhouseCoopers.
This major reversal in fortunes set in motion a number of regulatory and accounting changes that companies must implement this year. The solutions designed to restore corporate pension health are complex and challenge traditional corporate power structures, experts say. ‘It’s an attack on all fronts,’ says Orlando Harvey Wood, a pensions partner with the Deloitte consulting practice in London. ‘So much has been piled on companies in such a short period of time.’
‘You won’t find a magic bullet solution, in my view,’ says John Grout, technical director for the Association of Corporate Treasurers. ‘Companies will have great difficulties with their shareholders, who will not like what they see.’
Filling the holes
Under the UK’s Pensions Act 2004, most companies must plug their pension funding gaps within a decade. Some have increased fund contributions, while others are making one-off payments. Royal Bank of Scotland hacked its deficit downward with a £1.1 bn payment that included £750 mn in cash. Scottish & Newcastle’s cash one-off reduced its deficit to £372 mn. Another option is a buyout, which means providing enough assets to allow an insurance company to provide future benefits in full. The total cost, experts say, is much higher than the accounting figure on the books. Whatever the method chosen, UK companies in pension deficit must placate a new overseer: the pensions regulator.
To ensure full scheme funding, the regulator can prohibit dividends, halt mergers, acquisitions and divestitures, alter refinancings or stop other transactions. Lingerie manufacturer Sherwood Group, for example, was told to pay nearly £8 mn into its pension fund before a share buyback could proceed.
‘That shows the strength of the environment in which they’re operating,’ says Angela Knight, chief executive of the Association of Private Client Investment Managers and Stockbrokers (Apcims). ‘In fact, we have created something more powerful than the takeover panel on the Competition Commission.’ Bob Scott, partner at actuaries Lane Clark & Peacock, notes that potential mergers and acquisitions deals are already being curtailed.
While the regulator is a formidable force, company executives must also deal with newly empowered pension boards that have the authority to negotiate higher pension contributions. Pension trustees will be more demanding of cash, says Hommel. ‘It’s an opportunity for a trustee now at the corporate table to act as any other unsecured creditor,’ he adds.
Companies with huge deficits must negotiate better pension terms ‘or tell shareholders that cash flow will be going into the pension scheme,’ says Grout. ‘Not a welcome message for shareholders, and a nightmare for an IR director.’
Watch your step
Communicating pension deficit details and corporate fixes can be like walking in a minefield – one has to tread carefully. ‘If you’re a human resources person, an investor relations person or a general PR person, you’ve got a big problem,’ warns Grout. Different audiences have conflicting agendas: shareholders want return on investment, while workers want the promised retirement security.
‘The investor relations director has to juggle all of these things,’ says Grout. ‘In particular, you don’t say things to shareholders or analysts that do not exactly jell with what human resources is saying to the trade unions or the workforce. They will compare notes. Blogs will be set up and they’ll say things. It’s an unusually difficult job.’
Analysts are looking for clear explanations about pension deficits, actions and assumptions. ‘It is incredibly complicated,’ says Stephen Cooper, head of valuation and accounting research for UBS and one of the analysts calling for more information about assumptions. ‘But you need to disclose why it’s complicated and give the necessary explanations to help people interpret it. Companies shouldn’t hide behind long-held actuarial speak or technical jargon.’
Cooper thinks analysts will handle corporate valuations in a straightforward fashion, like debt. ‘Sure, these companies have large pension deficits,’ he notes. ‘But a company has to repay borrowings in the future; it’s like making lease payments on an aircraft, and they have to meet their pension obligations as well.’
Hommel says analysts will look at pension contribution impacts on cash flows, the scheme’s ranking against other creditors, claims on contingent assets, and the company’s ability to retain and motivate its workforce.
‘The pension deficit impact will be very hard for investors to measure,’ says Harvey Wood. ‘Most know it’s something to be worried about because it could have a material impact on stock price, dividend patterns and who knows what else.’
Analysts may face confusion as well. In his PhD study on analyst behavior, Ernst & Young partner and auditor Finn Kinserdal finds that many Norwegian analysts have difficulty with pension accounting. ‘These are smart people, but they think these [IAS19] rules are complicated,’ says Kinserdal, a member of the European Financial Reporting Advisory Group.
What lies ahead
UK companies don’t just have to deal with reducing deficits – they’ll also have to pay into a government Pension Protection Fund, which protects pensioners from company insolvencies. Premiums are based on the size of pension deficits and company credit
ratings, and, as analysts note, represent another use of corporate cash.
Reducing total pension costs will be a future priority for companies. Analysts believe more companies will follow the example of Rentokil Initial, the first FTSE 100 company to freeze its final salary pension scheme and funnel new employees into a new, less costly program.
Knight says these closures are a clear example of the ‘law of unintended consequences’. ‘Regulators didn’t expect that rules enacted to protect pensions would result in their demise,’ she says. ‘But something had to be done at companies like British Airways, which is a small airline attached to a large pension fund.’
Recent publicity about the stability of private and public pensions has brought much-needed attention to retirement funding. ‘People are saving more for their pensions, and
companies and employees are thinking more about it,’ Knight adds. ‘They’re not thinking of pensions as some sort of free benefit. Remuneration is a combination of salary and pension.’
The bad news is that the pension crisis isn’t going to disappear. ‘To think that it can’t get worse is to ignore the experience of Japan over the last 25 years,’ says Tony Osborn-Barker, a director in consulting at Deloitte. It seems that now is the time to bone up on the intricacies of communicating pension deficit details.
New reporting rules What exactly is the size of a company’s pension scheme deficit or surplus?
The answer is guided by IAS 19, the international accounting standard, and FRS 17, the British equivalent. All public companies in the UK and Europe are required to adopt IAS
19 beginning this year.
Under IAS 19, most companies are opting to reflect pension schemes’ actuarial gains and losses outside of profit calculations, although companies can recognize all pension costs against earnings immediately if they wish. And, for the first time, companies are required to incorporate a pension fund deficit (or surplus) directly onto the balance sheet, rather than putting the explanation in a note.
‘All I can say on the matter as an economist is that bringing corporate pension liabilities onto the balance sheet is a positive development,’ says Jean-Pierre Casey, head of research at the European Capital Markets Institute.
