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The Actuary The magazine of the Institute & Faculty of Actuaries
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Pensions: Staying power

The high-profile demise of highly successful, long-established institutions, such as Lehman Brothers and Bear Stearns, and difficulties faced by others such as AIG and HBOS, has dominated headlines as we head towards a global recession. They are a stark reminder that the idea of enduring corporate success is an illusion and pension schemes are not immune to the effects of the boom-and-bust cycle.

The analysis of current and likely future financial performance of sponsoring employers is a vital component of the assessment of employer covenant. We have looked at the fortunes of the companies making up the FTSE 100 in December 1988 and December 2008 and it shows that there are few companies for which the past 20 years has been a story of steady, uninterrupted success. The results show that success is transitory and that strong performance is subject to ebb and flow.

Of the 100 companies comprising the index at the end of 1988, only 33 remain. Of the other 67 companies, 15 were either acquired by, or merged with, another current FTSE 100 company, 42 were taken private or acquired by a non-FTSE 100 company, three have been demoted, four broken up and three ceased trading (British & Commonwealth Holdings, Maxwell Communications and Woolworths). Of the 33 companies that remain, 16 have outperformed the market in the past decade. Arguably, therefore, only 16% of the companies making up the FTSE 100 in December 1988 can be considered to have experienced some sort of lasting success. These findings are interesting, but what relevance do they have for defined benefit pension scheme trustees?

Risk of complacency
Employer covenant is a function of the employer’s ability to pay scheme contributions and make good scheme deficits, coupled with its willingness to pay. The covenant significantly weakens if the employer is trading poorly, suffering losses and absorbing cash. When covenant is weak, trustees must attempt to obtain a measure of protection for the scheme’s liabilities, often in the form of guarantees or security.

There is a risk of complacency for both trustees and management of companies that are currently trading strongly. Trustees may assume that they need take no action on protection for pension scheme liabilities due to the appearance of continued success of the sponsoring employer. Current strong trading and an implied strong covenant is not necessarily an indicator of continued success. We have seen that long-term corporate success over periods of 20 years is an illusion. These timeframes are short-term compared to the average remaining life of a defined benefit scheme of 60 to 70 years.

It is important for trustees to act prudently, even when covenant is strong. Ironically, the time for trustees to act on obtaining protection is when the company is healthy and, therefore, when it is most able to pay — because, as we have seen, the good times won’t last forever. When employers are in serious financial difficulties, it may already be too late to obtain additional funding for the scheme, as it is at times like this when the ability to pay is lessened. Cash is scarce, assets become impaired, other creditors scramble for security, and company guarantees may not be worth the paper they’re printed on.

If there is a degree of complacency from trustees and management, perceived corporate and covenant strength can also be adversely affected by other drivers identified in our analysis of the FTSE 100 changes. For example, a corporate transaction, such as a merger or acquisition, may not adversely impact trading but may have implications for covenant. Acquisitions may be highly leveraged, which may result in more of the company’s cash flows being needed for payments of interest and capital and potentially less available for the funding of pension liabilities. Also, the unsecured pension ‘creditor’ falls further down the payment priority pecking order if a high level of secured debt is introduced to the balance sheet.

Different priorities
New (possibly overseas) owners or venture capitalist backers may be less willing to pay for pension liabilities. They may have different investment priorities from existing management, and funding for nonoperational or non-capital purposes, such as pension funding, may be constrained. There are also more intangible effects — for example, trustees may rely on past good relations with management and management intentions in lieu of say, a formal guarantee for pension liabilities. Existing management teams may be changed or replaced by an acquisition or merger, rendering gentlemen’s agreements of little worth.

In conclusion, the employer covenant assessment is an increasingly important responsibility for trustees. This can be both a challenging and complex exercise, especially as we have seen that the illusion of continued corporate strength can lead to complacency, and result in missed opportunities to obtain protection for scheme funding.

Independent advice is an increasingly essential part of the covenant assessment process, as advisers can take an objective view of the sponsoring employer, provide advice on negotiating protection measures and implement monitoring procedures to flag warning signs to trustees in a timely and appropriate manner, allowing trustees to act to protect the scheme’s interests.

Gary Squires is a partner and leads the pensions advisory team at Zolfo Cooper Europe