01 Nov 2005, Credit
Only a few months ago the UK's top 100 companies were able to breathe a small sigh of relief after actuarial firm Lane Clark & Peacock reported that the sector's combined pension funding hole had fallen by £5 billion to £37 billion on an FRS 17 accounting basis. That sense of calm was bolstered by the activity of two companies: BT and The Royal Bank of Scotland, which each paid more than £1 billion into their pension schemes. At the same time Scottish & Newcastle and Alliance & Leicester plugged their funding holes to the tune of £200 million and £153 million respectively.
That improvement, coupled with the introduction of the Pensions Act 2004, which came into force at the start of April to more rigorously monitor the management of UK-based pension plans, contributed to a feeling that the country's spluttering occupational pensions market was on the mend.
But closer inspection of the legislation and its new rules for calculating pension liabilities shows that the funding deficits of the UK's largest 100 companies could well be at their worst ever. In fact, JPMorgan believes that the sector's combined shortfall is as much as £160 billion under the revised calculations.
"The Act has a number of major implications, the most important being the new method for calculating pension liabilities for funding purposes, which has increased significantly," says Jennifer Billings, senior analyst at JPMorgan. From September 23, 2005, the minimum funding requirement will be phased out and replaced by scheme-specific funding in which pension trustees will be given wide-ranging powers that include the ability to force companies to increase pension plan funding and influence corporate actions like dividends, investment and debt financing.
As a result, "liabilities for firms with UK-based pension plans will increase significantly under the new methodology, access to funding may become more difficult and the cost of debt may increase. Credit ratings could also be negatively affected and M&A is likely to become more problematic," says Billings.
Indeed, before February this year, companies were able to wind up their pension scheme irrespective of whether the employer was solvent or insolvent. But under the Pensions Act 2004 this has been eliminated with a shift away from the undemanding minimum funding requirement to a full buyout calculation – the amount a company would have to pay an insurance firm to assume its pension liability.
"Should a company wish to walk away from its UK pension fund then it would become liable to top up its assets to meet the cost of securing the benefits in full with an insurance company," says Alex Waite, a partner at Lane Clark & Peacock. "This is significantly more than the FRS 17 liability disclosed in company accounts. Under this assumption, we estimate the total shortfall for the FTSE 100 companies to be more than £150 billion."
Accurately estimating the buyout cost of a pension scheme from the information currently disclosed in a firm's annual report is impossible but JPMorgan's credit research team9 suggests that, by applying a multiplier of 125% to 150% to an FRS 17 calculation before scheme assets are deducted, a buyout number can be deduced. For example – and although there is no obligation for firms to disclose buyout figures in their annual reports – food company RHM, which has an FRS 17 funding deficit of £303 million, placed its buyout cost at as much as £1 billion in its recent IPO prospectus. Indeed when applying a multiplier of 150%, JPMorgan estimates that the pension deficits of various companies increase dramatically (see table).
Billings expects the Act to have a negative impact on market perception and bank view of credit risk for UK companies with defined benefit schemes, which could lead to a higher cost of borrowing and more difficult access to funding for some UK companies. "Recovery value for general unsecured debt will be negatively impacted by the new calculation of pension liabilities during a credit event. Unfortunately for credit investors, the magnitude of the pension liability increase under the Act is uncertain, as companies are not yet forced to disclose the buyout amounts," she says. "However, as the new regulation may be considered to cause a material change to a company's liability structure, firms may choose to disclose the buyout amount in the future for legal reasons. Or we think investors may threaten to withhold funding unless companies disclose the actual risk."
But Waite at Lane Clark & Peacock believes that the buyout issue should not be overstated and that trustees will not make extensive demands on their sponsors. "Going forward trustees will have a lot more power and are going to be able to ask companies for a lot more in terms of the contributions they pay, but whether that is as much as the buyout figure is questionable," he says.
Waite explains that trustees have three numbers to chose from: the FRS 17 calculation; a number that is perhaps slightly higher than this, which is known as the trustee funding target; and the buyout figure. "What we don't know yet is where in between the FRS 17 number and the buyout figure the trustees funding target is going to lie. That will depend on the power of the individual trustees and how secure the sponsor is."
The pensions regulator was due to issue guidance for trustees in October on how the funding target should set but that has now been postponed until December. "Until that information comes it is difficult to tell what trustees will do but the buyout number will only be demanded if the sponsor is likely to become insolvent within the next 12 months and trustees believe members are not going to get their benefits. But that is an extreme situation," adds Waite.
But Simon Surtees, head of credit research at Gartmore Investment Management, disagrees: "The default number for trustees is always going to be the buyout figure because that is the one that shows that trustees have done their job and upheld their duty to scheme members. That doesn't bode well for the company or its shareholders but the loyalties of the trustee do not lie with them. Unless a sponsor can persuade a trustee that the buyout figure is unnecessary or that it may go bust if it is forced to fork out the buyout cost then why would a trustee ask for anything else? It is a little bit naive to think otherwise."
What investors and analysts do agree on, however, is that UK corporates have not yet fully woken up to the potential problems they are facing and that only a high-profile blowout or downgrade will get them to sit up and take notice of what is going on.
"Obviously this is a huge issue and it is definitely going to affect companies going forward but the question is what the catalyst point will be to get everyone to pay attention to this issue," says JPMorgan's Billings. "It remains unclear to us what the trigger will be for credit markets to adjust the risk premium demanded."
Nonetheless, she suggests that the wake-up call might come from one of five different areas: increased disclosure by companies, such as in the case of RHM; ratings downgrades; documented examples of a company facing more difficult covenants and restrictions from banks; pension trustees forcing a company to go to the bond or equity market to attack the buyout amount, not just the FRS 17 deficit; and further failure of M&A, along the lines of UK retailer Marks & Spencer and television company ITV.
Indeed, many believe it is the ultimate responsibility of the rating agencies to provide guidance to the market, although the consensus among investors and analysts is that the rating agencies themselves are a little in the dark over the issue.
Nonetheless, Fitch Ratings hosted a seminar on pension fund deficits in October. Trevor Pitman, group managing director at Fitch Ratings, explains that when the rating agency first published its methodology in March 2003, there was a belief that companies were going to have a lot more time to respond to the pension issue than they actually had.
The new Pensions Act changes that and heightens the pressure on UK firms, he says; on top of that, the new law will put pressure on ratings over the next year or two. "But the pension issue is just one area that is taken into account when we assign a rating. Companies take their credit ratings very seriously and I am sure they are very worried about how we and the other agencies might react to this issue. But even if there were companies we were on the verge of downgrading because of the new regulations I could not reveal them before that information became public." The UK credit market sits and waits nervously.