Defending pensions

Faced with a deficit of more than £3.6 billion, BAE Systems' pension fund was forced to consider a variety of innovative solutions to plug the gap between its assets and liabilities. One of them was a sale and lease-back plan with the scheme's sponsor. Mark Pengelly reports

Pension funds' hunt for assets that better match their long-term liabilities has taken a new turn in the UK. Property is becoming the asset class of choice, and several innovative transactions have closed in the past few months. In January, British Airways' pension fund entered into a £445 million sale and lease-back deal with UK supermarket group Tesco. The transaction will generate 20 years of index-linked rental cashflows for the pension fund, with an option to terminate the deal after 10 years. In the same month, UK retailer Marks and Spencer announced that it would establish a partnership with its pension scheme to hold £1.1 billion of the group's property portfolio and lease it back to the company.

Sale and lease-back deals have been hailed as a good match for pension liabilities, as property is unaccounted for on firms' balance sheets and offers long-term inflation-linked returns. As such, it was the liability-matching solution chosen by BAE Systems, the UK-based defence contractor formed from the merger of British Aerospace and Marconi Electronic Systems in 1999. In 2006, BAE Systems Pension Funds Investment Management took complete ownership of around £240 million of its corporate sponsor's real estate under a straight sale and lease-back plan.

The arrangement is part of a £1 billion cash and asset injection into the company's assorted UK pension schemes. The property deals were masterminded by David Brief, London-based chief investment officer of BAE Systems Pension Funds Investment Management. He says the sheer scale of the fund's deficit meant many options, such as liability-driven investment or interest rate swaps, were not thought viable.

"If you're in surplus, you can afford to give away quite a lot of investment return to match your liabilities. If you're in substantial deficit, you have constraints. We examined endless solutions - none of which seem particularly appropriate to us," explains Brief.

Arriving at a final list of sites to be included in the deal involved brutal negotiations with the firm's tax and financial officers, says Brief. While some, such as an aircraft manufacturing centre in northwest England, are of core strategic value to the company, others are not and simply represent valuable real estate. In such cases, the trustees must decide if they want to sell the property.

In fact, the pension fund has already disposed of a factory and an office building in Edinburgh, pocketing £93 million. And for those properties remaining in its portfolio, increases in rent paid by its main tenant, BAE Systems, are linked to the UK retail price index. So the fund is left with an asset yielding index-linked rental returns, plus present and future capital gains. It is hoped that this, along with a package of other measures, will restore health to BAE's pension programmes.

This is no mean feat, given that just five years ago the fund was in trouble. The switch to mark-to-market accounting laid bare a funding gap of more than £3.6 billion across all BAE's UK schemes. This was exacerbated by changing actuarial assumptions of life expectancy, combined with poor UK equity returns in late 2002. Under the first action plan drawn up to halt the spiralling deficit, both annual employer and employee contributions were increased and the defined benefits scheme was closed to new entrants.

BAE Systems announced in June 2006 that it had completed its revised funding arrangements, and now expects to meet its various liabilities in full. Its two major pension schemes now hold around 10% in property assets. Brief says his team is working towards building a similar percentage allocation in private equity and infrastructure to further diversify core equity and fixed-income holdings. While both schemes remain heavily reliant on UK and overseas equities, at 50% and 70%, metrics are also in place to reduce these exposures as returns pick up, he adds.

Meanwhile, BAE Systems claims its longevity estimates are now among the most conservative of UK pension plans. A package of measures designed to curtail the deficit, which were the subject of tough talks with employees and unions from 2005-06, included the incorporation of a longevity adjustment factor into the formula used for calculating pension benefits. This equation attempts to hedge the scheme against incorrectly guessing life expectancies by trimming benefits if retirees begin claiming for longer.