My experience at WHSmith last summer was an object lesson in what a nuisance it can be to be a pension fund trustee. What I intend to do is relate the story of the WHSmith-Permira encounter last year from the trustee viewpoint, and discuss some of the conclusions I have drawn from it.
In 1999 I became chairman of WHSmith, which automatically also made me chairman of trustees of the WHSmith Fund. These roles had been combined for a quarter of a century, which was, under modern governance standards, an uncomfortable compromise, and when a large deficit emerged during 2001/2002, it became impossible to sustain. I had, however, decided to step down from chairing the board, and by remaining as pension fund chairman I could help the company effect the necessary governance switch.
As chairman of both, I used to think, "well, this is uncomfortable, and maybe a touch improper, but how lucky everyone is to have someone like me, who can balance conflicting views and find a compromise at the perfect point of rest". I know now that that position was ridiculous. To have to consider the interests of the beneficiaries exclusively has been good for me, and therefore good for them.
My first conclusion is this: those of you who are directors of the sponsoring company as well as trustees should resign at once from one position or the other. At once.
At the time of which I am speaking - the spring of 2004 - the market cap of the company was around £700-800 million. That was roughly the same size as the liability of the scheme on an FRS17 basis. The gross deficit on this measure was around £200 million - on a more stringent measure a good deal higher. So the fund was not only in deficit, but also very large compared with the company.
The trustee had powers to set contributions - not entirely unilaterally, but very strong powers nevertheless - and to wind the scheme up if the company ever misbehaved. Powers of this nature are increasingly within the grasp of all trustee groups, following recent legislation.
My second conclusion is this: possession of power entails the responsibility to use it; and to use it wisely. Failure to act when you are able to can be construed as negligent. Trustees should act, not wring their hands.
Permira approached WHSmith in March 2004 and asked it to perform due diligence as a preliminary to - potentially - bidding for the company. The board agreed, and the pension fund became part of this process. I should mention at this point that I was conflicted in every direction: past chairman of the company, responsible for appointing its new chief executive officer, whom Permira incidentally sought to replace, shareholder, chairman of trustees and adviser to the firm that was itself advising Permira. These egregious conflicts were generally considered to net out to zero, so I carried on - though I naturally had no contact with the relevant Goldman Sachs people, and no contact either with the company management except as strictly required to discuss their defence plans. We trustees kept the company and Permira at exactly the same distance: the future ownership of the company was not our business. The safety of the pension fund was our only business.
Third conclusion: trustees are not an extension of the corporate management and must act independently in a contested situation. I was enormously helped by having not only an honourable, thoughtful and hardworking bunch of member trustees, but two independents of great experience and ability. Without Louise Botting and Jeremy Stone I doubt we could have got through. My fourth conclusion, therefore, is that any trustee chairman who doesn't avail him or herself of good independent trustees is potty.
Permira intended, of course, to pile debt into the capital structure, and we would have been sitting right at the bottom. The bankruptcy risk was not huge, but nor was it negligible. The company had few assets to 'cut up' on liquidation, and - had it failed - we would have been left with a very substantial real deficit. Although we had no concerns about Permira's willingness to service the pension fund as part of a going concern, we clearly could not accept this. We therefore demanded some mixture of a) up-front coverage of the pension deficit by a cash injection; b) ranking pari passu with secured creditors for any remaining deficit; c) guarantee backed by other assets of Permira and its co-investors.
At the same time, the company had shared with us its defence plans, which involved selling a major division and returning cash to shareholders. From our point of view this would clearly have shrunk the company and weakened its covenant, so we stipulated a substantial one-off payment under these circumstances (which we have now received) of £120 million.
Our intention was to treat both management and bidder even-handedly; our only grounds for discrimination between them were a function of their different capital structures.
Fifth conclusion: people more learned than I am are fond of discussing the exact credit and security standing of the pension creditor. For me, a deficit in the pension scheme is an irregular situation that should not persist. All trustees have the responsibility of working out with the sponsor how this debt is to be repaid, and how quickly. There is no point bankrupting the sponsor, but you need to behave like an intelligent banker. Pension deficits are unpaid wages, looked at one way, or a loan acquired without consent from a uniquely vulnerable lender.
Eventually Permira pulled out, not because it could not reach agreement with the trustees, but because it realised the cost of such an agreement would force it to lower its bid to a level at which it did not expect to succeed. We can argue about whether this means that the equity market was not correctly valuing the pension fund deficit. WHSmith had certainly provided ample information to the market on this subject. But there still seem to be people out there who think these liabilities are in some way unreal or at least overstated.
My sixth conclusion, therefore, is this: trustees and finance directors must have no illusions about the size of the deficit. The actuarial convention according to which the composition of the assets determines the size of the liabilities is one of the weirdest emanations of the human mind. It's a metaphor - like saying that the advent of jet planes made the Atlantic narrower - and metaphor has a limited place in finance. We must move in the direction of a solvency measure, but one uninfluenced by the lack of appetite (and weak balance sheets) of insurance companies. The question is: how much money does a closed scheme need if the trustees sterilise its liabilities and run it as a not-for-profit insurance company?
Dealing with Permira, and facing the possibility of sponsor bankruptcy in the context of a leveraged buyout, made us more thoughtful about the risk of sponsor failure in general.
The most crucial issue now for many companies seems to be that the pension fund deficit is itself a major source of financial instability. Trustees are being pushed into inappropriately risky investment postures in the hope that lucky market moves extinguish the deficit. It's just as likely that unlucky moves bring the sponsor to its knees. Trustees will have to understand the value-at-risk in their own funds, and the consequences of potential volatility on their sponsors' cashflow and credit rating.
Seventh conclusion: pension fund deficits represent a major hazard not only for beneficiaries' schemes but also for the shareholders and sponsor if the risks are not properly understood and managed.
My final conclusion is a hopeful one. For many years, companies and defined benefit pension schemes were bound together by the simple fact that employees of one were beneficiaries of the other. With so many schemes closed, that's no longer the case - 'actives' are dying out. But trustees and directors, after decades of an inappropriately cosy relationship, can with luck, understanding and firmness on the part of trustees avoid moving into the highly adversarial situation that the problem of deficits at first appears to represent. In fact, we are all in this together.