by Commerzbank
Let’s be in no doubt: Europe has a pension problem — and corporations are being acutely affected. The cost of meeting pension promises made to past and present employees has risen dramatically since the global financial crisis. Falling interest rates have inflated pension liabilities and suppressed returns, while rising life expectancies mean pensions must be paid for longer. For businesses, a heady cocktail of quantitative easing, subdued inflation and slow economic growth has made pensions a major and ongoing concern.
A boardroom priority
“These are very unusual times,” concedes Joe Wicks, Co-Head of Pensions Solutions at Commerzbank. “Interest rates in the UK are at a 300-year low. Businesses across Europe are focused on their pension challenges like never before. Whether based in London, Paris or Frankfurt, there is a common theme: The cost of meeting pension promises has risen significantly in recent years. It’s keeping corporate treasurers and CFOs awake at night.”
To help mitigate the risks, Wicks points to three strategic responses that a growing number of companies, large and small, are choosing to explore. The first option for companies with funded pension plans is to change their asset allocations, typically by transferring to higher-yielding assets—by switching from bonds to equities, for example. This trend has helped to fuel the growth of alternative assets, such as commodities, private equity, hedge funds and other investments such as forestry, where investors can capture an illiquidity premium. However, “moving to higher-return assets invariably means moving up the risk curve,” reminds Wicks.
A second response could be for companies to increase their contributions to pension plans—a relatively straightforward move for companies that are in the fortunate position of having excess liquidity; but for others, this requires money to be raised in the capital markets.
“We recently helped a client raise more than €1bn in Germany via a senior secured bond, the proceeds of which were used to secure long-term funding of their German pension obligations, as well as for other general corporate purposes,” Wicks says.
It is not only Germany’s largest companies which are choosing to create plan assets, and Wicks points to an increasing number of small and midsized companies that are funding their future pension obligations for the first time. “Our multi-employer group contractual trust arrangement, CommerzTrust, is a pioneer in the German pensions market,” says Wicks. “It recently celebrated its 10-year anniversary with more than 100 companies of all sectors and sizes using the service to fund their future pension obligations.”
The third option is to restructure pension plans, which most commonly means shifting from defined benefit (DB) schemes—whereby a company promises to pay employees a future pension—to defined contribution (DC) schemes. Here, the investment and longevity risk is transferred from the company to the employee. This approach has changed the face of pensions in the UK in recent years; only a handful of the UK’s largest listed companies continue to offer any form of a defined benefit pension to new employees.
“It’s important to remember that restructuring to DC is not possible in all markets. In Germany, for instance, a local regulation called the Betriebsrentengesetz requires businesses to offer employees a pension with a capital guarantee. This is why corporates need sound advisers with expertise in their local markets,” says Wicks.
All three options have the same goal: to make pensions more sustainable. This is important because pensions obviously have to be paid: they are legal agreements between employer and employee. This is why they should be regarded as cash flows that, if not properly managed, can bring unexpected high costs and reduce shareholder value.
With the increasingly uncertain macroeconomic environment, the pension topic is likely to remain at the top of the corporate agenda in 2017. International equity investors, rating agencies and lenders are expected to become increasingly concerned, and openly critical, of unmanaged pension obligations, says Wicks.
New regulatory scrutiny
In the UK, the Pension Regulator’s recent rejection of a reported £250m offer from Sir Philip Green to shrink the BHS pension deficit also suggests that the regulatory approach is hardening. With limited capacity, the UK’s Pension Protection Fund is likely to come into play should a deal not be reached.
Jonathan Tyce, Bloomberg Senior Banks Analyst, EMEA, LATAM & Asia, warns that there are many businesses in the UK with large legacy problems and deficits that have not been addressed. He believes that all the negative publicity Green and BHS has attracted has served to galvanise the government. He expects one of the upshots to be that corporate boards and trustees will become far more stringent about how companies spend their cash flow and address any shortfalls.
“At the moment they [the UK government] are even talking about seizing Green’s yacht; it’s an extreme example, but it does show just where we’ve come to,” says Tyce. However, evaluating a company’s financial position remains a complex undertaking, and not all companies carrying large pension deficits face the same challenges. While plastic-components maker, Carlco, is the most high profile corporate to cancel its dividend, burgeoning pension deficits across-sectors including utilities EDF, Endesa and Enel continue to struggle with sub-optimal pension funding ratios. “Currency, inflation and yield divergences across different countries makes a one-size fits all approach impossible for multinational corporations,” notes Tyce.
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The importance of a a holistic approach
One of the headwinds creating uncertainty in the Eurozone has been the impact of currency fluctuations. UK companies with unfunded pension liabilities in Europe or the US may have seen the value of these liabilities rise (in sterling terms) following the Brexit vote for companies managing their pension liabilities, it is important that debt is considered in its totality.
“Companies have an opportunity to make it clear should be transparent in their communications transparently to their pensioners and other stakeholders about on how they are managing their pension liability as part of an overall process.” It is important that the company’s debt has been considered in its totality.
Prepare for the unexpected
Looking at 2017, rising inflation expectations following the pound’s Brexit-fuelled drop could provide some solace to many of the UK’s largest companies burdened with vast pension deficits. However, as the UK’s new relationship with the EU is still potentially years from being agreed, the situation remains uncertain.
Bloomberg’s Tyce, a seasoned investment professional, notes that the prolonged backdrop of negative deposit rates, zero percent interest rates and low or even negative inflation caught everyone by surprise. He believes the repercussions of recent years will change how companies come to think about their pension funds forever.
“When rates fell as fast as they did, and stayed low for as long as they did, suddenly these huge problems came into view,” he says. “The one thing I’m fairly sure that the boards of all big companies will be thinking about in the future: We don’t ever want to find ourselves in this situation again.”
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