Steven Dignall explores the fine line trustees must walk in order to protect and grow DB pension schemes without squeezing the life out of the corporate sponsor unnecessarily
BrightonRock analyst Con Keating claimed the sole risk to corporate DB schemes was sponsor default risk and the most pernicious element pension schemes should be concerned about was the level of funding.
He explained: "The problem schemes have, is if they fund prior to sponsor insolvency to the level that the scheme would need post insolvency, they'll increase the likelihood the company goes bust."
Keating stated pension funds had to realise insolvency risk was diversifiable and having scheme funding at levels beyond the insolvency bracket was inefficient.
Finding the balance in volatile times
However, Kroll partner Gary Squires argued current concerns around the credit crunch and employer default risk were having a knock-on effect on pension scheme funding.
He explained the change in employer risk as a result would tend to drive more prudent investment strategies and more prudent technical provisions.
Squires said: "With credit being less freely available, employers and particularly those who are already heavily geared will find it difficult to raise further finance, and as finance becomes more expensive, more pressure is placed on cash flow."
He continued by saying this pressure would initially be felt as banks adopted a more prudent risk stance.
In an economic downturn, business volumes may decline, customers may be taking extended terms and suppliers may be seeking shortened credit terms and increasing their prices, which puts further strain on the whole system.
When customers fail, companies are exposed to bad debts, which is a particular concern when there is a high degree of reliance on a small number of customers.
Other issues, including a lack of access to credit, increased cost of borrowing and exposure to bad debts and difficult trading conditions, raise the risk of employer default.
In this scenario, from a trustee's perspective, it can be a good thing to have prudent funding as that allows for security against employer default. But from the company's point of view, it has to manage capital and cash as efficiently as possible. Generally, company management would prefer not to have capital tied up in the pension scheme and instead have the capital freely available to grow the business or act as a defence against poor trading conditions.
Squires warned trustees needed to be wary of what is commonly referred to as reckless prudence. He said: "By being overly prudent [trustees] can potentially weaken the employer to the point where it becomes self harming. The employer may then default and the scheme may lose its underpin in the employer."
He added there was a fine balance in distressed situations to make sure the company paid no more than it could afford.
"Where it gets most difficult is where the scheme remains open. If the employer cannot afford to pay enough to meet accruals of benefits, the trustees' position deteriorates. Trustees can afford to be flexible where the employer is stressed or distressed, providing their position isn't deteriorating," he said.
However, if the trustees' position did start to deteriorate, they may need to trigger the termination of the scheme and that could lead to the insolvency of the employer.
HamishWilson consultant Gary Tansley said trustees must take a business-like attitude to running pension schemes now.
He said: "Essentially any shortfall or deficit in the scheme can be viewed in a similar way to a bank loan.
"It has often been said trustees should act like bankers and behave as such. They need to look at what they have to do to protect that loan and this will depend crucially on their assessment of the sponsor's covenant."
Currently, trustees are clamouring for extra contributions because of depressed asset values, largely as a result of the credit crunch. Grabbing extra money now would boost the pension scheme's funding position in the short term, but may prejudice the long term viability of the employer, which in turn might be crucial for the long term security of members' benefits.
"Accordingly, trustees need to think for themselves and not rely blindly on their pension advisers who may be urging greater prudence and pressing for more money than the company can afford if it is to remain viable," Tansley stated.
Data and communication
As well as seeking funding, it is imperative trustees also arm themselves with as much information as possible about the fund sponsor's business.
They need to get an assessment of the risk and have frequent updates to spot any adverse trends or signs of trouble. At the same time, they should try to gain an understanding of the opportunities there might be for securing a contingent charge over the sponsor's assets.
"If the scheme is poorly funded or the sponsor's strength is weak, trustees can gain comfort from 'contingent assets' over which they obtain a right for the benefit of the pension scheme in the event the employer becomes insolvent and the scheme has insufficient assets to secure members' benefits," Tansley explained.
Milliman principal and consulting actuary John Ehrhardt agreed and said trustees must ensure they communicate their desires to their investment advisers to limit their risk. "It is vital trustees are well educated on the risks they are taking. A fiduciary could be brought to task if they didn't know what they were doing and went into something with their eyes closed," he explained.
Tansley echoed that advice and said trustees should have a dialogue with the company and seek opportunities to ensure any new financial commitments or debt issued by the company ranked below the pension scheme.
However, trustees should also recognise that if any new capital raising activities are to be subservient to the pension scheme, the company might struggle to raise capital on those grounds and that may not be good for either the company or the pension scheme in the long run.
Squires warned that trustees needed to be much more alert to the trading performance of the employer. They should take on board the present employer covenant and fully understand what risk is currently involved.
He said: "This is not a one-off exercise. They then need to monitor the trading performance of the company."
Armed with that information, trustees can then decide what, if anything, they need to do to improve their position.
Squires added: "Particularly when the company is tightening its belt, it may not be particularly inclined to start paying more money into the scheme or providing security or guarantees. "And at a time when trustees perceive greater risk, the employer is going to be less inclined to do anything that is going to improve the trustees' position."
Employer covenant and investment strategy
The employer covenant is crucial in the management of a corporate scheme.
Squires said: "The strength of the covenant drives to a great extent the investment strategy and technical provisions underlying the calculation of the deficit."
Naturally, the stronger the covenant, the greater the flexibility schemes have in picking their investment strategy. Similarly, the company can have a higher risk strategy with more flexibility in choosing technical provisions.
Tansley continued: "If the funding position is strong, they may prefer a low risk investment strategy to lock in the good position. Where they have a substantial deficit, they may take the alternative view they need to be more aggressive on the investment strategy in the hope investment returns will help to close the funding gap not met by contributions."
He described it as a balancing act between trying to use investments to improve the scheme's funding position against adding to the downside risks.
Some UK trustees may take into account the scheme's funding position on the Pension Protection Fund's (PPF) section 179 when considering investment strategies.
Should the scheme have a deficit on the PPF measure, trustees may feel they can adopt a risky investment strategy safe in the knowledge that if the scheme had to be wound up because the investment strategy had not paid off, it would in Tansley's words be "tipped into the PPF and members would still get their full PPF compensation".
On the flip side, Tansley warned that if the scheme was funded above the PPF level, trustees could be worsening members' pensions if they took investment risks and it all went wrong.
He said trustees needed to take a pragmatic view and not just an insular view about the pension scheme in isolation.
Ehrhardt concluded: "On a pension plan, you are looking at a long term investment. You want to make sure you are investing in things that are going to be around for a long time."
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