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Why Pension Schemes Cannot Afford to Ignore Covenant
Katrina Martland, Senior Manager, Minesh Rana, Director, Mike Jervis, Partner, and Jonathon Land, Head of Pensions Credit Advisory, PricewaterhouseCoopers LLP, London, UKIntroduction
Although companies and pension scheme trustees have taken considerable action to shore up the level of pension scheme support since the introduction of the Pensions Act 2004, the pension problem has certainly not disappeared.
As at 31 May 2015, the PPF Index 7800 estimates deficits on a s.179 basis reached GBP 241.3 billion, compared with GBP 118.2 billion at the end of May 2014. While increasing longevity of pensioners is driving up pension liabilities in the long term, the economy also poses issues for UK pension schemes in the short term, with low interest rates and a reduction in gilt yields. Gilt yields are often used for discounting future pension obligations with low gilt yields leading to higher pension liabilities. Such conditions have led to companies struggling, or ultimately failing, to meet their pension obligations in recent years.
In this article, we discuss:
(a) How the economy has impacted UK companies’ ability to support their pension schemes (referred to as the 'employer covenant') and why employer covenant is important,
(b) Why asset-backed contributions (ABCs) can help to resolve pension related issues, and
(c) Three high profile cases, including Lehman and Nortel, where companies in distress have found innovative and thought-provoking solutions to their pension problem.
Impact of the economy on employer covenant
Most commentary about the relative risk of Defined Benefit (DB) schemes has concentrated on the size of the pension scheme deficit. However, the important question is whether, in the absence of sufficient investment returns, a company (the sponsoring employer of the scheme) has the ability to pay its obligations. PwC’s Pensions Support Index (PSI) provides a reliable, independent barometer of the level of support to DB schemes for FTSE 350 companies.
The PSI looks beyond the size of the pension deficit and focusses on the more important and useful question of whether a company has the ability to pay its obligations. It also gives a sense of how quickly this is likely to happen in light of economic conditions, and together these measure the strength of the employer covenant. To do this, the PSI considers the key components of employer support: a company’s net assets, operating profit, profit before tax, cash from operations and market capitalisation. It then measures the relative strength of each of these components against the company’s pension scheme obligations out of a possible score of 100.
Prior to June 2007 and the global 'credit crunch', improving company performance and increases in the value of pension scheme assets led to the PSI reaching its highest point of 88.1. However, between June 2007 and March 2009, the recession saw a 24.2 point drop to 63.9 as companies struggled to fund higher deficits.
From March 2009 to March 2011, the PSI gradually recovered to a level of 80.6, driven by a recovery in scheme asset values and an increase in the market capitalisation of employers.
Towards the second half of 2011, the PSI fell again to 67.8 due to quantitative easing pushing down gilt yields. This increased the discounted future value of liabilities and therefore increased pension deficits.
From 2012, the PSI stayed broadly flat until company performance improved over the second half of 2013, pushing the PSI score up to 84.6 by June 2014.
The improved score meant that the majority of companies in the FTSE 350 were in a stronger position to fund their deficits.
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