Vol 6 (2009) - Issue 4

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Pension Restructuring: Could This Be the Saviour of UK Manufacturing?

Picture the scene. A board of overseas executives are considering their strategy for their global manufacturing operations in light of difficult global trading conditions. Revenues are down in all territories, including the Far East and Eastern Europe into which the company has invested heavily in recent years. The organisation has interest payments to make, the banks are taking a very keen interest in trading numbers and their banking covenants appear tighter than expected.

Interestingly, according to the group balance sheet, the UK pension scheme deficit is smaller than previously stated. This appears to contradict the situation from three years prior when the UK pension trustees increased their funding demands and requested a recovery plan. Furthermore to eliminate the deficit the trustees are now asserting that the scheme actually needs twice as much funding as it did three years ago.

The root of the problem

The historical correlation between UK manufacturing and defined benefit (DB) pension plans gives some useful perspective to this problem. UK manufacturing was historically a booming business in the UK and companies set up retirement benefit schemes to provide for their employees assuming this boom would continue. However, UK manufacturing has been in decline since the 1980s, with much capacity moving overseas. These shrinking UK businesses now need to meet significant legacy pension promises, often relating to operations long since closed or sold from the group.

The fact that many of these UK manufacturers are now under overseas ownership or are listed overseas (of the top 50 largest manufacturers in the world, only one, BP, is UK based) adds an additional layer of complexity. This suggests that a major piece of the UK pension problem is in the hands of overseas owners who have limited experience of UK DB schemes and the relatively new UK pensions legislation.

Whilst most UK schemes have been through a scheme funding process under the current pensions legislation, this was probably at a time of buoyant trading and equity markets, and when understanding of the scheme funding process and its implications was less mature than is now the case.

The global downturn has had a major impact on UK pension deficits. In many cases the employer’s trading is no longer buoyant. This has resulted in weaker employer covenants (i.e. the financial strength of the companies supporting the scheme) meaning that a more prudent discount rate is used to calculate scheme liabilities, resulting in higher deficits. These higher deficits focus trustees on seeking protection for their schemes – just at a time when many employers can least afford it.

In addition, many pension schemes have invested heavily in equity markets in the belief they had a strong employer covenant. As equity markets have fallen, scheme asset values have declined which has increased scheme deficits further.

Considerations for the international group

Overseas executives often refer to their balance sheet (IAS19) to assess their pension liabilities. This accounting liability is calculated using a discount rate based on high-quality corporate bonds. The bond market however, has recently shown increasing yields (due to a combination of higher default rates and lack of liquidity in the market place) resulting in reduced pension liabilities when calculated on an accounting basis. This is different to the way trustees look at pension liabilities where it is increasingly common for the discount rate to be based on a margin above gilts resulting in increased liabilities. The starting position of overseas executives and UK trustees has therefore diverged.