The cartoon character Spiderman starts out as a geeky, put-upon student who after getting bitten by a mutant spider, develops the power to climb walls and spin webs—powers that he uses to fight crime. Something similar is happening to the lowly UK pension trustee, who having been bitten by a deficit, suddenly can throw bad guys—sorry, investment bankers and private equity investors—across the room. What is going on?
Once treated as an actuarial fiction that did not deserve a mention even in the footnotes to a company’s accounts, defined benefit pension fund deficits have come to dominate corporate finance. If a pension scheme’s assets are not sufficient to match an employer’s discounted future liability to scheme members, then the pension scheme has made a de facto unsecured loan to its corporate parent. This realisation is changing everything.
Consider the effect on takeovers. These used to be relatively straightforward. A bidder and an adviser would value a target, and make an offer to shareholders. The target company would propose a defence, and then the shareholders would determine the outcome. That was before Marks & Spencer and WH Smith, and more recently, Lazards and Allied Domecq—takeovers where pension fund deficits have emerged as deciding factors.
At the centre of the maelstrom is the once-lowly trustee. Lumped together with churchwardens and scoutmasters in the tradition of unpaid voluntarism, pension trustees are using their teeth. Speaking at last week’s National Association of Pension Funds conference in Manchester, the chairman of WH Smith’s pension fund, Martin Taylor, beamed as he listed the powerful covenants that enabled him to scupper Permira’s leverage-fuelled bid for WH Smith last year.
The debate is as much about value and risk as it is about sheer power. Taylor pointedly criticised Permira’s internal rate of return (IRR) calculations that ignored the need to pay off the pension scheme deficit. But why did the deficit need to paid off by Permira in accelerated fashion, when the liabilities were long-term? Because WH Smith under new ownership would have been more leveraged, and hence the pension scheme deficit would run a higher risk of default.
It is not just increase in debt that poses a problem for pension schemes in deficit, but changes in seniority—such as when a takeover is financed by secured bank debt ranking above the scheme in order of precedence. Then it becomes doubly important to enforce the scheme’s preferred status over shareholders, whom should not be allowed to receive dividends or other cash payments while a scheme deficit is permitted to languish.
Some investment banks are now approaching trustees directly, offering “credit default swap hedges” to take the risk off their hands. Effectively, this amounts to buying insurance in case a bidder goes bust after buying the company and can’t top up the pension fund. Unfortunately, the schemes that most need protection against sponsor default lack the cash to pay the default swap premium.
While trustees are enjoying their crack at the whip, some wonder if they understand the responsibility their power brings. For example, what if the bidder for a deficit-ridden company has a higher credit rating than the current owner? Rather than demanding cash – which they wouldn’t get from the current owner—the trustees ought to consider giving the bidder extra time to reduce the deficit, in the knowledge that their position will be more secure.
Some trustees have had to be persuaded to give up important rights, such as the power to set employer contribution levels, in order for the bids to succeed. Much of this nudging comes from regulators. Speaking at NAPF, David Norgrove, the Pensions Regulator’s chairman, warned trustees that he would not allow them to exercise the right to wind up a company if it meant putting current employees out of work. This is a touchy haves vs. have-nots issue, given that most defined benefit schemes are closed to new members, who typically must put up with far less generous defined contribution scheme.
Like the uncle who coached Spiderman in moral values, Norgrove has his work cut out as he guides trustees towards wise use of their power.
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