Over recent years, defined benefit pension schemes have become increasingly prominent creditors and stakeholders in the UK corporate landscape.
Between 2007 and 2017, the UK’s combined DB deficit rose from circa £450bn to £700bn (on a buyout basis according to The Pension Protection Fund’s 2017 Purple Book). Despite this dramatic increase, inadequate accounting disclosure requirements have enabled corporate boardrooms to reward yield-hungry investors with ever-greater handouts over the past decade.
Frustrated by UK’s apparent reluctance to confront its pension problems, TPR is reviewing its approach to ensuring companies are not prioritising the interests of a subordinated investor (the shareholder) over their obligations to current and former employees.
Prioritising calls on capital
In its 2018 annual funding statement, TPR made the equitable treatment of pension schemes a point of emphasis, declaring that, “Where distributions appear unreasonable relative to contributions, [TPR] expects trustees to negotiate robustly with the employer to secure a fair deal for the pension scheme”.
But what is meant by an “unreasonable” level of distributions? TPR does not provide any specific guidance on what it considers to be an acceptable level (as it doesn’t want to set a clear test which may not appropriate in all situations), but instead suggests that trustees should perform analysis of the relative amounts of dividends vs. pension contributions.
Regularly published comparisons of the levels of dividends versus pension contributions amongst various subsets of UK entities, have created a myth that pension contributions should be higher than shareholder returns.
While there is currently no hard and fast rule on how dividend payouts should factor relative to pension contributions, businesses must carefully prioritise calls on their capital. When declaring a dividend, the key judgement call for directors is whether the business is solvent. When it is, under the Companies Act 2006, the directors have a duty to “promote the success of the business for the benefit of its members (shareholders) as a whole”.
Dividends and/or share buybacks are a normal business activity for solvent companies – those who invest in a business, and put their capital at risk, should get a suitable return on their investment in exchange for the risks taken.
However, once there is doubt about a business’ solvency, the directors must also pay due regard to the interests of the company’s creditors and minimise their risk of potential losses. Typically, this would involve ceasing all distributions to shareholders until the position of the business improves or creditors are no longer at risk.
For pension schemes specifically, this might mean that scheme risks are transferred to an insurance provider (unlikely for a cash-strained employer), they are well funded on a prudent basis (for example self-sufficiency), or that the covenant has improved to the extent that member benefits are no longer “at risk”.
Where a pension scheme is in deficit, the trustees and the sponsor must agree a recovery plan to remove the deficit through future cash contributions, at an affordable level for the sponsor. Increasingly, schemes have lengthened their recovery plans in response to rising deficits, while continuing to pay out dividends thereby increasing both the investment risk in the scheme and length of the scheme’s exposure to covenant risk (meaning the risk of a failure of the sponsor).
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Pension schemes are not just another form of debt and should not be treated as a source of short-term funding. Under the currently regulatory regime, the onus is very much on sponsors to repay pension deficits as soon as they can afford to, without unnecessarily weakening the covenant – which is often a delicate balancing act.
Dividends (which can be discretionary) or share buybacks (which are entirely discretionary) are a clear indication of management’s decision to reward shareholders, rather than reduce the unrewarded risks taken by the pension scheme members. All too often, dividends become an obvious target for regulatory scrutiny and challenge.
That said, a simple comparison of the quantum of shareholder returns relative to pension contributions fails to take several important factors into consideration. These include:
- The strength of the employer covenant, in particular, the likelihood that the sponsor will be able to provide the required level of long-term support to the scheme. Where the covenant is weak, it is unlikely to be appropriate for sponsors to return value to shareholders unless there is clear benefit to the longer-term strength of the covenant from doing so (for example by retaining investor support)
- The size of the shareholder distribution relative to the value of the shareholders’ investment in the sponsor (the dividend yield)
- The market cost of capital (adjusted for risk) that an investor would expect to earn from an investment in a solvent company.
Inclusion of the above factors in any discussion around dividends helps to provide a much more nuanced view of the appropriateness of any shareholder reward in the context of the long-term health of the business.
Where sponsors are planning to reward shareholders, they should be proactive about engaging with pension scheme trustees and to justify why they believe the level of shareholder returns is appropriate, regardless of the level of contributions to the pension scheme. This could include:
- Assessing the employer covenant, demonstrating that the sponsor is likely to be strong enough (even after shareholder returns) to meet future the funding needs and investment risks in the scheme. In effect, this assessment would be demonstrating that shareholder returns do not materially increase the risk of the scheme not being able to pay benefits in full.
- Comparing of the cost of equity for peers and relative to the proposed level of returns to shareholders to show that these returns are not unreasonable. Businesses require either debt or equity investment, and trustees should keep in mind that their covenant will typically be stronger because of the investment from shareholders rather than from a provider of debt.
- Analysis of whether the sponsor would have sufficient distributable reserves to pay the return to shareholders, even if the scheme was measured on a more prudent basis (compared to the accounting basis) which doesn’t take advance credit for future investment returns. This would demonstrate that the sponsor has sufficient value to afford these returns to shareholders.
- Demonstrating to trustees that the position of the pension scheme has been considered by the directors when deciding whether to make the return to shareholders. This should include:
- An awareness of the current quantum of the risk within the scheme
- Agreement of contingency plans in event of a weakening in the covenant or adverse scheme experience.
Undertaking to reduce or even cease shareholder returns, if required, to fund increased pension contributions following a downturn, thereby ensuring that shareholders are bearing the business risks (as they are expected to) rather than pension scheme members.
Overall, while providing returns to shareholders is undoubtedly a normal and acceptable business activity for solvent companies, recent increases in returns to shareholders have created an easy target for TPR as it is faced with increasing pension recovery plan lengths.
Sponsors can, and need, to do more to justify why returns to shareholders are appropriate and do not increase the risk that pension schemes may not be able to pay their benefits in full. Simply comparing the level of dividends to pension contributions is too blunt an assessment for finance directors balancing an increasingly complex set of calls on capital.