Risk & Economy » Addressing legacy pension obligations in light of recent corporate failures

Over recent years we have seen a number of accounting scandals where the public image presented by companies does not appear to have been a true and fair reflection of their financial reality.

At the same time, the recent announcement from the Financial Reporting Council (FRC) that auditors need to reverse a decline in the quality of audit raises some very worrying questions about the reliability and completeness of the available financial information on UK companies.

As a result, many stakeholders (including employees, investors, and suppliers) who historically relied upon this information to assess credit and investment decisions, have suffered significant losses. This group of unhappy people also includes the members of many UK defined benefit pension schemes who may no longer receive the pension they were entitled to and were expecting.

Whilst directors and auditors may yet be saved from serious reprimand by the small print of current accounting standards, and well-crafted engagement letters, the simple fact is that the extent and reliability of financial disclosures has been called into serious question.

From a pensions standpoint alone, it’s increasingly clear to us that it is essential both that companies (i) increase their efforts to provide accurate and reliable information to pension trustees to allow them to make appropriate investment and risk decisions, and (ii) provide greater transparency of their pension issues to other stakeholders through greater disclosure. To this end we believe that there are a number of specific actions that sponsors should take in both of these areas.

Guidance for sponsors for sharing information with pension trustees

Some sponsors have historically been reluctant to share information with their trustees for varying reasons including confidentiality concerns, an unwillingness to engage with what is seen as a legacy financial issue, and a sense that the sponsor receives little benefit from sharing this information.

However, increasingly trustees are following guidance from the Pensions Regulator (TPR) that their investment strategy should reflect the ability of the employer covenant provided by their sponsor to support the risks in the Scheme. Typically, this will be based on the ability of the sponsor to provide additional funding in the event that the Scheme’s deficit does not reduce as expected.

TPR encourages trustees to only accept risks where the employer covenant of the sponsor can be shown to be strong, (as opposed to when risk is only reduced if the covenant is weak).

Companies should bear in mind that pension scheme members are not rewarded for the risks their pensions are exposed to. Ultimately the investment returns which are achieved serve only to reduce the amount funding required from the sponsor. Therefore, demonstrating covenant strength to trustees in order for them to justify taking investment risk should be in the best interests of the sponsor.

As a result, sponsors must do more to share information with their trustees. But how should they do this and what information should they share?

  1. We recommend addressing any confidentiality concerns through the use of non-disclosure agreements. Their use is already widespread with certain sponsors and schemes to facilitate the flow of information from sponsors to trustees. Where information is highly confidential, but deemed important for the trustees to be aware of, then that information could be provided to an approved and appropriate sub-committee (for instance, with non-employee trustees if there is a concern about sensitive information being leaked inside or outside the business).
  2. While providing historical financial information (in particular, the most recent audited accounts) may be of some benefit, trustees should be most focussed on understanding the position and prospects for the sponsor. Management should therefore ensure that trustees are provided with up-to-date balance sheets (together with sufficient supporting information to understand the assets and liabilities shown) and forecasts (over three years rather than simply a one year budget). This is a key requirement to ensure that trustees can reach an informed view of the sponsor’s ability to support scheme risk.
  3. Management should meet with pension trustees on a regular basis to provide them with a summary of developments at the sponsor and an updated view on its prospects. In our experience, pension trustees also welcome presentations on specific topics (such as performance in certain divisions, or growth plans) as it builds a sense of commitment from the sponsor to ensuring that trustees are well-informed about the business.
  4. Finally, management should take a keen interest in the level of risk in their pension scheme and the impact that adverse situations (such as a major market downturn) would have on its funding needs (in addition to the existing level of funding). In our experience, sponsors can often be unaware of the level of risk in a scheme and, with TPR taking an increasingly strong line when it comes to funding pension deficits, sponsors will be expected to take action over a shorter period of time to recover from a shock, than in the past.

Therefore, it is crucial that management understands, and demonstrates that they understand, the risks in their scheme to provide confidence to the trustees that the scheme is only taking risks that the sponsor can, and will, underwrite if a downside event arises.

Guidance for sponsors when disclosing their pension obligations

Press coverage of recent corporate failures has demonstrated the shortcomings of current accounting standards, and that improved pension disclosures are required across the board to improve stakeholder understanding of pension issues. Recent news articles have quoted a variety of data points including accounting deficits, funding deficits, PPF deficits, or buyout deficits without a clear (or accurate) description of what the deficit showed and how it should be used. As a result, the scale of the pensions problem is rarely known or understood until an insolvency occurs.

To some extent, this is not surprising. After all, defined benefit pensions are highly complex financial products, a fact which is typically not fully appreciated but which makes them difficult to report on accurately. But it’s also the result of a lack of consistent information which is available on the health of these schemes in the public arena.

It’s not just the journalists who struggle –analyst coverage of the pension obligations of listed companies is often ill-informed and, whilst reference may be made to ongoing cash funding requirements, rarely considers the level of risk in the scheme and the impact that this could have on future cash funding requirements.

We have two key recommendations of what can companies do to regain stakeholder trust in their pension disclosures.

First, sponsors should go above and beyond the statutory minimum accounting disclosures required and:

  1. Disclose details of all contributions due to their pension scheme under the latest recovery plan;
  2. Include measures of the level of investment risk within their scheme, such as a value-at-risk; and
  3. Disclose details of the pensions deficit when measured on a consistent low-risk basis (i.e. a basis which does not take advance credit for future investment returns)

Finally, we recommend that sponsors take into account the ‘true’ pension scheme deficit when considering the reserves position of the sponsor and its ability to pay dividends. Doing this would help to prevent situations where significant value is taken out of the sponsor potentially impacting its ability to meet its ongoing obligations to the pension plan.

Ultimately, if we can improve both the quality and quantity of information shared between sponsor, Scheme and other stakeholders we may be able to improve the quality of decision-making by all stakeholders.

 

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