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K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012
Pension Risk to the
Corporate Sponsor Karen Heaven
25 October 2012
1
K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
50%
60%
70%
80%
90%
100%
110%
120%
Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12
UK Pension Schemes Funding Level (PPF basis)
30 Year Gilt Real Yield
82.3%
Corporate Pension Risk: Market Environment
2
Falling real yields have driven up liability
valuations, contributing to sharp declines in the
aggregate funding position of UK schemes...
Source: Pension Protection Fund (PPF 7800 index), Bloomberg
Gilt real yield (%) (%) Funding Level
110.7%
K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012
9.2
16.6
26.5
29.1 28.0
0
5
10
15
20
25
30
35
0
50
100
150
200
250
300
350
2007 2008 2009 2010 2011 2012
Annual Deficit Repair Contributions
UK Schemes - Aggregate deficit of schemes in deficit (PPF basis)
£258.2bn
£30.5bn
(RHS)
(LHS)
Increased Drain on Corporate Cash...
3
Source: Pension Protection Fund PPF 7800 index and Purple Books; (1) Annual contributions shown for previous financial year ending March
Annual Deficit Contributions(1) (£bn) (£bn) Aggregate Deficit Weaker funding positions have
forced many sponsors to significantly
increase deficit repair contributions
K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012
Corporate Pensions Risk: Significance
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Share Price
Company
Credit Rating
Pension Scheme
(Trustee)
Reliance on
sponsor support
(sponsor covenant)
Cash Flow impact Deficit repair
contributions
Balance Sheet
volatility Investment strategy
/ funding level
volatility
Obligation to
support pension
scheme
• In addition to adverse market conditions, the introduction of FRS17 / IAS19 accounting standards over the past decade and the
creation of the Pensions Regulator have both made pensions and the risks they pose to companies significantly more visible to
shareholders, equity analysts and credit rating agencies
K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012
• Pension Liabilities vs. Market
Capitalisation
• Pension Deficit vs. Market
Capitalisation
• Ldity: Constraint caused by deficiquiit
repair contributions
• Ability to pay dividends after annual
contributions are met
• Value-at-risk: Minimum expected
deterioration in the net funding
position (assets minus liabilities) in a
downside scenario
• Contributions-at-risk: Minimum
expected increase in the sponsor
contributions in a downside scenario
• “What if” stress tests
Measuring Corporate Pensions Exposure: Three Dimensions
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Scale Impact
• Debt ratios e.g. Net Debt / EBITDA
• Interest Coverage (i.e. ability to service
debt)
• Liquidity: Do deficit repair contributions
cause a liquidity constraint?
• Ability to pay dividends after pension
contributions are paid ?
Examples of Key Metrics
Risk
Equity Analyst Reports Shareholders’
Perceptions
Rating Agencies’
Assessments
Share Price Volatility Impact on Credit Rating /
Cost of Funding
How large are the pension schemes
compared to the corporate? How does pension exposure impact key
financial metrics of the corporate? How “risky” is the pension scheme?
Examples of Key Metrics Examples of Key Metrics
K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012
• Measuring the pension liabilities and deficit against a company’s market capitalisation provides a broad view of the scale of the pensions
exposure relative to the size of the company.
• The charts below compare the metrics of a FTSE 350 company in the consumer non-cyclical sector with medians for the index and
sector. In the FTSE 350, 35 companies have pension liabilities in excess of their market capitalisation.
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21% 27%
180%
0%
20%
40%
60%
80%
100%
120%
140%
160%
180%
200%
FTSE350 Consumer, Non-cyclical Firm X
IAS19 Liabilities to Market Capitalisation
1.5% 1.8%
16.8%
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
FTSE350 Consumer, Non-cyclical Firm X
IAS19 Deficit to Market Capitallisation
0
20
40
60
80
100
120
Number of Companies
Liabilities / Market Capitalisation
FTSE 350 Pension Liabilities vs. Market Capitalisation
0
20
40
60
80
100
120
140
Number of Companies
Deficit / Market Capitalisation
FTSE 350 Pension Deficit vs. Market Capitalisation
Source: Bloomberg & Annual Financial Reports, Redington calculations. Analysis on an IAS19 accounting basis due to availability of data
Firm X Firm X
Measuring Corporate Pensions Exposure: Scale
K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012
Measuring Corporate Pensions Exposure: Impact
• The charts below show the impact of the pension deficit on the Net
Debt / EBITDA ratio of a FTSE 350 company in the consumer cyclical
sector
• The impact can be compared to the medians for the sector and for
the overall index. Firm Y is in line on the pre-pension measure but
has a significantly higher ratio than its peers post-pensions
adjustment
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• The requirement to support the pension scheme can serve as a
significant drain on corporate liquidity, reducing cash flow available
to finance new investments and potentially undermining credit
strength
• The charts below show pension contributions as a proportion of
the company’s total pre-pension Free Cash Flow with comparable
medians for the sector and index
Example - Impact on Key ratios Example - Impact on Cash Flow
0.84 0.71
0.87
0.23
0.13
1.4
0.0
0.5
1.0
1.5
2.0
2.5
FTSE350 Consumer, Cyclical Firm Y
Net Debt / EBITDA
Impact of Pension Deficit on Net Debt / EBITDA
Pension Adjustment
Unadjusted Ratio
10.4%
13.4%
17.1%
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
FTSE350 Consumer, Cyclical Firm Y
Contributions / FCF
Pension Contributions to Pre-Pension Free Cash Flow
Source: Bloomberg & Annual Financial Reports, Redington calculations. Pre-Pension Free Cash Flow
and Contributions reflect adjustments for both deficit repair and ongoing contributions
(Industry of Firm Y) (Industry of Firm Y)
K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012
Measuring Corporate Pensions Exposure: Risk
• Having gained a picture of the current pension impact, it is equally important to take into account the level of risk being run by the
schemes.
• There is no perfect way to measure pension risk, however analysis can provide us with useful tools to measure the magnitude of risk and
the relative sources of risk.
• Redington employs a number of metrics to assess scheme risk. Here we look at Value-at-Risk and Contributions-at-Risk:
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Minimum expected
deterioration in the net funding
position (assets - liabilities) in a
1-in-20 downside scenario
Value-at-Risk (VaR)
Impact on the size of the
pension funding position
(i.e. deficit / surplus)
Implications for equity
analysts’ and rating
agencies’ assessment
Minimum expected increase in
the sponsor contributions
necessary to reach full funding
as planned in a 1-in-20
downside scenario (i.e. on top of
contributions which are already
being paid)
Contributions-at-Risk (CaR)
Possible increase in
sponsor contributions to
Pension scheme
Significance to Corporate
K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012
Measuring Pension Risk: Value-At-Risk vs. Corporate Earnings
• We have estimated a one-year 95% Value-at-Risk for Firm A’s pension
scheme (Firm A is a FTSE 350 industrial).
• To place pension risk in the context of the company earnings, we show
the VaR as a proportion of the corporate’s EBITDA .
o A 1-in-20 downside (or VaR95) event would cause an increase
in deficit equivalent in size to at least 189% of Firm A’s annual
earnings.
• These metrics are shown relative to sector and FTSE 350 medians.
• We estimate that 20 companies in the FTSE 350 have a VaR greater
than their most recent annual EBITDA while four have a VaR greater
than twice their annual EBITDA.
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Value-at-Risk (VaR)
0 5
10 15 20 25 30 35 40 45 50
Number of Companies
VaR to EBITDA Ratio
FTSE 350 Distribution of Pension Scheme Value-at-Risk vs. EBITDA
Source: Bloomberg & Annual Financial Reports, Redington calculations.
Analysis excludes companies not providing a breakdown of the pension fund asset allocation.
31%
52%
189%
0%
20%
40%
60%
80%
100%
120%
140%
160%
180%
200%
FTSE350 Industrial Sector Firm A
VaR/EBITDA Value-at-Risk to EBITDA Ratio
Firm A
(Industry of Firm A)
K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012
Measuring Pension Risk: Contributions-at-Risk vs. Free Cash Flow
• Contributions-at-Risk (CaR) measures the minimum expected increase
in the sponsor contributions necessary to reach full funding as planned
in a 1-in-20 downside scenario (i.e. in addition to contributions already
being paid).
• As CaR represents a further potential drain on corporate cash, we
show this as a proportion of the sponsor’s pre-pension Free Cash Flow
(FCF).
• A 1-in-20 downside (or CaR95) event would be equivalent to an
increase in contributions equal to at least 21% of Firm A’s pre-
pensions Free Cash Flow
• Overall, we estimate that 19 companies on the FTSE 350 have a
Contributions-at-Risk greater than 30% of their annual pre-pensions
Free Cash Flow whilst 3 companies have a Contributions-at-Risk
greater than 100% of pre-pensions Free Cash Flow.
• This analysis assumes a 10-year recovery plan for UK schemes.
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Contributions-at-Risk (CaR)
0
10
20
30
40
50
60
70
80
90
100
Number of Companies
CaR to FCF Ratio
FTSE 350 Distribution of Contributions-at-Risk vs. Pre-pensions Free Cash Flow
Source: Bloomberg & Annual Financial Reports, Redington calculations.
Analysis excludes companies not providing a breakdown of the pension fund asset allocation.
Note: Estimates are shown on an accounting basis. In practice, contribution schedules are based on the
Technical Provisions .
7.2%
14.0%
21.1%
0%
5%
10%
15%
20%
25%
FTSE350 Industrial Sector Firm A
CaR/ FCF Contributions-at-Risk vs. Pre-pensions Free Cash Flow
Firm A
(Industry of Firm A)
K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012
“Right Sizing” Pension Risk
• It is reasonable (and unavoidable) to run some degree of risk with a defined benefit pension scheme’s investment strategy.
• Having quantified the pensions impact on the corporate sponsor, it is possible to incorporate these results into a clear strategic
framework setting out objectives and constraints to guide investment strategy over time.
• Only when you know exactly what you want (and don’t want), can you make the decisions that enable you to reach your objectives. We
call this the Pension Risk Management Framework (PRMF).
• The PRMF helps to facilitate effective governance by concentrating the minds of trustees and sponsors on core objectives and
constraints, such as meeting the risk budget and target date for full funding.
• The objectives set out in the PRMF can be defined with direct reference to corporate metrics, for example:
o “The increase in the deficit in a 1-in-20 downside scenario should not wipe out a year’s earnings”.
o “Additional annual contributions needed in a 1-in-20 downside scenario should be less than half of the free cash available from
business operations”.
• The following slide sets out examples of objectives and constraints from an illustrative PRMF.
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K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012
Example from a Pension Risk Management Framework
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Metric Current Position Objective Significance Progress
Earnings
EBITDA £200m
VaR should be less than
£200m
or VaR/EBITDA = 1.0
The increase in the deficit in
a downside scenario should
not wipe out a year’s
earnings
Aggregate Pension Scheme Value at
Risk £375m
Pension scheme VaR /EBITDA ratio 1.88
Cash Flow
Contributions at Risk (1-year, 95th
percentile) £38m
CaR should be less than
£17.7m
or CaR/FCF = 0.1
Additional annual
contributions needed in a
downside scenario should be
smaller than a target % of
free cash
Adjusted Free Cash Flow £177m
CaR/Adjusted FCF 0.21
Funding Position
Funding Ratio (IAS19 basis) 86.1%
Expected Return on Assets
> Required Return to reach
full funding by [2022]
Aiming for higher expected
return is a trade-off,
dependent on sponsor’s
ability to bear pension risk
Expected Return on Assets (over Swaps) 200bps
Required Return on Assets (over Swaps)
to reach full funding on an IAS19 basis
by [2022]
220bps
Metric is at or above target Metric is within 10% of target Metric is more than 10% away from target
K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012
Trustee Perspective: Incorporating Covenant Risk
• There is an implicit credit risk to the deficit recovery contributions agreed between the trustees and sponsor.
• In the sample analysis below, we assign a “survival probability” to the sponsor, based on credit ratings and use these to weight the current
agreed level of contributions into the Scheme. This shows that taking into account sponsor credit risk can have a significant impact on the
Scheme’s funding outlook:
o Chart 1 shows the return on assets required to reach full funding by a given target date, for different sponsor survival probabilities (“Zero
Default” assumes all agreed contributions are received, “Default” assumes no contributions are received).
o Chart 2 shows the estimated full funding date if the return on assets is held constant at 0.65%, and the survival probability weighting is
applied to the contributions.
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0.65% 0.69% 0.74%
0.92%
1.18%
1.50%
2.48%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
Zero Default
Risk
Single 'A' Triple 'B' Double 'B' Single 'B' Triple 'C' Default
Required Return over Swaps
Chart 1: Required Returns with Probability Weighted Contributions
(Full Funding by March 2030 for Sample Scheme) Chart 2: Flight Plan – Full Funding Horizon with Probability Weighted
Contributions (0.65% required return)
0
200
400
600
800
1,000
1,200
1,400
1,600
£mn
Liability value Assets Asset Value - Single 'A' Asset Value - Triple 'B' Asset Value - Double 'B' Asset Value - Single 'B'
Assets / Liabilities
Rating Full Funding Date
Single ‘A’ Aug-31
Triple ‘B’ Oct-33
Double ‘B’ Jul-43
Single ‘B’ Never
K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012
Conclusion Thoughts: Implications for Sponsors and Trustees
For Sponsors
• Clear understanding of scale, impact and risk of the pension scheme(s) on the corporate metrics and that of peers.
• Importance of a holistic approach: Consider discussing with trustees a risk management strategy to ensure pension risk is appropriate for
the corporate sponsor.
• The output of the exercise is a robust strategic framework linking pension objectives to corporate metrics, ensuring that pension risk is
“right sized”.
For Trustees
• Ongoing monitoring of sponsor covenant and implications for risk budget and funding objectives.
• Recognition of relationship between risks facing the pension scheme and wider business risks (correlation between pension and business
risk).
• Ensure that investment strategy objectives take into account the sponsor’s risk budget and ability to support the scheme.
o Can the sponsor afford to bear the risk that the scheme is running?
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K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012
13-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 www.redington.co.uk
Contacts
Karen Heaven Vice President | Investment Consulting
Direct Line: 020 3326 7134
karen.heaven@redington.co.uk
Risk Management Firm
of the Year (2011, 2012)
Pension Consultant
of the Year 2012
http://twitter.com/redingtontweets
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