Plug pension fund deficits with cheap debt

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UK corporates that use cheap debt to fill the gaps in their pension funds could enjoy significant strategic, cash flow and accounting benefits. James Courtenay-Evans, Managing Director, and Shoaib Yaqub, Associate Director, Corporate Financing Solutions at RBS, explain.

Ballooning pension liabilities on the back of low bond yields have led to a big increase in pension deficits and a step change in annual sponsor contributions, which have settled after almost doubling since 2008. But the low bond yields have also created a unique opportunity to fund deficits faster with debt raised at attractive terms. While all companies will need to consider their own tax circumstances, for a profitable company, the cash flow benefits of this include crystallisation of the tax shield and therefore a tax deduction earlier – which will be more advantageous as UK corporate tax rates continue to fall. Using cheap debt also helps companies reduce their overall cost of capital. And it arguably leads to some equity risk – implicit in the pension deficit – being diversified. Companies need to think about this now. Doing nothing could lead to more strain on their balance sheets and the cheaper debt available might then be out of their reach. Other benefits of using cheap debt to fund pension deficits are:
  • New accounting rules mean that the impact of upfront funding on earnings per share will be positive in most cases
  • Using debt funding that matches the pension cash contribution tenor – typically five to 10 years – rather than the length of the pension liability may result in a funding cost arbitrage
  • Terming-out the material ongoing cash contributions by a one-off debt funding may lead to medium-term cash flow gains
  • Rating agencies could see it in a positive light
Changes to the IAS 19 accounting standard made effective this January mean the impact of a company’s pension fund on its profit and loss (P&L) accounts is more akin to paying interest. This removes any advantages of aggressive asset allocation for sponsors and will hit the P&L for companies with higher deficits harder. It therefore pays for corporates to focus much more closely on pension deficits. There are various ways they can fund them, such as cash contributions or granting charges over assets. Despite the benefits, some businesses have been reluctant to use debt because it involves tying in debt capacity against a long-term liability that may disappear over time. But strong debt market conditions – at least for now – are making such a move more attractive. There are benefits, as well as some drawbacks, whatever happens to interest rates in future. If rates remain the same, companies will see a cash flow benefit in the medium term and will have addressed an ongoing pension funding gap – allowing them to concentrate on their core business. They will have strong balance sheets and be more profitable thanks to cheap debt driving a lower cost of capital. One downside is that they will not be able to borrow as much for investment, although this will be less of an issue for stronger corporates with plenty of debt capacity, particularly following a sustained period of deleveraging corporate balance sheets. If we enter a higher interest rate environment, companies with debt-funded pensions may have cheap, long-term debt locked in, reducing any future cash constraints through potential contribution holidays. The flip side is that they will have no recourse to the pension surplus but there are structures that can address that. If interest rates fall even further, corporates will still have improved balance sheets and enjoy greater profitability. A nd in a difficult macroeconomic environment with low growth, proactively addressing the pension deficit might be seen as positive by employees, shareholders and customers. Whatever happens, there is a strong case for injecting debt-backed cash into the pension pot now. It’s no wonder that more and more businesses are considering it very carefully.


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