The first stress tests for occupational pensions in the European Union revealed that 140 funds were likely to face a combined funding shortfall of €428 billion ($477 billion), even if a shock in financial markets were avoided.*
Hybrid issuance and asset securitisation as ways of managing the amount of current deficit in the balance sheet
In some cases it may be desirable for the company to consider reducing its pension liability by introducing some form of assets to the pension fund. With hybrid bond issuance, pension liability is turned in effect to a form of equity – the liability can be as long as 100 years, often bearing a fixed interest rate. Over the past couple of years, a number of companies have issued hybrids to fund their pension deficits.
Another option to consider is to transfer some form of the company’s own assets to the pension fund, either directly or indirectly. If the latter, income from either operational or non-operational buildings, for example, could be ring-fenced and turned into a pension asset that will offset a component of the pension liability. In both of these cases a reduction in the pension deficit without a cash outlay can be affected. It is worth noting that by transferring assets or by acquiring debt to pay down the current deficit, the future variability of the pension deficit remains a concern as described above.
* The European Insurance and Occupational Pensions Authority (Eiopa) conducted stress tests in 17 EU countries of 140 defined benefit and hybrid schemes with more than €500 million in assets. Results were announced in January 2016.
Case study: a recent acquisition case
Commerzbank advised on a recent acquisition case. The client was a UK corporate that acquired a German company with annual defined benefit pension payments of €3.6 million and future pension obligations amounting to a “pension deficit” of €50 million.
Commerzbank guided the CFO of the UK client (the acquiring company) through three fundamental considerations related to pensions in Germany:
1. The structure of the pension plan going forward: Establishing a Contractual Trust Arrangement (CTA) will enable the company to manage the pension plan in an efficient way, at the same time allowing for protecting of pension claims in the event of corporate insolvency. Through the CTA the company can fund the plan with assets and then apply hedges to minimise future volatility of the deficit and/or payments.
2. Comparing the economic payments to the actuarial ones provided by the pension actuaries. The economic basis will in most cases lead to a higher liability value than the actuarial basis. The difference between economic and actuarial deficit calculation is based on a different assessment base: the actuarial deficit only takes into account the past service of employees, whereas the economic deficit also incorporates the future service into the calculations.
The two assessments merge at some stage when all active workers will have retired and so all future services will have converted into past service. The simplified table below demonstrates accordingly how the higher the percentage of active members with low average age (and long time to retirement), the bigger the expected economic deficit is likely to be, compared to the actuarial one.
3. How to manage the pension deficit in the future: The transfer of the deficit to an insurance company through a buyout as a final settlement solution is only possible under specific circumstances under German law. Therefore another option that the CFO of the UK corporate considered was to create a “synthetic” insurance solution by evaluating hedging ideas for longevity-, inflation-, discount rate risks. The hedges would help the company acquire protection against future increases in the pension payments which would continue to be the responsibility of the company.
By using this “synthetic” solution the company can fund the deficit over time to the CTA or pension plan whilst in the buyout case a fee amounting to the current pension deficit plus additional premium, depending on the pension plan, would have to be paid to the insurance company up front.
It is worth noting that there is no obligation for a company in Germany to fund the deficit, but instead an annual contribution to a public insolvency protection plan has to be paid to protect the plan members. Many companies prefer to fund the plan regardless in the current environment where funding costs are low.