While lower long-dated yields might hurt defined benefit schemes' funding positions, it stands to reason that their sponsors should be able to benefit from access to lower cost long-term financing rates. But the structure of the UK lending market is problematic in this regard. First, term finance with a modified duration of around 20 years is not typically available through bank channels. Second, the proportion of firms large enough to issue bonds is small, and longer-term bond finance is available only to a higher credit quality subset of large companies. The result has been that while firms have incurred costs with respect to higher pension liabilities, they have not been able to benefit from lower long-term financing rates.
However, authors observe that the ability of DB sponsors to underfund their pension schemes has provided them with a means by which lower long-term yields have translated into lower long-term financing costs. It is important to note that this is an observation and not a recommendation!
A defined benefit pension liability can be analogised as long-term borrowing, financed at an interest rate equal to the sum of three components.
First is a component informed meaningfully from long-term government bond yields. The pension fund discount rate is chosen through a process of negotiation with the sponsor’s appointed actuary (where a higher discount rate will reduce the present value of the liability and so reduce any pension deficit, but increase the hurdle rate for pension fund asset returns over subsequent years).
Second, there is a component analogous to the credit spread. The Pension Protection Fund applies a levy, the size of which is a function of the sponsoring firm’s Experian credit score, the size of the pension scheme’s s179 liabilities, the size and nature of scheme assets and contingent assets, and the needs of the Pension Protection Fund. The larger the underfunding, the larger the cost to firms. This levy ran as low as 17 basis points, and ran up to a ceiling of 383 basis points in 2016. As such this feature is analogous to being short a credit rating (and scheme asset-liability basis risk) linked coupon. The ‘credit costs’ applied by the Pension Protection Fund, while potentially debilitating and procyclical from the point of view of a sponsor-firm that is sliding rapidly towards insolvency, cap out at rates that are low by public sub-investment grade credit market standards, as well as by bank standards. The risk-based levy is rarely of sufficient magnitude to influence sponsors contribution decisions.
Third, there is an optionality component, typically not formalised but whose value could be significant in cheapening the financing cost, taking both regulatory and scheme-specific form. From a regulatory perspective, money ‘borrowed’ through under-contributing can be instantly repaid in full (through special contributions), while cumulative over-contributions can only be ‘withdrawn’ over a very long time period. Furthermore, the covenants attached to pension scheme funding requirements are typically much lighter than those attached to bank borrowings – being able to extend this shadow borrowing in the form of pushing out pension scheme contribution periods must have considerable value from a company perspective.
Hence, sponsors of pension schemes can seek to finance current spending/investment by underfunding pension schemes, and in so doing, create long-dated bond-like ‘cov-lite’ obligations. Clearly there is a strong role for the trustees and regulator in ensuring there are limitations on the extent that this is undertaken. Such funding is currently done with low yields that have a small (although highly variable) rating-linked coupon, and includes an American call option. In most cases, this form of financing can appear favourable against other financing options.
Having said all that, in author‘s experience, company finance directors tend to view pension schemes as users of funds rather than sources of funds. But the decision as to whether to correct an historic deficit with special contributions, especially if financed through debt issuance, takes so closely the form of a financing decision as to become indistinguishable from one. Given the size and prevalence of these financing decisions, it is curious that they have been hitherto absent from financing surveys.
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