GKN scheme closures and debt issuance to combat £1bn deficit

The FTSE 100 company issued a £300m 3.375 per cent annual unsecured bond in the first half of 2017, of which it expects to inject £250m into the GKN2 scheme.

The narrative that DB accrual is becoming increasingly unaffordable will be a familiar one to trustees, employers and industry professionals alike.

I don’t think I’d have a problem with it in principle because you always want money in the scheme

Richard Butcher, PTL

A May report by consultancy JLT Employee Benefits found that less than a quarter of FTSE 100 employers are still providing DB benefits to a significant number of employees. Meanwhile there are signs of similar strain in the public sector, with the Universities Superannuation Scheme revealing a £17.5bn deficit last week.

A dent in the deficit

GKN has already wound up one of its schemes – the GKN Group Pension Scheme – in January after completing successive buy-ins and buyouts.

Combined with the closure of the GKN2 and GKN3 schemes, effective from July 1 2017, this is expected to control costs for the company.

“During the first half of 2017 good progress was made towards reducing both ongoing cash contributions and volatility in respect of the group's UK defined benefit pension schemes, though the schemes remain exposed to changes in asset values, interest rates, inflation and mortality assumptions,” GKN’s half-year report explained.

Source: GKN

Both schemes are currently finalising funding valuations. The company expects that its payment of £250m into GKN2 will reduce its annual deficit recovery payments for that scheme, which currently stand at £42m a year.

However, the cash injection will not be sufficient to cover the firm’s overall deficit, which stands at £1.05bn for funded UK pension schemes.

The deficit has reduced since the end of 2016, but with assets of £2.37bn, the schemes remain just 69 per cent funded on an accounting basis, significantly lower than the FTSE 100 average, which JLT analysis states as 94 per cent at June 30.

When is debt issuance the right option?

Funding a deficit by issuing debt is becoming more popular among employers as the cost of doing so falls, according to Lynda Whitney, senior partner at consultancy Aon Hewitt.

Deciding whether the approach is suitable is, however, highly dependent on the particulars of the scheme and its sponsor, she said. Schemes with a “risk of there being too much money in the scheme” might seek alternative funding arrangements such as bank letters of credit or surety bonds.

“The honest answer is there’s a lot of different options out there and what you have to do is assess the likelihood of you needing to put that cash into the scheme,” she said.

Where cash injections can smooth the process of mergers and acquisitions, Whitney explained that financial directors with sufficient budget might equally prefer to insure liabilities, at rates that are probably lower than the return offered to investors when using debt to finance liabilities.

Should trustees be concerned?

Some corporates may even issue debt in order to fund bulk annuity transactions, according to Richard Butcher, managing director at professional trustee firm PTL.

He said this move would be logical, as deficits are sensitive to a wide variety of risks, including investment, operational, and longevity risk.

“You’re swapping it for a one-off fixed payment with a given term,” he said. “The only risk that you retain is if the interest rate is variable.”

Employers may also borrow to make deficit repair contributions, Butcher added.

“[As a trustee] I don’t think I’d have a problem with it in principle because you always want money in the scheme,” he said.

Where businesses borrow from banks to fund their deficits, Butcher said he would have more concerns. Bank lenders typically demand a lower return than bond investors, but will likely have security over assets within the sponsor’s business, and could compete with the scheme in the event of insolvency.