Refinancing pension debt – an underutilised option?

Estimates of the combined deficits of the circa 5800 UK defined benefit pension schemes range from £150bn on a gilts plus basis, as PwC’s Skyval index showed at the end of September 2018, to over £700bn on a full buyout basis, according to figures from the Pension Protection Fund in March 2017.

For many companies, refinancing pension debt could be a very logical step to be considered alongside the various hedging and derisking options available

Over the past few years there have been isolated examples of UK companies raising debt specifically to refinance pensions debt. For example, in 2018 BT issued £2bn of bonds to the BT Pension Scheme under its Medium Term Note Programme, coinciding with a large cash contribution into the BT pension scheme.

A logical step for many companies

Financial debt has, on the face of it, a number of advantages over pension debt as part of the corporate capital structure that a board is charged with optimising in the interests of stakeholders and particularly shareholders.

Key positive characteristics of financial debt versus pension debt include:

• Known quantity, price and duration.

• Ratable and tradeable.

• Clear terms for hedging and early redemption/refinancing.

• Relatively deep markets.

• Clearly understood by equity and debt markets.

One size does not fit all – but for many companies, refinancing pension debt could be a very logical step to be considered alongside the various hedging and derisking options available.

To expand on this point, why would a relatively strong company, well in control of its capital structure and with flexible access to the capital market, not want to lock down its pension risks in the scheme that are beyond its control – such as investment risk in the asset portfolio and longevity risk in the liability base.

Inefficiently allocating risk

Additionally, as schemes are derisked the accessibility of insurance and consolidation options can open up.

Many companies, however, continue to take significant pension risk, relying on investment returns to achieve full funding and to minimize actual demands for cash funding from the sponsor.

The potential flaw in this approach is that it is an inefficient allocation of risk. Shareholders have invested for return against the known risks facing the company rather than the extraneous risks presented by the pension scheme, which are often not self-evident.

Nevertheless, many strong companies continue to run significant pension debt, perhaps believing that the very uncertainty inherent in a scheme offers funding, contractual or timing opportunities that any refinancing may preclude.

It would, however, be a missed opportunity if the window for refinancing were to narrow as global interest rates rise just as boards and shareholders come to see more favour in closing down these exogenous risks.

Clearly the incentive on a relatively weak company to close down on pension risk through refinancing should be all the greater.

One size does not fit all

Nevertheless, such a company may not have the debt capacity to effect such a refinancing and there may be other features present in pension debt funding that appear to render the refinancing option less attractive.

Refinancing with financial debt may be seen as unattractive for several reasons:

• Financial debt presents a known contractual obligation, pension debt can be much less certain.

• IAS accounting treatment may require a harsher recognition of financial debt than pension obligations.

• Refinancing may cede any upside interest for the sponsor in pension scheme investment returns by effectively locking in the deficit.

• Trustees may be more flexible counterparties than equivalent lenders.

• The insurance market may appear to offer a cheaper refinancing in the future.

Notwithstanding the above, in a perfect world where the risks presented by financial debt versus pensions debt are fully valued, the incentive on a relatively weak company to manage down these risks must surely be even greater than for a strong company.

Moreover, capacity constraints should theoretically be adjusted through a rebalancing of both risk capital and leverage to focus the company on the key risks that the board are experts at managing.

Maintaining pension debt allows a chief financial officer to carry a portion of total debt in a variable form, where absolute scale depends on the strength of the company covenant, service cost depends on the trustees’ appetite for risk, and maturity depends on the company’s ability to pay – having taken into account all other competing interests for cash.

Such flexibility is hard to ignore, but with it comes a ceding of control that appears to conflict with the shareholders' expectation that – to the best of its ability – a company will only take risks that it understands and is paid to take, it will focus this risk on the assets of which it has charge and construct an efficient capital structure to enable efficient ownership of such assets for an appropriate return.

Paul Jameson is managing partner at Penfida