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Pension Risk to the Corporate Sponsor

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Pension Risk to the Corporate Sponsor

  1. 1. K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012Pension Risk to theCorporate SponsorKaren Heaven25 October 20121
  2. 2. K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012-0.4-0.20.00.20.40.60.81.01.21.450%60%70%80%90%100%110%120%Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12UK Pension Schemes Funding Level (PPF basis)30 Year Gilt Real Yield82.3%Corporate Pension Risk: Market Environment2Falling real yields have driven up liabilityvaluations, contributing to sharp declines in theaggregate funding position of UK schemes...Source: Pension Protection Fund (PPF 7800 index), BloombergGilt real yield (%)(%) Funding Level110.7%
  3. 3. K.Heaven Pension Risk to the Corporate Sponsor 25 October 20129.216.626.529.128.0051015202530350501001502002503003502007 2008 2009 2010 2011 2012Annual Deficit Repair ContributionsUK Schemes - Aggregate deficit of schemes indeficit (PPF basis)£258.2bn£30.5bn(RHS)(LHS)Increased Drain on Corporate Cash...3Source: Pension Protection Fund PPF 7800 index and Purple Books; (1) Annual contributions shown for previous financial year ending MarchAnnual Deficit Contributions(1) (£bn)(£bn) Aggregate DeficitWeaker funding positions haveforced many sponsors to significantlyincrease deficit repair contributions
  4. 4. K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012Corporate Pensions Risk: Significance4Share PriceCompanyCredit RatingPension Scheme(Trustee)Reliance onsponsor support(sponsor covenant)Cash Flow impactDeficit repaircontributionsBalance SheetvolatilityInvestment strategy/ funding levelvolatilityObligation tosupport pensionscheme• In addition to adverse market conditions, the introduction of FRS17 / IAS19 accounting standards over the past decade and thecreation of the Pensions Regulator have both made pensions and the risks they pose to companies significantly more visible toshareholders, equity analysts and credit rating agencies
  5. 5. K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012• Pension Liabilities vs. MarketCapitalisation• Pension Deficit vs. MarketCapitalisation• Ldity: Constraint caused by deficiquiitrepair contributions• Ability to pay dividends after annualcontributions are met• Value-at-risk: Minimum expecteddeterioration in the net fundingposition (assets minus liabilities) in adownside scenario• Contributions-at-risk: Minimumexpected increase in the sponsorcontributions in a downside scenario• “What if” stress testsMeasuring Corporate Pensions Exposure: Three Dimensions5Scale Impact• Debt ratios e.g. Net Debt / EBITDA• Interest Coverage (i.e. ability to servicedebt)• Liquidity: Do deficit repair contributionscause a liquidity constraint?• Ability to pay dividends after pensioncontributions are paid ?Examples of Key MetricsRiskEquity Analyst ReportsShareholders’PerceptionsRating Agencies’AssessmentsShare Price VolatilityImpact on Credit Rating /Cost of FundingHow large are the pension schemescompared to the corporate?How does pension exposure impact keyfinancial metrics of the corporate?How “risky” is the pension scheme?Examples of Key MetricsExamples of Key Metrics
  6. 6. K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012• Measuring the pension liabilities and deficit against a company’s market capitalisation provides a broad view of the scale of the pensionsexposure relative to the size of the company.• The charts below compare the metrics of a FTSE 350 company in the consumer non-cyclical sector with medians for the index andsector. In the FTSE 350, 35 companies have pension liabilities in excess of their market capitalisation.621% 27%180%0%20%40%60%80%100%120%140%160%180%200%FTSE350 Consumer, Non-cyclical Firm XIAS19 Liabilities to Market Capitalisation1.5% 1.8%16.8%0%2%4%6%8%10%12%14%16%18%FTSE350 Consumer, Non-cyclical Firm XIAS19 Deficit to Market Capitallisation020406080100120Number ofCompaniesLiabilities / Market CapitalisationFTSE 350Pension Liabilities vs. Market Capitalisation020406080100120140Number ofCompaniesDeficit / Market CapitalisationFTSE 350Pension Deficit vs. Market CapitalisationSource: Bloomberg & Annual Financial Reports, Redington calculations. Analysis on an IAS19 accounting basis due to availability of dataFirm XFirm XMeasuring Corporate Pensions Exposure: Scale
  7. 7. K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012Measuring Corporate Pensions Exposure: Impact• The charts below show the impact of the pension deficit on the NetDebt / EBITDA ratio of a FTSE 350 company in the consumer cyclicalsector• The impact can be compared to the medians for the sector and forthe overall index. Firm Y is in line on the pre-pension measure buthas a significantly higher ratio than its peers post-pensionsadjustment7• The requirement to support the pension scheme can serve as asignificant drain on corporate liquidity, reducing cash flow availableto finance new investments and potentially undermining creditstrength• The charts below show pension contributions as a proportion ofthe company’s total pre-pension Free Cash Flow with comparablemedians for the sector and indexExample - Impact on Key ratios Example - Impact on Cash Flow0.84 0.710.870.230.131.40.00.51.01.52.02.5FTSE350 Consumer, Cyclical Firm YNet Debt /EBITDAImpact of Pension Deficit on Net Debt / EBITDAPension AdjustmentUnadjusted Ratio10.4%13.4%17.1%0%2%4%6%8%10%12%14%16%18%FTSE350 Consumer, Cyclical Firm YContributions /FCFPension Contributions to Pre-Pension Free CashFlowSource: Bloomberg & Annual Financial Reports, Redington calculations. Pre-Pension Free Cash Flowand Contributions reflect adjustments for both deficit repair and ongoing contributions(Industry of Firm Y) (Industry of Firm Y)
  8. 8. K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012Measuring Corporate Pensions Exposure: Risk• Having gained a picture of the current pension impact, it is equally important to take into account the level of risk being run by theschemes.• There is no perfect way to measure pension risk, however analysis can provide us with useful tools to measure the magnitude of risk andthe relative sources of risk.• Redington employs a number of metrics to assess scheme risk. Here we look at Value-at-Risk and Contributions-at-Risk:8Minimum expecteddeterioration in the net fundingposition (assets - liabilities) in a1-in-20 downside scenarioValue-at-Risk (VaR)Impact on the size of thepension funding position(i.e. deficit / surplus)Implications for equityanalysts’ and ratingagencies’ assessmentMinimum expected increase inthe sponsor contributionsnecessary to reach full fundingas planned in a 1-in-20downside scenario (i.e. on top ofcontributions which are alreadybeing paid)Contributions-at-Risk (CaR)Possible increase insponsor contributions toPension schemeSignificance to Corporate
  9. 9. K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012Measuring Pension Risk: Value-At-Risk vs. Corporate Earnings• We have estimated a one-year 95% Value-at-Risk for Firm A’s pensionscheme (Firm A is a FTSE 350 industrial).• To place pension risk in the context of the company earnings, we showthe VaR as a proportion of the corporate’s EBITDA .o A 1-in-20 downside (or VaR95) event would cause an increasein deficit equivalent in size to at least 189% of Firm A’s annualearnings.• These metrics are shown relative to sector and FTSE 350 medians.• We estimate that 20 companies in the FTSE 350 have a VaR greaterthan their most recent annual EBITDA while four have a VaR greaterthan twice their annual EBITDA.9Value-at-Risk (VaR)05101520253035404550Number ofCompaniesVaR to EBITDA RatioFTSE 350Distribution of Pension Scheme Value-at-Risk vs. EBITDASource: Bloomberg & Annual Financial Reports, Redington calculations.Analysis excludes companies not providing a breakdown of the pension fund asset allocation.31%52%189%0%20%40%60%80%100%120%140%160%180%200%FTSE350 Industrial Sector Firm AVaR/EBITDAValue-at-Risk to EBITDA RatioFirm A(Industry of Firm A)
  10. 10. K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012Measuring Pension Risk: Contributions-at-Risk vs. Free Cash Flow• Contributions-at-Risk (CaR) measures the minimum expected increasein the sponsor contributions necessary to reach full funding as plannedin a 1-in-20 downside scenario (i.e. in addition to contributions alreadybeing paid).• As CaR represents a further potential drain on corporate cash, weshow this as a proportion of the sponsor’s pre-pension Free Cash Flow(FCF).• A 1-in-20 downside (or CaR95) event would be equivalent to anincrease in contributions equal to at least 21% of Firm A’s pre-pensions Free Cash Flow• Overall, we estimate that 19 companies on the FTSE 350 have aContributions-at-Risk greater than 30% of their annual pre-pensionsFree Cash Flow whilst 3 companies have a Contributions-at-Riskgreater than 100% of pre-pensions Free Cash Flow.• This analysis assumes a 10-year recovery plan for UK schemes.10Contributions-at-Risk (CaR)0102030405060708090100Number ofCompaniesCaR to FCF RatioFTSE 350Distribution of Contributions-at-Risk vs. Pre-pensions Free Cash FlowSource: Bloomberg & Annual Financial Reports, Redington calculations.Analysis excludes companies not providing a breakdown of the pension fund asset allocation.Note: Estimates are shown on an accounting basis. In practice, contribution schedules are based on theTechnical Provisions .7.2%14.0%21.1%0%5%10%15%20%25%FTSE350 Industrial Sector Firm ACaR/ FCFContributions-at-Risk vs. Pre-pensions Free Cash FlowFirm A(Industry of Firm A)
  11. 11. K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012“Right Sizing” Pension Risk• It is reasonable (and unavoidable) to run some degree of risk with a defined benefit pension scheme’s investment strategy.• Having quantified the pensions impact on the corporate sponsor, it is possible to incorporate these results into a clear strategicframework setting out objectives and constraints to guide investment strategy over time.• Only when you know exactly what you want (and don’t want), can you make the decisions that enable you to reach your objectives. Wecall this the Pension Risk Management Framework (PRMF).• The PRMF helps to facilitate effective governance by concentrating the minds of trustees and sponsors on core objectives andconstraints, such as meeting the risk budget and target date for full funding.• The objectives set out in the PRMF can be defined with direct reference to corporate metrics, for example:o “The increase in the deficit in a 1-in-20 downside scenario should not wipe out a year’s earnings”.o “Additional annual contributions needed in a 1-in-20 downside scenario should be less than half of the free cash available frombusiness operations”.• The following slide sets out examples of objectives and constraints from an illustrative PRMF.11
  12. 12. K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012Example from a Pension Risk Management Framework12Metric Current Position Objective Significance ProgressEarningsEBITDA £200mVaR should be less than£200mor VaR/EBITDA = 1.0The increase in the deficit ina downside scenario shouldnot wipe out a year’searningsAggregate Pension Scheme Value atRisk£375mPension scheme VaR /EBITDA ratio 1.88Cash FlowContributions at Risk (1-year, 95thpercentile)£38mCaR should be less than£17.7mor CaR/FCF = 0.1Additional annualcontributions needed in adownside scenario should besmaller than a target % offree cashAdjusted Free Cash Flow £177mCaR/Adjusted FCF 0.21Funding PositionFunding Ratio (IAS19 basis) 86.1%Expected Return on Assets> Required Return to reachfull funding by [2022]Aiming for higher expectedreturn is a trade-off,dependent on sponsor’sability to bear pension riskExpected Return on Assets (over Swaps) 200bpsRequired Return on Assets (over Swaps)to reach full funding on an IAS19 basisby [2022]220bpsMetric is at or above target Metric is within 10% of target Metric is more than 10% away from target
  13. 13. K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012Trustee Perspective: Incorporating Covenant Risk• There is an implicit credit risk to the deficit recovery contributions agreed between the trustees and sponsor.• In the sample analysis below, we assign a “survival probability” to the sponsor, based on credit ratings and use these to weight the currentagreed level of contributions into the Scheme. This shows that taking into account sponsor credit risk can have a significant impact on theScheme’s funding outlook:o Chart 1 shows the return on assets required to reach full funding by a given target date, for different sponsor survival probabilities (“ZeroDefault” assumes all agreed contributions are received, “Default” assumes no contributions are received).o Chart 2 shows the estimated full funding date if the return on assets is held constant at 0.65%, and the survival probability weighting isapplied to the contributions.130.65%0.69% 0.74%0.92%1.18%1.50%2.48%0.0%0.5%1.0%1.5%2.0%2.5%3.0%ZeroDefaultRiskSingle A Triple B Double B Single B Triple C DefaultRequired Returnover SwapsChart 1: Required Returns with Probability Weighted Contributions(Full Funding by March 2030 for Sample Scheme)Chart 2: Flight Plan – Full Funding Horizon with Probability WeightedContributions (0.65% required return)02004006008001,0001,2001,4001,600£mnLiability value AssetsAsset Value - Single A Asset Value - Triple BAsset Value - Double B Asset Value - Single BAssets / LiabilitiesRating Full Funding DateSingle ‘A’ Aug-31Triple ‘B’ Oct-33Double ‘B’ Jul-43Single ‘B’ Never
  14. 14. K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012Conclusion Thoughts: Implications for Sponsors and TrusteesFor Sponsors• Clear understanding of scale, impact and risk of the pension scheme(s) on the corporate metrics and that of peers.• Importance of a holistic approach: Consider discussing with trustees a risk management strategy to ensure pension risk is appropriate forthe corporate sponsor.• The output of the exercise is a robust strategic framework linking pension objectives to corporate metrics, ensuring that pension risk is“right sized”.For Trustees• Ongoing monitoring of sponsor covenant and implications for risk budget and funding objectives.• Recognition of relationship between risks facing the pension scheme and wider business risks (correlation between pension and businessrisk).• Ensure that investment strategy objectives take into account the sponsor’s risk budget and ability to support the scheme.o Can the sponsor afford to bear the risk that the scheme is running?14
  15. 15. K.Heaven Pension Risk to the Corporate Sponsor 25 October 201213-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 www.redington.co.ukContactsKaren HeavenVice President | Investment ConsultingDirect Line: 020 3326 7134karen.heaven@redington.co.ukRisk Management Firmof the Year (2011, 2012)Pension Consultantof the Year 2012http://twitter.com/redingtontweetsDisclaimerFor professional investors only. Not suitable forprivate customers.The information herein was obtained from varioussources. We do not guarantee every aspect of itsaccuracy. The information is for your privateinformation and is for discussion purposes only. Avariety of market factors and assumptions mayaffect this analysis, and this analysis does not reflectall possible loss scenarios. There is no certainty thatthe parameters and assumptions used in thisanalysis can be duplicated with actual trades. Anyhistorical exchange rates, interest rates or otherreference rates or prices which appear above arenot necessarily indicative of future exchange rates,interest rates, or other reference rates or prices.Neither the information, recommendations oropinions expressed herein constitutes an offer to buyor sell any securities, futures, options, or investmentproducts on your behalf. Unless otherwise stated,any pricing information in this message is indicativeonly, is subject to change and is not an offer totransact. Where relevant, the price quoted isexclusive of tax and delivery costs. Any reference tothe terms of executed transactions should be treatedas preliminary and subject to further due diligence .Please note, the accurate calculation of the liabilityprofile used as the basis for implementing anycapital markets transactions is the sole responsibilityof the Trustees actuarial advisors. Redington Ltd willestimate the liabilities if required but will not be heldresponsible for any loss or damage howsoeversustained as a result of inaccuracies in thatestimation. Additionally, the client recognizes thatRedington Ltd does not owe any party a duty of carein this respect.Redington Ltd are investment consultants regulatedby the Financial Services Authority. We do notadvise on all implications of the transactionsdescribed herein. This information is for discussionpurposes and prior to undertaking any trade, youshould also discuss with your professional tax,accounting and / or other relevant advisers how suchparticular trade(s) affect you. All analysis (whether inrespect of tax, accounting, law or of any othernature), should be treated as illustrative only and notrelied upon as accurate.Redington Limited (reg no 6660006) is a companyauthorised and regulated by the FinancialServices Authority and registered in England andWales. Registered office: 13-15 Mallow StreetLondon EC1Y 8RD15

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