Pension Risk to the Corporate Sponsor

K.Heaven Pension Risk to the Corporate Sponsor 25 October 2012

Pension Risk to the

Corporate Sponsor Karen Heaven

25 October 2012

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-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

50%

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 12

UK Pension Schemes Funding Level (PPF basis)

30 Year Gilt Real Yield

82.3%

Corporate Pension Risk: Market Environment

2

Falling real yields have driven up liability

valuations, contributing to sharp declines in the

aggregate funding position of UK schemes...

Source: Pension Protection Fund (PPF 7800 index), Bloomberg

Gilt real yield (%) (%) Funding Level

110.7%


9.2

16.6

26.5

29.1 28.0

0

5

10

15

20

25

30

35

0

50

100

150

200

250

300

350

2007 2008 2009 2010 2011 2012

Annual Deficit Repair Contributions

UK Schemes - Aggregate deficit of schemes in deficit (PPF basis)

£258.2bn

£30.5bn

(RHS)

(LHS)

Increased Drain on Corporate Cash...

3

Source: Pension Protection Fund PPF 7800 index and Purple Books; (1) Annual contributions shown for previous financial year ending March

Annual Deficit Contributions(1) (£bn) (£bn) Aggregate Deficit Weaker funding positions have

forced many sponsors to significantly

increase deficit repair contributions


Corporate Pensions Risk: Significance

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Share Price

Company

Credit Rating

Pension Scheme

(Trustee)

Reliance on

sponsor support

(sponsor covenant)

Cash Flow impact Deficit repair

contributions

Balance Sheet

volatility Investment strategy

/ funding level

volatility

Obligation to

support pension

scheme

• In addition to adverse market conditions, the introduction of FRS17 / IAS19 accounting standards over the past decade and the

creation of the Pensions Regulator have both made pensions and the risks they pose to companies significantly more visible to

shareholders, equity analysts and credit rating agencies


• Pension Liabilities vs. Market

Capitalisation

• Pension Deficit vs. Market

Capitalisation

• Ldity: Constraint caused by deficiquiit

repair contributions

• Ability to pay dividends after annual

contributions are met

• Value-at-risk: Minimum expected

deterioration in the net funding

position (assets minus liabilities) in a

downside scenario

• Contributions-at-risk: Minimum

expected increase in the sponsor

contributions in a downside scenario

• “What if” stress tests

Measuring Corporate Pensions Exposure: Three Dimensions

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Scale Impact

• Debt ratios e.g. Net Debt / EBITDA

• Interest Coverage (i.e. ability to service

debt)

• Liquidity: Do deficit repair contributions

cause a liquidity constraint?

• Ability to pay dividends after pension

contributions are paid ?

Examples of Key Metrics

Risk

Equity Analyst Reports Shareholders’

Perceptions

Rating Agencies’

Assessments

Share Price Volatility Impact on Credit Rating /

Cost of Funding

How large are the pension schemes

compared to the corporate? How does pension exposure impact key

financial metrics of the corporate? How “risky” is the pension scheme?

Examples of Key Metrics Examples of Key Metrics


• Measuring the pension liabilities and deficit against a company’s market capitalisation provides a broad view of the scale of the pensions

exposure 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 and

sector. In the FTSE 350, 35 companies have pension liabilities in excess of their market capitalisation.

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21% 27%

180%

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

FTSE350 Consumer, Non-cyclical Firm X

IAS19 Liabilities to Market Capitalisation

1.5% 1.8%

16.8%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

FTSE350 Consumer, Non-cyclical Firm X

IAS19 Deficit to Market Capitallisation

0

20

40

60

80

100

120

Number of Companies

Liabilities / Market Capitalisation

FTSE 350 Pension Liabilities vs. Market Capitalisation

0

20

40

60

80

100

120

140

Number of Companies

Deficit / Market Capitalisation

FTSE 350 Pension Deficit vs. Market Capitalisation

Source: Bloomberg & Annual Financial Reports, Redington calculations. Analysis on an IAS19 accounting basis due to availability of data

Firm X Firm X

Measuring Corporate Pensions Exposure: Scale


Measuring Corporate Pensions Exposure: Impact

• The charts below show the impact of the pension deficit on the Net

Debt / EBITDA ratio of a FTSE 350 company in the consumer cyclical

sector

• The impact can be compared to the medians for the sector and for

the overall index. Firm Y is in line on the pre-pension measure but

has a significantly higher ratio than its peers post-pensions

adjustment

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• The requirement to support the pension scheme can serve as a

significant drain on corporate liquidity, reducing cash flow available

to finance new investments and potentially undermining credit

strength

• The charts below show pension contributions as a proportion of

the company’s total pre-pension Free Cash Flow with comparable

medians for the sector and index

Example - Impact on Key ratios Example - Impact on Cash Flow

0.84 0.71

0.87

0.23

0.13

1.4

0.0

0.5

1.0

1.5

2.0

2.5

FTSE350 Consumer, Cyclical Firm Y

Net Debt / EBITDA

Impact of Pension Deficit on Net Debt / EBITDA

Pension Adjustment

Unadjusted Ratio

10.4%

13.4%

17.1%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

FTSE350 Consumer, Cyclical Firm Y

Contributions / FCF

Pension Contributions to Pre-Pension Free Cash Flow

Source: Bloomberg & Annual Financial Reports, Redington calculations. Pre-Pension Free Cash Flow

and Contributions reflect adjustments for both deficit repair and ongoing contributions

(Industry of Firm Y) (Industry of Firm Y)


Measuring 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 the

schemes.

• There is no perfect way to measure pension risk, however analysis can provide us with useful tools to measure the magnitude of risk and

the 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:

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Minimum expected

deterioration in the net funding

position (assets - liabilities) in a

1-in-20 downside scenario

Value-at-Risk (VaR)

Impact on the size of the

pension funding position

(i.e. deficit / surplus)

Implications for equity

analysts’ and rating

agencies’ assessment

Minimum expected increase in

the sponsor contributions

necessary to reach full funding

as planned in a 1-in-20

downside scenario (i.e. on top of

contributions which are already

being paid)

Contributions-at-Risk (CaR)

Possible increase in

sponsor contributions to

Pension scheme

Significance to Corporate


Measuring Pension Risk: Value-At-Risk vs. Corporate Earnings

• We have estimated a one-year 95% Value-at-Risk for Firm A’s pension

scheme (Firm A is a FTSE 350 industrial).

• To place pension risk in the context of the company earnings, we show

the VaR as a proportion of the corporate’s EBITDA .

o A 1-in-20 downside (or VaR95) event would cause an increase

in deficit equivalent in size to at least 189% of Firm A’s annual

earnings.

• These metrics are shown relative to sector and FTSE 350 medians.

• We estimate that 20 companies in the FTSE 350 have a VaR greater

than their most recent annual EBITDA while four have a VaR greater

than twice their annual EBITDA.

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Value-at-Risk (VaR)

0 5

10 15 20 25 30 35 40 45 50

Number of Companies

VaR to EBITDA Ratio

FTSE 350 Distribution of Pension Scheme Value-at-Risk vs. EBITDA

Source: 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 A

VaR/EBITDA Value-at-Risk to EBITDA Ratio

Firm A

(Industry of Firm A)


Measuring Pension Risk: Contributions-at-Risk vs. Free Cash Flow

• Contributions-at-Risk (CaR) measures the minimum expected increase

in the sponsor contributions necessary to reach full funding as planned

in a 1-in-20 downside scenario (i.e. in addition to contributions already

being paid).

• As CaR represents a further potential drain on corporate cash, we

show 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 an

increase 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 a

Contributions-at-Risk greater than 30% of their annual pre-pensions

Free Cash Flow whilst 3 companies have a Contributions-at-Risk

greater than 100% of pre-pensions Free Cash Flow.

• This analysis assumes a 10-year recovery plan for UK schemes.

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Contributions-at-Risk (CaR)

0

10

20

30

40

50

60

70

80

90

100

Number of Companies

CaR to FCF Ratio

FTSE 350 Distribution of Contributions-at-Risk vs. Pre-pensions Free Cash Flow

Source: 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 the

Technical Provisions .

7.2%

14.0%

21.1%

0%

5%

10%

15%

20%

25%

FTSE350 Industrial Sector Firm A

CaR/ FCF Contributions-at-Risk vs. Pre-pensions Free Cash Flow

Firm A

(Industry of Firm A)


“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 strategic

framework 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. We

call 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 and

constraints, 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 from

business operations”.

• The following slide sets out examples of objectives and constraints from an illustrative PRMF.

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Example from a Pension Risk Management Framework

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Metric Current Position Objective Significance Progress

Earnings

EBITDA £200m

VaR should be less than

£200m

or VaR/EBITDA = 1.0

The increase in the deficit in

a downside scenario should

not wipe out a year’s

earnings

Aggregate Pension Scheme Value at

Risk £375m

Pension scheme VaR /EBITDA ratio 1.88

Cash Flow

Contributions at Risk (1-year, 95th

percentile) £38m

CaR should be less than

£17.7m

or CaR/FCF = 0.1

Additional annual

contributions needed in a

downside scenario should be

smaller than a target % of

free cash

Adjusted Free Cash Flow £177m

CaR/Adjusted FCF 0.21

Funding Position

Funding Ratio (IAS19 basis) 86.1%

Expected Return on Assets

> Required Return to reach

full funding by [2022]

Aiming for higher expected

return is a trade-off,

dependent on sponsor’s

ability to bear pension risk

Expected Return on Assets (over Swaps) 200bps

Required Return on Assets (over Swaps)

to reach full funding on an IAS19 basis

by [2022]

220bps

Metric is at or above target Metric is within 10% of target Metric is more than 10% away from target


Trustee 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 current

agreed level of contributions into the Scheme. This shows that taking into account sponsor credit risk can have a significant impact on the

Scheme’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 (“Zero

Default” 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 is

applied to the contributions.

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0.65% 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%

Zero Default

Risk

Single 'A' Triple 'B' Double 'B' Single 'B' Triple 'C' Default

Required Return over Swaps

Chart 1: Required Returns with Probability Weighted Contributions

(Full Funding by March 2030 for Sample Scheme) Chart 2: Flight Plan – Full Funding Horizon with Probability Weighted

Contributions (0.65% required return)

0

200

400

600

800

1,000

1,200

1,400

1,600

£mn

Liability value Assets Asset Value - Single 'A' Asset Value - Triple 'B' Asset Value - Double 'B' Asset Value - Single 'B'

Assets / Liabilities

Rating Full Funding Date

Single ‘A’ Aug-31

Triple ‘B’ Oct-33

Double ‘B’ Jul-43

Single ‘B’ Never


Conclusion Thoughts: Implications for Sponsors and Trustees

For 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 for

the 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 business

risk).

• 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?

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13-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 www.redington.co.uk

Contacts

Karen Heaven Vice President | Investment Consulting

Direct Line: 020 3326 7134

[email protected]

Risk Management Firm

of the Year (2011, 2012)

Pension Consultant

of the Year 2012

http://twitter.com/redingtontweets

Disclaimer

For professional investors only. Not suitable for

private customers.

The information herein was obtained from various

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Please note, the accurate calculation of the liability

profile used as the basis for implementing any

capital markets transactions is the sole responsibility

of the Trustees' actuarial advisors. Redington Ltd will

estimate the liabilities if required but will not be held

responsible for any loss or damage howsoever

sustained as a result of inaccuracies in that

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Pension Risk to the Corporate Sponsor

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