The Benefits of Borrowing to Pay Off Pension Debt

Brian Spence

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At a time when the prospects for the future success of many business’ is now affected by the level of their pension scheme deficit, companies are employing ever more innovative solutions to address the problem with which they are faced. The changes which the government imposed in June 2003 mean that it is now extremely difficult for solvent employers to escape from the liabilities they have already accrued. However, what is still possible is to control the timescale over which deficits are met and the finance methods used to fund them. One potential solution currently being employed is the use of bank lending to cap off the liability level as this re-financing can reduce cost, control risk and provide a degree of increased certainty for shareholders and employees alike.

UK pension scheme deficits have arisen as a result of a combination of falling equity markets, lower than expected future investment returns, falling interest rates and increased life expectancy and ultimately the Pensions Act changes have meant that the liabilities companies have accrued will need to be met in full at some point. Funding these deficits can be facilitated over many years and can offer some degree of flexibility of funding. Clearly the level of deficit and therefore contribution payable by the company is dependent upon the assumptions used in to the future and should future reality turn out to be better than what has been assumed then the amount payable could be lower. However, this is primarily a bet on equity returns and companies and their shareholders need to consider the potential implications for their business should returns prove to be below those expected, or indeed hoped for.

In addition adopting this approach means that dependent upon the level of the assets held in the pension scheme compared to the value of the business the risk profile of the business can be significantly skewed. For example a business which offers printing services in the UK should be valued in to the future according to the success of it’s UK printing activities, however should the pension liabilities be significant in terms of the business value and be invested primarily in equities in a non related sector or even not in the same national economy then it becomes increasingly difficult for shareholders to identify the risks to which they are exposed and their likelihood of future success. It is this very issue which has resulted in shareholders looking for a more certain method of business valuation and therefore the use of bank finance.

The starting point is for the company to identify the level of funding required to cap the pension liability, the current buy-out cost, and to look to borrow an amount to finance the debt. At the same time the assets would be moved to a lower risk investment portfolio, such as bonds, which more closely matches the scheme liabilities and therefore reduces risk exposure. It is important to bear in mind that the risk is significantly reduced, although it can not be totally eliminated.

Utilising this approach has a number of additional benefits:-

  • Flexible funding is replaced by finite transparent cost thereby making the business more easily valued
  • The contribution made to the scheme is tax relievable and as such for a large company a deficit of say £5M would only require borrowings of £3.5M
  • The interest payments would also be tax relievable as a business expense and, depending on how debt is organised, there can be initial cashflow savings
  • The security of members past service benefits are increased as the scheme becomes fully funded and this could be used as a potential area of negotiation for a change to the basis of pension accrual going forward
  • When the risk based levy for the Pension Protection Fund (PPF) is introduced the scheme should pay a lower amount
  • Not only is borrowing to plug pension fund deficits proving popular with shareholders and companies, but some lenders too are becoming increasingly supportive of this option because it makes it easier for them to value the business as they have now recognised that lending to a business with a scheme deficit exposes them to the risk of that deficit widening and the corresponding risk of exposure to bad debt.

That’s why, rather than having an unknown liability carried forward, many lenders would instead prefer to cap it so that they know, going forward, what the expenditure will be and whether they are prepared to lend the company additional funds, in order that the sum already lent is secured against the risk that the debt will not rise at any point in the future.

There is however something of an anomaly in this area as clearly the larger the scheme deficit in relation to company value the less likely they are to be able to secure bank finance and the smaller the scheme deficit in relation to shareholder value the less likely the business is to need any form of lending. However there is a significant sector of the market, particularly the SME sector, who could benefit from exploring this potential solution.

ENDS

Published in Pension Age in May 2005 and Professional Pensions on 27/03/05.

Brian Spence

Post by Brian Spence

Fellow of the Institute and Faculty of Actuaries and Society of Actuaries in Ireland, scheme actuary, professional pension trustee

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