Pensions play a crucial role in insolvency

Pensions play a crucial role in insolvency

For firms in financial duress, employee pensions expenses can be fatal. Giving them a spot at the table may be a better option.

The latest trends in the UK and the eurozone show economic growth to be stagnating, with ‘Japanification’ taking hold on the continent.

Businesses already under pressure from the slowing economic conditions may face an even greater problem with their employee’s pension funds. Quantitative easing and negative bond yields provide another blow to a firm’s pension fund.

This presents the problem of a firm that is under pressure by both falling or at the very least stagnating profits and of a growing ‘debt’ in the form of fulfilling their pension obligations to their employee, especially if they elected to have a defined benefit pension plan.

If a firm becomes insolvent due to cash flow issues, there are the usual suspects that may take the lead in order to keep the firm solvent, but increasingly the employee pension is beginning to have more of a voice at the table, partly due to regulatory changes.

Pension’s priority

In the event that a firm becomes insolvent and can no longer operate, defined benefit pensions for the most part are protected by the Pension Protection Fund. Retired employees or those of retiring age will receive 100% of their current pension while those still working will receive 90% of their pension up to a certain cap (around £36k). High-profile insolvencies have placed pension schemes from Carillion and Thomas Cook under assessment in this fund. But at the same time a successful restructure, as was the case for firms like Debenhams and Arcadia, can save both the firm and the pension scheme from going under.

Dan Mindel, managing director from Lincoln Pensions says that bringing pensions into any restructuring decision should be a priority: “Financial creditors are usually the ones in the driving seat if a company is insolvent and will lead the process of restructuring the company’s debt to a level that is supportable going forward.

“There will usually be secured creditors, and they will often either overlook or marginalise the pension scheme (which is typically unsecured), or they’ll try and find a way of removing the scheme altogether as they can be a material liability on the balance sheet. The old mentality would have been, it would be so much better if we could get rid of the scheme, but they’re finding that harder to do because the Pension Regulator is now much more proactive in using both its regulatory powers and its political influence to step in directly and also to provide support to trustees.”

Employee pensions can become a huge liability for a struggling company and properly managing it will greatly affect the overall longevity and continued existence of the firm. For example, before Kodak went into administration in 2012, its pension and ‘other post-retirement liabilities’ were its largest creditor. In 2010, Kodak’s last annual report before declaring bankruptcy showed that its pension scheme accounted for more than a third of their total liabilities. Obviously, pensions were not the main reason Kodak went under, but this case underscores the fact that pensions can weigh heavily on the bottom line and it may hinder efforts to modernise and change the way a firm does business.

Therefore, engaging with the pension scheme and giving them a place at the table during a restructuring may help to improve the chances of keeping a company solvent.

Pension’s place in the sun

With pensions issues becoming a greater issue for boardrooms, it still remains vital for those who represent the pension fund to think of the longevity of the firm.

There are always competing demands for cash in a firm, whether it be for R&D, investment or salary and pension contributions. With the pension scheme getting a stronger voice, the question becomes how does one decide who gets what?

If you are sitting as a trustee of the pension scheme you need to give all these competing demands due consideration, for while it’s important for the business to make good on its pension commitments, the business’s continued success and growth should also be a priority. Any discussions during a restructuring should not be limited to ‘how to make the business succeed for the benefit of the scheme’ but also ‘how to make it succeed and meet the interests of all of its stakeholders’.

As a trustee, you have a responsibility to act on behalf of the members of the pension scheme, but you also have a responsibility to the company. Mindel notes: “As a trustee, you want the company to survive. The company needs to fund the scheme, but it is self-defeating to demand a level of contributions that the company cannot afford to make. So, what can you do? There’s always the standoff, one has to live with the other. Now the question becomes, how do you do that? How do you work together with the company to make sure everyone’s best interests are protected?”

Therefore, the role of a pension’s advisor is not solely to advocate on behalf of the pension but to work with the business as a whole. By providing advice like how to mitigate detriment to the scheme, negotiating a compromise of scheme benefits or reviewing ‘moral hazard’ risks, the advisor can help both the business and the pension scheme reach an equitable solution.

The death of defined benefits

Defined benefit pensions are a dying breed, they were once seen as the norm, when workers would stay with ‘the company’ for life. While that idea is no longer popular, it is this cohort that are now retiring, who are no longer paying into the pension fund but finally taking from it.

The firm’s pension scheme also faces pressure from what were once safe investments. Government bonds were once seen as sound and reliable ways to grow a pension fund but negative bond yields in the eurozone and in developed economies elsewhere have made a critical part of the pension fund portfolio a depreciative asset.

Given the state of the global economy Mindel warns that many firms may be living on borrowed time “They are probably companies, not necessarily badly run companies, just companies that have been running out of steam, kept artificially alive by very low interest rates, with margins that have just been eroded over time”.

It is these double pressures of a retiring workforce and poor financial market conditions that make defined benefit pension schemes untenable and why most firms no longer offer it. Instead, defined contribution pension schemes have become the norm, shifting retirement responsibility from the employer to the employee.

While the Pension Protection Fund gives security to an employee’s pension, it ultimately is a fund of last resort. It is therefore in everyone’s best interest for a firm to continue operating. Tackling the pension scheme may be a firm’s greatest challenge, but also the firm’s best opportunity to keep itself solvent and to help itself return its balance sheets to black.

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