Other than the Beatles and Rolling Stones, it isn't often you can genuinely say you heard it first in the U.K. We have America to thank for many of our cultural influences and, as it happens, for a good number of the ideas that shaped the rebirth of the U.K. pensions regulatory regime in 2004-05.
Indeed, the U.S. was well ahead of the U.K. when, in 1974, the Employee Retirement Income Security Act was signed into law, leading to the creation of the Pension Benefit Guaranty Corp. as a safety net should a plan sponsor collapse. ERISA was the legislative response to the collapse in 1963 of the automaker Studebaker with the loss of around 4,000 jobs, and provides compensation in return for an insurance premium paid by all plans.
Learning from the U.S., following the well-publicized and scandalized case of the collapse of the Robert Maxwell Group in the early 1990s, a new regulatory body was created in the U.K. with the passing of the 2004 Pensions Act through Parliament.
As with all the best ideas, they are hopefully borrowed and further built upon. Benefiting from the experience in the U.S., the Pensions Act introduced a PBGC-like body called the Pension Protection Fund and established a new regulator, the Pensions Regulator. This led to the birth of a new principle, that of "sponsor covenant risk," which defined benefit pension plans are required to assess and monitor.
Learning from both U.S. and U.K. corporate failures, the new British regulator recognized the following, seemingly self-evident, but until then ignored risk: "a pension is only as secure as the business or public body standing behind it." On both sides of the Atlantic, the systems were premised on the assumption that companies were longstanding and enduring institutions that didn't fail. Sponsors' vulnerability to ever changing commercial markets was not properly understood. With the benefit of hindsight, it now seems quite obvious that businesses and public bodies can (and do) fail and with them, their pension plans. This creates intergenerational issues, as retired members get what they can from the residual pots but current active employees have no pension and no job — a double whammy.
So, for more than a decade now the U.K. regulatory regime has included the need for plans to assess and monitor the strength of their employer covenant. Large accountants and specialist covenant firms provide U.K. plans and sponsors with ongoing analysis of the credit risk being run with a given sponsor and advice on how to manage it.
What's the problem?
Whether you are a Fortune 100 company or a mom-and-pop corner shop, all U.S. pension plans are treated the same. They fund to the same standard and take as much investment risk as they like, irrespective of whether the sponsor can absorb the results of poor outcomes. Consequently, the U.S. system is carrying billions of dollars of embedded and unexamined credit risk.
A recent trip to Washington revealed this inconvenient truth — there is widespread recognition in the U.S. pension industry of the impending failure of the defined benefit system. As many notable commentators further revealed privately — the next five to 10 years will see many DB plans simply run out of money and collapse. Many believe the PBGC itself will be swamped and unable to cope with the rate of systemic failure in the system as it crystallizes. Unchecked, this could cause a financial crisis worse than that experienced following the 2008 sub-prime collapse.
Whether it's U.S. corporate, multiemployer union, multiple employer, or city or state plans, many are (compared to their U.K. counterparts) generally very poorly funded, overly reliant on investment returns (rather than corporate contributions) and, the funding position bears no relation to the credit quality of the sponsor supporting the scheme.
A consequence of the U.K. regime considering covenant, where the U.S. regime doesn't, is that U.K. plans are ensuring participants of British plans are higher in the pecking order than their U.S. counterparts, should things go wrong for the businesses, through securing guarantees and other forms of financial security.
Since 2005, the U.K. defined benefit market place has had to adapt and put sponsor covenant risk at the heart of risk management and pension plan funding negotiations — whether as part of a triennial valuation cycle, a merger or acquisition, a restructuring transaction affecting the covenant, or as part of a compromise of the benefits where there is no viable alternative.
Leading up to the sub-prime collapse, banks lent to consumers who couldn't afford to repay the debt. The irony is that, if you view a pension as deferred pay, then pension plan participants are potentially lending to corporations that can't afford to repay those debts. If things go wrong, will pension funds be bailed out in the way many banks were?
Unfortunately, despite the overwhelming body of evidence supporting the need to consider sponsor risk, it will require a change to the current U.S. regime, and we understand there is little political appetite at this time. Sadly, we expect it will likely take a U.S. version of a recent well-publicized U.K. case, BHS, for politicians to take note and revisit ERISA, as they did following Studebaker.
It's good to discuss these issues now so that if a BHS-equivalent crisis happens in the U.S., well-pondered measures can be introduced swiftly. At least something good would then emerge out of such a situation.
We therefore predict, in time, the fact that a pension plan must consider the covenant of the business or public body sponsoring it will become as accepted and commonplace in the U.S. as it is in the U.K. You heard that first here, too.
Darren Redmayne is CEO and Richard Farr is managing director, Lincoln Pensions. This content represents the views of the authors. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.