LONDON - The Church of England's (pounds) 800 million ($1.27 billion) loss on its real estate holdings might have been a blessing in disguise.
That's because the discovery, initially made in 1992, has caused the church to realize it has really big problems: huge, previously undetermined liabilities for pensions and other clergy-related benefits that far outstrip the church's ability to finance them.
Currently, pension benefits, stipends for clergy and housing benefits all are financed out of a (pounds) 2.4 billion ($3.84 billion) church fund.
As a result, church and outside bodies are calling for creation of a separate pension fund for clergy, for trimming of benefit increases, and for dioceses to pick up the burden of funding future benefit accruals.
The problem for the church is huge. Unless current trends are halted, pension benefits eventually could swallow up virtually all of the central church's available income, leaving little or nothing for other church functions, according to a study by a church-appointed group.
The church's financial crisis already has led the Church Commissioners, the 94-member body overseeing the church's finances, to cut subsidies for stipends. Churches in the poorest parishes - in the inner cities and rural areas - already have shortages of clergy as gaps occur between appointments and ministers are assigned pastoral duties in multiple parishes. Ultimately, some of the poorest churches may be closed down as these subsidies are trimmed, warned a recent report from the House of Commons' Social Security Committee.
In the report, the Social Security Committee lambasted the Church Commissioners for overconcentrating assets in property, financing and borrowing money for speculative development, failing to oversee projects properly, disguising capital as income, and having inadequate accounting and reporting procedures.
From a peak of (pounds) 3 billion at the end of 1989, church assets declined 30% to (pounds) 2.1 billion in assets at the end of 1992. Assets had recovered to (pounds) 2.4 billion by the end of 1993, the most recently available figures, but only (pounds) 50 million of the gain was attributable to the real estate portfolio.
A statement from the Church Commissioners notes nearly all recommended changes in improving procedures, receiving external advice, and enhancing oversight. A new chief executive has taken charge, plus new posts for a deputy for finance and a real estate expert have been added.
High real estate exposure
The church's high concentration of assets in real estate - using a target of 50% in recent years but actually approaching 60% - has contributed heavily to the church's problems. The Financial Times newspaper first exposed the church's huge real estate losses three years ago.
As essentially a closed-end fund, with no new assets coming in, the church depends on its investment income to pay for clergy pensions, stipends, housing and other expenses. Plus, the church is barred from eroding its capital base to cover expenditures. This makes the high commitment to highly illiquid real estate questionable, according to the House of Commons committee.
The church historically has been a large landowner. When the church's real estate holdings were first valued in 1958, it was found 31% of assets were invested in property. That figure more than doubled to 66% in 1981, slipping to 48% in 1986, but rising once again to 59% in 1990.
This renewed commitment to real estate took the form of a major push into retail properties, reaching 38% of the property portfolio in 1988.
What's more, the Church Commissioners concentrated their retail holdings in a few very large projects. The biggest of them is the MetroCentre at Gateshead, the largest covered shopping center in Europe. Development costs totaled (pounds) 272 million, more than twice the original budget.
Still, the property has performed well, and the church recently put up for sale a long leasehold interest in the 2.2 million-square-foot mall. The church will retain 10% of MetroCentre's (pounds) 20 million per year income stream.
The sale of the leasehold may provide a much-needed boost to the church's assets. The problem is that the mall accounts for too high a proportion of the church's overall assets, officials have said.
The church has sold off other retail properties, as it pares down its real estate portfolio. A church spokeswoman declined to specify to what level the church seeks to reduce its real estate holdings.
The Ashford project
Much more troublesome was the Church Commissioners' purchase of a one-third interest in Ashford Great Park. Located near the mouth of the Channel Tunnel, the proposed development would have turned 1,500 acres of marshy farmland into a minitown with houses, a shopping center and a business park, the Social Security Committee report said.
Both of the commissioners' joint partners went belly up, forcing the church to bear the entire financing cost. Worse, the partners had been financed by church loans, thus eliminating their investment risk. "The best interpretation we can put on these activities is that they display unbelievable naivete," the House of Commons report said.
The commissioners have poured (pounds) 80 million into the Ashford project - before even obtaining planning approval for its first phase.
The entire future of the project now is in doubt; the church's 1993 accounts valued the site between (pounds) 1 million and (pounds) 10 million. The Social Security Committee urged the Archbishop of Canterbury, the head of the church, to appoint an independent investigator to study the fiasco. The archbishop instead has turned the task over to the church's newly appointed audit committee, which will be assisted by outside experts.
Coopers & Lybrand, in a 1993 study of the church's finances, noted the lack of clear policy or procedures to assess ability of development partners to carry out their roles, and the lack of adequate project appraisals. Reports to the church's assets committee also were inadequate, they found.
The church also borrowed money to finance its speculative developments. Bank loans totaled (pounds) 518 million at the end of 1990, or more than one-sixth of the church's entire investment portfolio. Interest rates significantly below market sometimes were used in appraisals, Coopers & Lybrand noted, making projected costs appear lower than in reality.
To inflate church income, the Church Commissioners employed questionable accounting practices, the accountants found.
Among other things, the commissioners used a series of subsidiary real estate development companies, whose fees were charged to capital while profits counted as income. Creating some 37 U.K. and U.S. subsidiaries also enabled the church to circumvent the 1985 Charities Act and avoid jeopardizing its tax-exempt status.
It took the commissioners six years to consolidate their accounts, which also boosted income.
Despite misgivings by the Church Commissioners' new chief executive, Sir Michael Coleman, the commissioners still engage in "coupon trading," a method of gilt stripping that accounts for profits on government bonds by receipts instead of on an accrual basis. The net effect was to increase income by 46.4 million in the past five years, and a consequent reduction in capital.
These methods of inflating income stem from a key difficulty for the church: during the 1980s, it made financial commitments far in excess of its ability to pay.
In the 10 years through 1991, the church increased clergy stipends 44% above retail price inflation, although only 2% over the U.K. average earnings index. Pensions were boosted 82% above RPI and 17% above the earnings index. In addition, the church agreed to finance additional housing benefits for clergy.
In fact, the need to meet these "ambitious expenditure commitments influenced investment policy toward development activities," the Coopers & Lybrand report said.
In a 1994 actuarial study, R. Watson & Sons, Reigate, found the commissioners' poor investments harmed the fund but were not the primary cause of the church's crisis. "The accumulating unrecognized liabilities can be likened to a time bomb waiting to go off: poor performance within the asset portfolio merely shortened the fuse," the study said.
But the Social Security Committee found the Church Commissioners' investment policy has "irreparably damaged" the church's investment income, threatening poor parishes and hurting the church's ability to increase pension benefits.
The annual cost of clergy pensions has been growing at the rate of 6 million a year, hitting 70 million in 1993 - nearly 45% of the church's total financial support.
Need for a pension fund
All parties, within and outside the church, agree on the need of creating a separate pension fund for clergy. What struck the committee is that financial projections of pension liabilities had not been made sooner.
Howard Gracey, chairman of the Church of England Pensions Board and Watsons' recently retired senior partner, had told the committee that no actuarial assessment of pension liabilities had been made prior to the crisis.
He explained: "There was no valuation of liabilities on a traditional actuarial assessment beyond back-of-envelope calculations which I have done myself to make sure there was not a silly situation."
A subsequent actuarial valuation carried out by Watsons (whose selection the report criticized for having a conflict of interest) suggested transferring 1.36 billion of church assets into a separate pension fund to cover projected benefits from accrued service. Annual contributions for future service would cost about 32 million a year, Watsons said.
Church officials suggest the actual figure transferred might be less, but the minimum amount needed to cover accrued benefits at current levels would be 770 million.
The responsibility for funding future accruals, however, will be passed on to dioceses and parishioners, and will be considered as part of the cost of employment.
The church recently put up for sale a long leasehold interest in the 2.2 million-square-foot MetroCentre.