Carillion highlights the many problems of credit crunch era pension financing

by Shaun Richards
This morning’s news brings us back to a problem which has dogged the credit crunch era. The advent of first official interest-rate cuts and then central bank balance sheet expansion was designed to pull economic demand from the future to the present. This poses an issue for pensions as it does for all long-term savings contracts as they rely on the future. The issue has become clearest when we look at a consequence of the widespread monetary easing which was reflected in a question on Thursday to ECB ( European Central Bank) President Mario Draghi which mentioned “10 Trillion” dollars of negative yielding bonds. If you start doing any sort of maths you find that the negative yields imply you will be getting less back in the future than you pay in now and that is before you factor in the impact of inflation. Who invests to make a loss?
Putting it another way here are the real yields as of today from Germany. Not what economics 101 would predict for am economy in a boom is it?

Just for clarity some of the nominal yields are negative as shown in the chart but even when they go positive they are negative if we allow for inflation prospects and estimate a real yield.
This reflects the conceptual issue as we note that its business model was to take advantage of the era of monetary easing. Take a look at this from the House of Commons Briefing Paper.

Over the eight years from December 2009 to January 2018, the total owed by Carillion in loans increased from £242 million to an estimated £1.3 billion – more than five times the value at the beginning of the decade.

So it was able to borrow on a large-scale as we note an effect of these times which is often forgotten. Not only did it become cheaper to borrow for many purposes but there was an availability of credit meaning that Carillion could borrow ever more as well as cheaply. As an aside the banks would no doubt have been happy to make some business lending but as I reported many years ago now about Japan you don’t always get the sort of business lending you want as we note what it did with it.

In the eight years from 2009 to 2016, Carillion paid out £554 million in dividends, almost as much as the cash it made from operations. In the five years from 2012 to 2016, Carillion paid out £217 million more in dividends than it generated in cash from its operations.

Now let us skip to the pensions situation.

Carillion has 13 UK defined benefit pension schemes with 27,000 members. In January 2018, the trustees estimated that the schemes’ Pension Protection Fund (PPF) deficit (the shortfall compared to what is needed to pay PPF compensation levels) was up to £900 million

So shareholders got dividends and we know the directors were well paid and were able to think of the future. From the Financial Times.

Allowing clawback conditions to be changed a year ago, striking out corporate failure as a reason to take back bonuses.

Yet they were somewhat more forgetful about the futures of others.
When did this start?
Rather concerningly the problems were long-standing. From Josephine Cumbo in the Financial Times.

In written evidence to the Committee, Robin Ellison, chair of Carillion pension scheme trustees, said the trustees had tried to agree higher funding contributions from the company in 2008, 2011 and 2013.

Even worse there are higher estimates of the problem emerging from the woodwork.

In his letter to the committee, Mr Ellison revealed that the funding shortfall for five of the six Carillion pension funds he chairs widened from £508m in 2013 to around £990m in 2016 when measured on a “technical provisions” basis. This is the measure used to set contributions from the employer every three years. However, the “buyout” deficit, or the measure used by the Pension Protection Fund to value a creditor claim for the pension debt, is nearer £2bn according to Mr Ellison.

This brings us to the subject of the regulator as we wonder what it has been doing over the past decade?

On Monday, the Work and Pensions Select Committee published new evidence claiming that the Pension Regulator (TPR) was alerted to problems with the company’s main pension plans as long ago as in 2008, when the scheme’s trustees and the company were locked in a funding dispute.

We seem to be back to the issue of who regulates the regulators as this looks like the behaviour of yet another paper tiger.
What is a pensions deficit?
In theory this is easy as it is simply an expected future shortfall. The problem is that more than a few variables are unknowable such as investment returns, inflation and interest-rates and yields in the future. The modern era started in 1997 with the Minimum Funding Requirement which had an impact on the markets I was working in/on at the time. From HM Parliament.

it appears to have created some extra demand in the long end of the gilts market, which may have contributed to the depression of yields.

This led to the view that one of the aims of the MFR was to support the Gilt market. Then another issue arose which has continued which is the use of yields to value pensions as only a year later there was a big change for dividend yields in pension funds.

the dividend yield is no longer a reliable measure of “value” for UK equities – this is partly due to the abolition of tax credits on UK dividends in the July 1997 Budget, which
has changed companies’ behaviour over profit distribution, and partly because investors are willing to value shares on future long-term expectations, despite the
absence of dividends or profits

More recently we have seen corporate bond yields used for pension deficits but this has brought its own problems as central banks have intervened here. Firstly by making them more attractive by cutting interest-rates then reinforcing it via balance sheet expansion via bond buying. Then explicitly by actually buying corporate bonds as the Bank of England did in August 2016 and less obviously via the ongoing ECB programme as UK companies do issue Euro denominated bonds.
The irony of all this is that if you had bought long-dated UK Gilts two decades ago you would have done really rather well especially if you sold to the “Sledgehammer” buying of the Bank of England as it sent the market to all time highs with its panic inspired move.
What about direct contribution pensions?
These are simply ones where you put money in ( and if lucky your employer does as well) and it is invested and you make or loss depending on how the investments do. This is different to the schemes above where the employer promises a return based on your salary or earnings. According to the Financial Times just over a week ago the costs here are not quite what we are told.

The total cost of investing in popular funds, including those run by Janus Henderson, BlackRock and Vanguard, is up to four times higher than first thought, FTfm can reveal today. The Mifid II trading rules, which came into force this month, have forced asset managers to disclose hidden charges.

Some care is needed as platform charges are not caused by the fund management group but there are charges which are far from transparent.
There is much here to consider. The concept of investing for the future is simple and yet the credit crunch era has made it more complicated. For example there was a time ( and no doubt regulatory rules still suggest it) that the safest investment was a government inflation or indexed linked bond. No we see a time when in the UK and Germany you are pretty much guaranteeing yourself a loss in real terms if you hold them to maturity. If we look at conventional bonds they yield so little there is no fat on the bone as real yields are hard to come by.
Ironically this will have benefited some as if you had been holding bonds over the ,long-term then you are quids ( Dollars, Euros,Yen) in as we have been in a bull market. More recently equities have joined that party but here is the rub. In my opinion central baking easing has helped drive this too as current investors/pensioners benefit from borrowing from future returns. The claimed “wealth effects” must make it harder to make money going forwards as we note that like in Japan zombie companies which is what we are increasingly looking at with Carillion were indeed propped up.
Meanwhile I would suggested that especially if we consider their student debt burden millennials are unlikely to be able to buy a home and invest in a pension simply by giving up takeaway coffee and avocado toast.
Also I am pleased to report that the spirit of Sir Humphrey Appleby is alive and kicking at the UK Pensions Regulator.

The Regulator said: “It is too early to comment on whether with different information we could or would have taken action in the past or whether we will take action in the future, based on any new information that comes to light.” ( h/t @JosephineCumbo )


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