Pensions White Paper? Boring. Here's the story of one FD whose business nearly went under thanks to today’s crazy pensions landscape.

Until April this year, John Buckley was FD of leather maker Pittards. You might remember him: he was profiled in the July/August 2002 edition of Real Finance. The leather business is tough and unpredictable, he told us; the company was investing in some sophisticated R&D and marketing to help it succeed. But there were many external factors that were difficult to deal with.

Here’s how we recorded his preparations for the next board meeting. “Pittards’ pension scheme is under review. ‘We are aware of what other companies are doing, and you’ll notice from the accounts that our FRS17 numbers weren’t terribly flattering,’ he says. But Pittards has a strong family ethos. ‘We pay medium to lower-quartile salaries but manage to find 300 people to work for us,’ he says. ‘That’s why the pension scheme isn’t something we give up lightly.’ Buckley won’t say what conclusion the board has come to, but it looks likely that the defined benefit scheme will go. ‘We’re not doing it as a cynical exercise to save money,’ says Buckley. ‘We just need to reduce our exposure to the volatile impact of FRS17 on the balance sheet.’”

The DB pension scheme did indeed close in September 2002. But that wasn’t enough: in May this year the scheme was passed over to the Pension Protection Fund (PPF). It was only thanks to some pretty skilled deal-doing by management, and some very understanding shareholders, that the pension fund deficit that emerged between the time we visited Buckley and the end of last year didn’t bring the whole company down.

Pittards continues to trade; jobs have been saved and the company’s scheme members will get 90 per cent of their pensions. But lest you think this is a tale of negligence or mis-management, we’ll begin the story in 2000, when Pittards had one of its triennial pension fund valuations.

“The scheme was fully funded when the actuaries looked at it,” says Buckley, speaking last month. “Liabilities were projected to grow by five per cent a year, but they told us a fair assumption was that equities would grow 7.5 per cent annually.”

But even based on these extremely benign numbers, by 2002 Buckley could sense there was trouble brewing. Five years earlier, Gordon Brown’s decision to tax pensions’ dividend income had spelled trouble (70 per cent of the Pittards fund was in equities) and now FRS17 was starting to bite. Hence his concern by 2002 that the point-in-time valuations for the scheme’s deficit could be a problem. Equities were on the slide by then, and DB schemes had started to fall out of favour.

Buckley and the team decided they had to act. “To their credit the employees went along with us closing the scheme, not just to new members, but to all future accruals,” he says. “We recommended that we move to a defined contribution scheme, but in 2002 that just looked like a step too far. So we compromised on a career average scheme, and new employees only had the option to go into a DC scheme.”

At about this time, the board also recognised that the company and the trustees needed to take separate advice. “We realised that the interests of the two different bodies were in conflict,” says the former FD. “The advice we took suggested there was no obvious solution to the problem. There were various things we could try and our advisers also identified the ‘nuclear option’ which at that time was coming to some kind of compromise with the trustees. But that would have been horrendously difficult to do because of the trustees’ duties.”

But despite taking this action early on (many companies persisted with DB schemes far longer and didn’t address the conflict of interest), there was more bad news to come. The next actuarial valuation almost exactly coincided with the bottom of the market in March 2003 – the 2000 valuation, remember, had taken place at the top of the bull run. Result? A deficit of around £20m – for a supporting company with a market cap of about £11m; Pittards’ net assets were about £20m.

“After the 2003 valuation, we knew what our contribution needed to be – we had to double it from £1.2m to £2.5m,” says Buckley. “And the business really wasn’t earning enough – that’s cash out, remember, so there was precious little left for investment, and investment is what we needed in order to remain competitive.”

Pittards immediately stopped consenting to early retirement and increased employee contributions by a third. “And with employer contributions doubled, we were effectively paying the same into the career average scheme as we used to pay into the final salary scheme – and we had to pay about £1.2m a year off the pension deficit, too,” says Buckley.

The fundamentals were starting to cause real concern. “The company, along with the rest of the leather industry, had been contracting rather than growing,” he says. “So we had a pension scheme that had 2,500 members, but we were down to 500 or 600 active employees. And the business was going through a difficult time, particularly since the dollar devalued by about 15 per cent in the last quarter of 2003 and over half our revenues are in dollars.”

And while in 2000 the actuaries had been fairly breezy about the growth in both assets and liabilities (although that 7.5 per cent forecast for annual growth in equities had turned into a 21.5 per cent loss three years later), in 2003 they were making the situation worse. “It was a nightmare – and nobody in the industry could offer you any sort of solution,” says Buckley. “The actuaries’ response was particularly poor. There was a general feeling that the actuaries had served us all very badly: they’d engaged in an overcompensation so that nobody would ever be able to accuse them of underestimating the problem again. It seemed they were almost conjuring up ever worse ways of evaluating the deficit just to be sure.”

To illustrate the problem, Buckley cites the different ways the Pittards scheme could have been valued. Under the Minimum Funding Requirement, it would have been short by £11.8m. FRS17 would have seen a £32m deficit on the books. Under the PPF’s own calculations, there was a £45m shortfall. And if Pittards had wanted to wind up the scheme, it would have cost the company about £100m.

“As an FD I’m more financially sophisticated,” says Buckley. “But imagine trying to explain this to your employees and your fellow trustees. We’d been doing everything by the book, so more than a third of trustees were nominated by the members, three were nominated by the company, there was a pensioner plus an independent chairman. It was tricky.”

Things took a turn for the worse with the passing into law of the Pensions Act 2004. “That really brought matters to a head,” says the former FD. “It didn’t come into effect until April 2005, but the Pensions Regulator [TPR] let it be known that he wasn’t having any of this 15 or 20 years to pay off your pension deficit – it was going to be seven, or at best ten, years. And as well as TPR, the act introduced the PPF. With a PPF-basis deficit of £45m and ten years to pay it off, our payments were going to more than double again to £5m-plus, and with the initial indications of where the risk-based levy was going to be, we thought we are going to be in for £500,000 on that as well.”

The one glimmer of hope? While the “nuclear option” in 2003 had been some kind of wind-up deal with the trustees (a fairly horrific prospect for a management that placed such a big emphasis on taking care of its staff), at least the PPF meant that if the worst happened, the pensioners and deferred members would be largely covered.
“Just do the maths: if we were going to contribute £5m a year to close the deficit, plus whatever the PPF levy was, it was going to drive us out of business,” he says. “You are duty-bound to notify TPR when you’ve got a problem – so we did, and we prepared a document that said that based on our cash flow forecast and business plan, we could not sustain the pension.”

This was autumn last year – and suddenly things started moving quickly. “It is to the great credit of their set-up how swiftly things moved and how professional the people we dealt with were,” says Buckley. “They asked us a few questions – they wanted to check that we had approached the thing professionally and objectively. In fact I found myself hopelessly conflicted in the middle of 2005: I was a shareholder, I was FD, I was a member of the pension scheme and I was a trustee – and those are incompatible in my book. So I resigned as a trustee, I withdrew from the pension scheme and we did what proved to be the smartest move of all, which was to appoint an independent corporate trustee to replace me.” All great advice for any FD in this situation…

Pittards turned to an appointee from Independent Trustee Services (ITS), a division of Jardine Lloyd Thompson specialising in this kind of expertise. “He’s an absolute star,” says Buckley. “Apart from anything else he has the respect of the regulator and the PPF – and that’s all-important. The fact that we had an independent trustee and both the trustees and the company were independently advised ticked important boxes with the regulator.”

The pitch to the regulator, then, at the start of December 2005? Without some kind of resolution to the pension problem, the company was going under. TPR agreed to pass Pittards’ case over to the PPF immediately. “By mid-December we were sitting across the table from a representative of the PPF and within four weeks of that – including Christmas – we got a basic deal structured,” says the former FD.

Buckley is at pains to point out that the PPF, itself heavily scrutinised, doesn’t do any deal without being sure it works for the fund and for the pensioners it’s designed to protect. “But I got the feeling that they were well prepared for our sort of situation, because we are far from unique. The numbers spoke for themselves. We said if we went into receivership and the parts of the business were sold as a going concern, there would be £1m left for unsecured creditors – 90 per cent of whom was the pension fund.”

That’s important. The PPF needs to work out how much cash the company can afford to pump into the scheme if it takes over. After some negotiation, Pittards agreed to a £1.6m cash payment. The PPF also agreed to take a chunk of the company’s equity. “If the money is coming from the existing shareholders, they look to take a third of the enlarged equity at the end of the day,” says Buckley. “If it’s new money, they look to take ten per cent” – presumably to reflect the fact that a new shareholder has made a commitment – “but it wasn’t immediately obvious where the £1.6m could come from. So we were fortunate in finding a new investor.”

This was Peter Gyllenhammar, who paid £2m for a 65 per cent stake in the company – which meant the PPF would take a hybrid position: an 18.5 per cent stake. “That left 16.5 per cent of the equity for the shareholders,” says the former FD. “The preference shareholders got 6.6 per cent and the ordinary shareholders got 9.9 per cent – so that was effectively a dilution of 90 per cent for the ords.”

Pittards had to go through a form of insolvency to qualify for PPF protection, and that’s where the Company Voluntary Arrangement (CVA), in March, came in. It also ensured all of Pittards creditors, with the exception of the pension scheme, got paid. That was crucial to ensuring the company could continue to trade. “The CVA was unanimously approved by creditors and shareholders; part two was to go to shareholders for approval of the fundraising exercise in order to deliver the deal,” says Buckley.

That was tougher. “There was a bit of a rearguard action, I guess, in the hope that we would renegotiate and maybe look to them for some alternative way of raising the funds,” he says. “But they recognised that actually there simply wasn’t the time to do it, to bash out a deal with them and then go through the time-consuming and costly rigmarole of circulars for a share issue. Thankfully, at the vote, everybody came into line.”

It was close: at one point it looked like some of the shareholders had voted down the deal. But with just hours to go, they changed their minds and OK-ed it. It wasn’t easy – and the management’s case was probably helped by a vigorous campaign by the Western Daily Press to get shareholders to vote for the deal and save local jobs. “And our employees have been fantastic through this,” says Buckley. “We have had regular briefing meetings, the unions were absolutely on-side and they have been very understanding and helpful.”

So this drama, that took the best part of ten years to unfold, was finally resolved at the eleventh hour on Friday, May 12. How did Buckley feel as the saga came to a close? “I was encouraged from the moment that we went to see the regulator that there was a solution here, there was a will to prevent the worthwhile parts of the company going under,” he says. And on that final day? “Fantastic!”

In March, on the eve of the CVA, the shares stood at 7.5p and the market capitalisation at £1.6m; when the shares came back from suspension on May 22, they closed at 6p and the enlarged share capital was valued at £13.4m. A great result.

Buckley’s final word of advice if you’re dealing with a pensions problem? “My guiding principle throughout has always been the best interests of the company and its stakeholders,” he says. “It’s very dangerous to err from that balanced view; it’s an absolute minefield if you are any less than totally objective and appear to favour one particular group of stakeholders.” Even-handed to the end – the FD’s natural state.

Is your pension at risk from Dun & Bradstreet?

John Buckley’s story perfectly illustrates the challenges facing FDs of companies with DB pensions – and highlights some of the things you can do about them. But coincidentally, we had an email from another FD last month warning about yet another new danger. He writes: “We were disappointed to find that our Dun & Bradstreet rating went down after we published our 2005 accounts. Our pension deficit was lower this year, and our balance sheet had got slightly stronger against the previous year, restated for FRS17.

“I spoke to a representative from D&B who explained why our rating had been reduced. Basically, D&B compares the balance sheet from year to year, but despite the fact that we have reported our FRS17 deficit in the notes to accounts for the past three years, they don’t take it into account until you adopt FRS17 fully, on the actual balance sheet itself. So, they were comparing our balance sheet for 2004 without the FRS17 deficit with our balance sheet for 2005 with the deficit, giving us a higher risk this year – even though in practice we have a lower risk than 2004.

“You may think that all this means is that 2004 D&B risk scores were artificially low, and that they are now correct, so no problem.

“But D&B is the ‘chosen one’, on whose risk ratings the Pensions Regulator will set the PPF risk-based levy for each company. Many will not have implemented FRS17 when the regulator set the base-line levy, so they’ll now be rated on an artificially high risk rating. During the coming year, everyone will either be reporting with FRS17, or the comparable IFRS, so all companies with a pension deficit will see their risk rating get worse.

“This will mean an automatic, and massive, increases in the risk-based levy for UK plc as a whole. A fundamental flaw in analysing the strength of a business, I would have thought, particularly when the purpose for which the ratings will be used is related to the deficit – the very factor not taken into account in those ratings! We are quite fortunate, in that our risk rating is pretty good. But the fact that it has got worse from the base level means a higher levy next year anyway…”

This FD is waiting for further information on the situation from the regulator, but it’s worth pointing out that many companies will face penalties for a poorer D&B rating othet than simply paying a higher PPF levy. Debt covenants, for example, may be affected, not because the underlying strength of the balance sheet is worse, but because the pension is hitting the balance sheet for the first time. Not good.

Please get in touch if you can help clarify the situation – or if you’ve had a similar experience to this FD. All replies will be treated in full confidence if you email catherine@realfd.net

Key lessons from the Pittards rescue

After we interviewed John Buckley about his experiences, we offered him a suggestion of our own: having coped with a real pensions nightmare (it’s a word too easily bandied around these days) and helped engineer a fix to suit all stakeholders, he should become a consultant for other FDs. He demurred, so although we’ll happily pass on any of your thoughts or questions to him via catherine@realfd.net, we’ve boiled down his experiences to the following pointers that might help those of you with pensions problems.

Get great advice. The pensions industry hasn’t been brilliant in finding solutions to the DB crisis, but trying to handle the incredible stress of a scheme in trouble on your own is not smart.

Separate yourself from the scheme. As FD, and as a management team, you need to be able to show the trustees are acting in the best interests of pensioners and you are acting in the best interests of all the stakeholders. Trustees and management should also have separate sources of advice.

Keep talking. Well-informed and well-motivated employees (many of whom will be scheme members) will be more willing to help out if they understand the complete picture. That’s crucial both in terms of scheme decisions and those that might protect the ongoing survival of the business.

Aim for a win-win scenario. Trustees are required to be single-minded, but as FD you need to look at all the stakeholders – staff, shareholders, suppliers and customers.

Tags: john buckley, frs 17, pensions, deficit, pittards,

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