Letter number 94 of May 2016
- QUESTIONS & COMMENTS
First of all, let’s remember that there are two types of pension obligations:
- defined contributions schemes under which the company undertakes to contribute a certain amount every year to build up a pension for the employee (these amounts are then invested until the employee retires for funded pension schemes, or paid out to pensioners for pay-as-you-go schemes). So the employee doesn’t know how much he/she will get on retirement (this depends on the success of the investments made by the funds that manage these pensions). These types of schemes are not recorded as liabilities on a company’s balance sheet but simply as an expense resulting from a cash pay-out;
- defined benefits schemes under which the company undertakes to pay the employee, on retirement, a percentage of his/her final salary (or an average of his/her salaries). The company can, prior to the retirement of its employees, invest in assets which will be liquidated as the pensions are paid. But it is not obliged to do so in all countries. Moreover, the commitment made by the company depends on the life expectancy of the future pensioner and the number of years spent in the company. In this case, the company will record a provision that reflects the estimation of the present value of pensions to be paid following deduction of the value of hedging assets in which the company has invested.
Provisions for pension obligations can represent substantial amounts: $3.8bn for Total, €8.5bn for Deutsche Telekom, $21.6bn for General Motors). Overall, in the United Kingdom, pension deficit reached £244bn in 2015 (£1 298bn in assets compared to £1 542bn in obligations). In the United States, the pension deficit for the 100 companies with the largest deficits reached $326bn in 2014.
Although these pension deficits can be considered as financial debt for financial analysis and valuation, for the financial director, they have a clearly accounting nature: today, no financial institution or investor would lend these amounts. In fact, it’s the employees who do so!
A recurrent and complex question for the financial director who has to manage a large amount in pension obligations is to know whether it would be best for the company cover this deficit in the short term or not, or even (this is sometimes possible) to ask an insurer to take the place of the company for these obligations.
The possible options
- Do nothing… and live with the deficit. The cash requirements will materialise when the employees take retirement. For a relatively young company, this is certainly not an absurd way of looking at it.
- Gradually fill the deficit from year to year. Note that exceptional contributions made to fill the deficit are set off directly against equity capital and are not booked as an expense on the income statement. Some countries have laws that require the deficit to be filled over a certain period (7 years in the United States for example).
- Borrow in order to fill the deficit immediately.
- Transfer, in exchange for a cash payment, all or part of the obligations to an insurance company which will replace the company for payment of the pensions. In practice, this option is only possible for fixed benefit schemes. Insurers are more at ease with the “acquisition” » only of employees who are already retired (but they may account for a large part of the obligations of industrial groups)
- Only transfer the risk of changes to mortality tables using longevity swaps.
- Close the plan to new entrants and halt any new benefits for employees already in the plan. This way the obligations will be frozen (except for the percentage of employees who do stay in the company until they retire). Obviously, compensation will have to be offered to employees (generally a defined contribution plan). In the United Kingdom, 34% of pension plans are frozen. In 2015, US Steel decided to freeze the acquisition of new benefits in its plans (which had already been closed to new entrants since 2003). … At least close the plans to new entrants (by offering new employees a defined contribution plan) which will solve the problem, at least in the medium term! In the United Kingdom half of all pension plans are closed to new entrants.
Criteria to be taken into account
Options open for dealing with pension liabilities and the best option for managing them depend on the situation of each company:
- in which country does the company have defined benefits? Depending on the geographies, the tax and legal parameters (ability to close plans, obligation to compensate employees, deductibility of contributions, tax on deficits) will be different, but so will the sophistication of investors (for example longevity swaps are frequent in the United Kingdom and the Netherlands but still extremely rare in France);
- are open plans open to new entrants?
- are plans closed in terms of accumulating new benefits for employees already in the plans?
- what is the proportion of pensioners in the plans?
These criteria will influence the appetite of insurance companies for taking on all or part of these obligations. This appetite will materialise in line with their willingness to do so or not and on the amount of the payment they will require (which can go from 100% of the book value to over 150% of the book value)
Moreover, the company will be sensitive to:
- the capacity to raise financing
- whether third parties (rating agencies, analysts, investors) take these obligations into account or not.
Below is a list of the arguments on both sides:
- Arguments for transferring liabilities
Get rid of risks that the company doesn’t know how to manage. The value of pension obligations on the balance sheet will vary in line with mortality tables, the financial performance of the markets, interest rates, the company’s compensation policy, the number of years employees stay in the company, etc. Some of these risks form part of the company’s activity (HR policy for example), and others are imposed without the company having any leverage. In extreme cases, where the company transfers all of its risks to an insurance company (which will accept this in exchange for a payment of course), the company can concentrate on its operations without its financial performances being impacted by, for example, greater life expectancy.
Benefit from economies of scale. Here again, if the option chosen is to outsource the obligation to an insurance company, the latter will aggregate the obligations of several companies.
Reduce the tax burden (especially in the United States). The US authorities levy a tax of 3% (this rate is revised regularly, upwards, and could reach 4% in 2019) on US pension deficits. Which is a good incentive for filling the deficit.
Demonstrate pro-active management of the company’s obligations. Both in terms of shareholders and creditors (largely represented by rating agencies) a pro-active and transparent management of pension obligations demonstrates awareness of the importance of the matter for the company.
Improve the appearance of financial performances. Pension obligations are booked partly as personnel expense (acquisition of new rights, plan expenses) and partly as financial expense (“accretion” i.e. record one year less in the calculation of net present value). Thinking it was going to get rid of a plan which was open to the acquisition of new benefits, the company would be transforming personnel expense into financial expense (on the debt raised to finance the transfer of the obligations) which would result in an improved EBITDA. But this is a bit theoretical as insurers are not prepared to take on open plans or plans that entitle members to new benefits.
- Arguments for maintaining the status quo
To avoid reducing the company’s debt period. Pension obligations are very long term obligations. Replacing them with a debt that is necessarily more short term (in Europe in any case, where bank debts rarely exceed 5 years and bond debts 15 years) will thus reduce the average duration of the company’s debt (in as far as analysts will effectively restate it as debt!).
Avoid imposing, de facto, a restatement that has not been performed by all analysts / investors. It’s certainly regrettable, but not all analysts and all investors have read the Vernimmen and some do not restate pension obligations as debt. Replacing a provision with a financial debt highlights this matter which some may have forgotten or ignored.
The topic of pension obligations is highly technical and requires an understanding of a number of very diverse fields (accounting, tax, company law, HR management, etc.). This is enough to put off more than one financial director. But given the amounts at stake, it would be unconscionable to ignore them. Accordingly, it would be a very good idea to carry out an in-depth study of each plan and what options can be envisaged.
 In France the obligation ends when the employee leaves the company, in most other countries, the obligation is weighted by the number of years (in relation to the whole career) that the employee spends in the company
 See chapter 7 of the Vernimmen
 This is a rather unfortunate term given that insurers get paid for taking on these obligations
Not as volatile as may be be expected. But do not forget that constituents of the MSCI index are among the most efficient listed companies. Moreover a global index smoothes out individual or sectorial gyrations.
By David Le Bris, lecturer-researcher at the Toulouse Business School and Sébastien Pouget, professor at the University of Toulouse 1 Capitole (IAE and TSE)
This year, Yale University Press published The Origins of Corporations. The Mills of Toulouse in the Middle Ages, the translation of a History of Law thesis submitted by Germain Sicard in 1952. A French thesis translated into English is something rare. That this should happen 60 years after it was submitted is quite exceptional!! It has to be said that this thesis turns our understanding of economic history on its head.
It is Holland, or even England that claims, not without pride, paternity over the first real joint stock companies with the various Indies companies that appeared in around 1600. But Sicard brilliantly set out how perfectly modern joint stock companies were formed three centuries before to manage a private activity - the grain mills on the Garonne in Toulouse.
Sicard provides details on the genesis of two authentic medieval companies. Adherents of Roman law, the law of succession was not implemented in the Midi, which resulted in the creation of legal structures called pariage, which made it possible for an asset to be collectively owned. Introduced initially in order to ensure equal inheritances, the technique of pariage was subsequently used in a number of different contexts. The most famous of them is Andorra, co-administered by the Count of Foix, whose heir is the President of France. In Toulouse, pariages were formed as early as the 12th century to manage the mills on the Garonne.
Hundreds of owners (pariers) owned shares (uchaux) in the various mills located in three different parts of the town. Progressively, the expenses common to the mills of having a stand (street running along the river, proceedings) became onerous, encouraging owners to modify the initial associations. In 1194, a mutual insurance agreement was signed among the owners to rebuild any mill, using common funds, that might be destroyed, and then different forms of temporary associations were tried out. In 1372, a company, Honor del molis del Bazacle was definitively set up; its 3-metre long foundation charter is still kept in the archives. After centuries of milling, the company converted to electricity production in 1888. It went on to be listed on the Toulouse stock exchange and then the Paris stock exchange, until it was nationalised in 1946 when EDF was created.
Will Goetzmann and I relied on this extraordinary thesis in order to complete the series of share prices and dividends for the Bazacle mill collecting series that were virtually complete from 1530 to 1946. The first results show a dividend rate of 5% with capital gains close to zero over the long term, despite high volatility of share prices due to the volatility of wheat but also to destruction resulting from flooding. The real value of the dividend observed between the first and World War II is practically identical to that received by a shareholder in the early 16th century. We also show that share prices are consistent with expectations of future flows, which validates the theory of present value, a fundamental financial theory but one which is seldom verified empirically. These future flows are discounted at a rate that varies in concert with macro-economic and climatological variables, such as the summer temperature (measured approximately on the basis of the harvest dates in Burgundy). Notwithstanding the risk of a disaster, there was not an excessive risk premium, unlike what has been observed more recently (equity premium puzzle).
In a second paper, we show how these mills resolved the problems inherent to the separation between ownership and actual control over a company. The problems of governance were central for this mills – melior gubernatione is the first reason raised in the setting up of Bazacle in 1372! From the outset, shareholders enjoyed limited liability. In 1427 and then in 1587, the articles of association set out in detail how management is delegated by the shareholders to different agents, of which a CEO, called Conterôlle, who has actual control over the company, and a treasurer who is independent from the latter. The moral hazard resulting from the delegation is limited, thanks to the fact that the company is prohibited from accumulating financial reserves and from using explicit incentives (a fraction of the profits is paid to employees) and implicit incentives (employees are required to swear an oath).
Additionally, the shareholders monitor activities attentively. An annual general meeting (Cosselh general dels senhors paries am gran deliberacio) is held for taking major decisions, passed by majority vote of shareholders present. As early as 1390, eight shareholders were appointed every year to make up a board of directors to supervise the company’s activities and two others for auditing the accounts. Finally, institutional investors formalise their supervision, like the Mirepoix University College which sets out in its articles of association of 1423 the manner in which its investments in the uchaux of Toulouse were to be monitored.
So the governance solutions developed by these mills since the Middle Ages are very similar to those seen today at contemporary joint stock companies. These solutions were arrived at through ordinary private contracts, whereas the Indies companies only emerged thanks to government support. This shows that the joint stock company is suitable for different economic contexts and is able to emerge as soon as certain institutional conditions are met, starting with well-established rights.
Accordingly, contrary to popular belief, we show that ownership rights have been in existence since the 12th century in Toulouse. Shareholders, whether they were ordinary shopkeepers, religious institutions or even the King of France, are on a strictly equal footing. They stood up to various attempts at expropriation which only succeeded in the 20th century. So, the conceptual tools that enabled the development of the joint stock company have been present in certain parts of Western Europe since the Middle Ages. This overturns the genealogy, widely accepted since the work of North, of an institutional revolution in the north of Europe which led to the Industrial Revolution. The joint stock company has existed since the Middle Ages but it did not result in a decisive economic take off.
Le Bris D., Goetzmann W. and Pouget S. (2015) Testing Asset Pricing Theory on Six Hundred Years of Stock Returns: Prices and Dividends for the Bazacle Company from 1372 to 1946, NBER Working Paper, wp. 20199.
Le Bris D., Goetzmann W. and Pouget S. (2015) The Development of Corporate Governance in Toulouse, NBER Working Paper, wp. 21335.
Sicard G. (2015) The Origins of Corporations. New Haven, Yale University Press
Over time, we have collected hundreds of quotes related to finance, or more generally to the economy, and we display one of them every day on the vernimmen.com website.
Can you guess who said:
Money is like manure. You have to spread it around or it smells.
The purpose of the company is not solely the production of profit, but the very existence of the company as a community of people who are seeking the satisfaction of their basic needs.
Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.
The Antarctic offshore fund was my big mistake ... Now my assets are completely frozen.
Putting the money to good use is a better value for shareholders than paying a dividend.
Any fool can buy a company - the time for congratulations is when you exit a company.
Owners of things are owned by the things that they own.
There is only one reason a stock is being offered at a bargain price: because other people are selling. There is no other reason. To get a bargain price you have to look where the public is most frightened and pessimistic.
A million dollars isn't cool. You know what's cool? A billion dollars.
Anything that has a price is of little value.
Contrary to the widely held perception, derivatives have made the world a safer place, not a more dangerous one.
What is my financial strategy? That my grand-children should be proud of me.
- Warren Buffett
- Charles de Gaulle
- Jean-Louis Dumas
- Albert Einstein
- a Financial Times joke
- John Paul II
- John Paul Getty
- Henry Kravis
- Merton Miller
- Friedrich Nietzsche
- Sean Parker
- John Templeton
In case you have forgotten, Jean-Louis Dumas was the CEO and owner of Hermès, John Paul Getty was an oil billionaire, Henry Kravis co-founded the LBO fund KKR, Sean Parker co-founded Napster and became an early investor in Facebook, and John Templeton was a legendary stock investor. And if you don’t know who Merton Miller is, you should re-read chapters 32 and 33 of the Vernimmen.
Money is like manure. You have to spread it around or it smells. John Paul Getty
The purpose of the company is not solely the production of profit, but the very existence of the company as a community of people who are seeking the satisfaction of their basic needs. John Paul II
Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it. Albert Einstein
The Antarctic offshore fund was my big mistake ... Now my assets are completely frozen. a Financial Times joke
Putting the money to good use is a better value for shareholders than paying a dividend. Warren Buffett
Any fool can buy a company - the time for congratulations is when you exit a company. Henry Kravis
Owners of things are owned by the things that they own. Charles de Gaulle
There is only one reason a stock is being offered at a bargain price: because other people are selling. There is no other reason. To get a bargain price you have to look where the public is most frightened and pessimistic. John Templeton
A million dollars isn't cool. You know what's cool? A billion dollars. Sean Parker
Anything that has a price is of little value. Friedrich Nietzsche
Contrary to the widely held perception, derivatives have made the world a safer place, not a more dangerous one. Merton Miller
What is my financial strategy? That my grand-children should be proud of me. Jean-Louis Dumas