Stagecoach says pensions a big risk to rail industry

Stagecoach Group shares were wavering above and below the waterline on Thursday morning, after the company provided further information on the approach it had taken on pension risks in its three most recent bids for UK rail franchises.

The FTSE 250 passenger transport company had been disqualified from those bids by the Department for Transport, with the board saying it was providing the information in light of “significant” media comment on the disqualifications and, in particular, on the issue of pensions.

It had announced on 10 April that it had been informed by the DfT that it had been disqualified from a total of three rail franchise bids.

Stagecoach had been shortlisted in three following franchise competitions - the East Midlands, where it was bidding independently; South Eastern, where it was bidding with support from its intended partner, Alstom; and the West Coast Partnership, where it was part of a joint bid with Virgin Group and French state railway operator SNCF.

“A senior Department for Transport official verbally advised that we had been excluded from all three competitions for submitting non-compliant bids, principally in respect of pensions risk,” the Stagecoach board said on Thursday.

“In our bids, we refused to accept the potential pension risks that the Department for Transport requires operators to bear in relation to the three new franchises.

“The full extent of these risks is unknown, but we estimate them to be well in excess of £1bn for the three franchises.”

Stagecoach explained that the Railways Pension Scheme (RPS) is a defined-benefit scheme split into a number of sections, including sections covering the franchised train operating companies.

Each section operates on a ‘shared cost’ basis, with the employer responsible for 60% of the total contributions payable to the scheme and the employees responsible for 40%.

Throughout the period of the privatised UK railway since the mid-1990s, a franchised train operator's obligation to RPS had been limited to paying the employer contributions due for the period of its franchise.

No train operator had thus far been held responsible for any scheme deficit remaining at the end of its franchise, Stagecoach noted, and nor had it had any entitlement to benefit from any scheme surplus at the end of the franchise.

“Since privatisation, the Department for Transport has had and continues to have a veto over train operating companies' decisions on RPS funding, benefit and contractual arrangements.”

It said the sections of RPS relating to franchised train operators had been funded on a long-term basis, with that funding approach determined by the RPS Trustee Board, with Stagecoach saying it “took comfort” from its understanding that the DfT effectively stood behind any RPS liabilities as each franchise ended.

“More recently, the Pensions Regulator has questioned that extent to which RPS does in fact benefit from that underpinning support from the Department for Transport.

“We understand that the Pensions Regulator considers there to be a deficit of up to £7.5bn across the franchised train operators and is seeking significant additional contributions to the scheme which are as yet unquantified.”

As a result, in the absence of any contractual protection, an operator of any new rail franchises could have an exposure to “substantial” additional pension contributions.

As yet, there had been no final determination by the trustees or the Pensions Regulator of the extent of the liability that would be borne by franchisees, Stagecoach noted.

While ultimately the DfT provided limited protection against the risk in the specification for the three current franchise competitions, the company said its assessment was it still left the successful operators with “substantial risk” which could not be assessed.

The DfT’s protection was limited to the 2019 scheme valuation only, so the train operator took the full risk of contribution increases arising from the 2022 and all subsequent valuations; as well as deficit contributions only, so the operator took the full risk of contributions in respect of contribution increases relating to ongoing employee service costs.

It was also limited to employer contributions only, so the operator took the risk that employees were unwilling to accept increased employee contributions leading to either industrial action or a need for the operator to fund the increases.

“In previous UK rail franchises, we accepted that each of our train operating companies bore the risk of increases in the pension contributions payable to RPS during the period of the applicable franchise.

“However, that was prior to the requests from the Pensions Regulator for substantial and not yet fully quantified increases in contributions to RPS.

“Therefore, in our more recent franchise bids, we took specialist actuarial advice.”

Stagecoach explained that, after “careful consideration” of the protection offered by the DfT, plus a review of potential downside scenarios, the outcomes showed that the potential additional cost and risk were “substantial”.

“We therefore, as a responsible business, included increases in pension costs in our bid forecasts and sought additional contractual protection beyond that offered.

“The additional contractual protection sought was to ensure that in the event a bid was successful, the relevant train operating company's exposure to increases in pension contributions to RPS would be limited to a manageable level which it would be reasonable for a train operator to bear should those circumstances arise.”

Notwithstanding the “significant increases” in pension costs included in its forecasts for the three bids and the contractual protection offered by the DfT, the pension risks remained “substantial”, Stagecoach said.

It outlined one downside scenario, reflecting a 20% fall in the value of pension scheme assets post-2019 and a reduction in the discount rate applied to liabilities from 5.7% to 2.7%, reflecting the views of the Pensions Regulator on private pension schemes more widely.

Based on that scenario, the additional cost in the bid would have been £81m for East Midlands, £167 for South Eastern, and £102m for the West Coast Partnership.

Further downside risks would have totalled £319m for East Midlands, £358m for South Eastern, and £589m for the West Coast Partnership.

Those figures represented undiscounted contributions over the expected lives of each franchise, and were in addition to risks covered by the contractual protection offered by the DfT.

“Notwithstanding the disqualifications, we continue to believe we were right not to accept the pensions position sought by the Department for Transport and that to have done so would have been to take on unknowable risk and been contrary to the success of the company and also contrary to the interests of employees, customers and the franchise.

“Our West Coast Partnership bidding partners, Virgin and SNCF, and Alstom - our proposed partner for South Eastern - supported those bidding positions.

“We also note media reports that at least one other bidder took a similar position and was disqualified from the East Midlands competition.”

Stagecoach said that, while a parent company's liability to any particular UK rail franchise should be limited to its risk capital - primarily, performance bond and loan commitments - an exhaustion of that parent company risk capital, in the board's view, was not desirable for customers, employees or the relevant franchise.

“We experienced this first hand through our involvement in the Virgin Trains East Coast franchise.

“The Department for Transport was clear that it expected the parties to that franchise agreement to adhere to all of their obligations under that agreement, regardless of any changes in circumstances.

“We would therefore expect the Department for Transport to apply the same approach on any other new franchise, and this was reflected in our approach during the bidding processes.”

As at 0929 BST, shares in Stagecoach Group were down 1.12% at 132p.