What pension deficits mean for investors

It comes to something when a discussion about pension scheme deficits features in a TV prime time comedy. But this issue was the topic of conversation in ITV's Monday Monday series about office life, and it reveals the degree to which pension deficits are now a feature of the corporate landscape.

Pension deficits have become a major factor in stockmarket assessments of companies. Some deficits are enormous, such as those of British Airways, BT Group, GKN, Invensys, Go-Ahead Group and Premier Foods, which are more than 250% bigger than their sponsors' market capitalisations.

There are dozens more companies for whom their final salary scheme is a major stumbling block to expansion, and merger and acquisition activity.

Companies have been taking drastic steps to deal with this elephant in the room. In 2008, which was recognised as the year of the buyout, many employers were able to rid themselves of their pension liabilities - lock, stock and barrel - by paying an insurance company to take them off their hands.

This, however, was only possible where the company had sufficient funds to be able to find the sum of around 130% of liabilities required to offload the fund and escape the multiple risks of running a pension scheme.

Strategic swaps

In 2009, the focus has turned to longevity swaps, which address the big risks associated with future improvements in life expectancy. Investment banks such as Credit Suisse and Deutsche Bank have been vying to take on pensions schemes' longevity exposure, but not their inflation or interest rate risks.

The deals agreed so far involve engineering support services company Babcock and insurance company RSA Group, but these swaps only cover pensions already being paid and not the current or deferred members who will retire in due course.

Whenever these major restructurings occur, the sponsor's share price normally rises as soon as it becomes public knowledge that an employer has taken steps to address its problem, whether it's by changing the terms of the pension or agreeing a recovery plan.

Babcock, for instance, surged 16.5% to 480p on news of the swap, although the impact was hard to disentangle from its better-than-expected results which were announced on the same day.

What is odd is that the shares rise on news of remedial action whether or not the solution has actually put the company in a better position. In a buyout or longevity swap, for example, the company will have paid a price to get rid of its liabilities.

Although pricing has been competitive as providers seek to build share in a new market, actuarial consultants say that trustees generally overestimate the life expectancy of their pension members and might be paying through the nose for this protection.
One factor that apparently skews a scheme's experience away from the mortality pattern in the general population is that a scheme's membership will have all worked for a living - the very wealthy live longer than their nine-to-five peers.

"The market does irrational things when told a pension is being sorted out," says Kevin Wesbroom, head of defined contribution services at Hewitt Associates. "But the question is: how much has the company paid for the solution? And has anything really changed?"

Steel products group Delta was a classic case. In June 2008, with pension liabilities three times higher than its market value, the group agreed to transfer £400 million of the pension scheme's total £640 million assets to buyout specialist Pension Insurance Corporation.

Delta injected a further £50 million so PIC could buy a bulk annuity to guarantee the 10,000 members' pension entitlements. The shares rose 8p to 135p on the news, despite the £50 million cost.

"All that has happened is that the trustees have chosen one investment over another, but the share price popped," adds Wesbroom. "That is evidence in my mind that analysts do not have a clue what is going on at these companies. There's a price for certainty, but that's a misplaced price."

It's true that the reduction in liabilities, to about £240 million, will improve Delta's financial covenants, reflecting the improved security of the scheme, and make it cheaper to service. For small employers that arrange for their schemes to be bought out, there are also huge savings in running costs and in complying with endless legislation.

For the private investor, however, the trick is knowing that any step taken to deal with a company's pension situation usually pushes up the shares. Keep a watch out for regulatory news, for example.

In February 2009, the pensions regulator clarified that trustees could take a more relaxed attitude to deficit recovery plans, and a raft of troubled stocks jumped on the news.

Shares will also bounce when the trustees agree a new funding arrangement, generally by persuading the sponsor to increase or hasten the cash injections required to pay the deficit down.

British Airways, for example, received a £600 million funding boost in July 2009 when the pension scheme trustees agreed to release bank guarantees worth £300 million and the company issued a £300 million convertible bond. The airline's shares climbed nearly 4% on the day.

Workforce agreement

Shares often react when the terms of pension changes are agreed with the workforce. Investors can easily keep an eye out for such developments because they are subject to a statutory consultation period of 60 days.

BT bounced late 2008 when it agreed to cut its yearly pensions contributions by £100 million and proposed raising the retirement age, increasing member contributions and switching to a calculation based on a career average rather than final salary.
Many more companies are expected to follow the lead of IBM and Barclays, which are currently consulting on closing their UK final salary schemes.

Remedial action often follows a pension scheme's triennial review, as this will drive accounting assumptions.

These reviews take a long time to be published, and those conducted in March 2009 will have suffered the triple whammy of equity valuations at a low ebb, a reduction in gilt yields caused by the Bank of England's quantitative easing plans and a requirement to include tougher mortality assumptions in line with the pension regulator's guidance.

As a simple rule of thumb, adding one year to longevity increases a pension fund's liabilities by 3%.

Funding carnage

"We will not see the full extent of the funding carnage from late 2008 and the first quarter of 2009 until later this year," says Peter Elwin, head of accounting and valuation research at Cazenove Equities.

"March 2009 triennials are likely to be particularly bad compared with the preceding triennial priced in March 2006, when real gilt yields were higher, lowering liabilities, and pension funds were stronger, producing much lower funding deficits."
Consequently, companies with March 2009 triennials are probably not shares for widows and orphans, but may be worth buying on further weakness if the management look like they will grapple with the deficit problem.

"[Otherwise] the bear argument is simply that trustees sit ahead of equity holders in the queue and will become more aggressive in putting scheme members' interests first," adds Elwin.
Looking ahead, rising real gilt yields could start to create opportunities, because when gilt yields rise deficits fall dramatically and the shares most obviously hampered by huge deficits should benefit.

Many predict gilt yields will rise further because of inflation worries, the volume of gilts issued by the government and concern about the Bank of England's exit strategy from quantitative easing - not least how the market will behave when the Bank of England starts to sell back gilts that it has bought.
Another dynamic where private investors can read the runes is the impact that improving equity markets have on reducing deficits.

"There's a lot of room for investment managers to improve their understanding of the risks and, indeed, the degree of potential upside," says Michael Berg, a partner in Lane Clark & Peacock's corporate consulting practice.

"For example, when companies bounced back from the trough of 2003-04, those companies that recovered most strongly tended to be in sectors such as engineering. One of the factors behind Rolls-Royce's sharp recovery, for example, was the impact of the equity recovery on its pension fund."
Finally, be aware of the difference between the market's perception of small companies, where the scale of the pension deficit is often not fully understood, and their larger peers, where it is followed by analysts.
With the tiddlers, most of the unknowns are on the downside. "At our coal face, there is a lot of awareness about small listed companies, where neither the company nor the pension fund is well known, and it can be difficult to work out how on earth their share prices are justified," says Berg.

"We've seen situations where a potential acquirer eliminated a deal because of concern about the pension scheme that was in no way reflected in the share price."

This article was originally published in Money Observer - Moneywise's sister publication - in September 2009