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.
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.
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%.
"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
A catch-all phrase that can range from assessing the price of a property or vehicle before offering it for sale or the net worth of assets in an investment portfolio to the prices of shares on a stock exchange.
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).