How Pension Scheme Deficits Threaten Your Dividends
LONDON -- It's common nowadays to come across company final-salary pension schemes that are worth more than the sponsoring company. In a few cases, the scheme is so large that it would be more accurate to describe it as a pension scheme that happens to run a company as a sideline. In the case of a large scheme, any change in its performance can easily affect the company's profitability.
JLT Pension Capital Strategies, a subsidiary of Jardine Lloyd Thompson Group, recently published a study that looked at the pension schemes operated by companies that are in the FTSE 100 index. It turns out that the financial position of some of them has worsened to the point where it's starting to affect the company's ability to pay dividends and reinvest for the future.
How these schemes work
On one side of a final-salary pension scheme's balance sheet are its assets -- the money that's been set aside to pay for pensions and other benefits. On the other side are its liabilities -- an actuarial calculation of the value in today's money of the benefits that have already been earned by its members, the current and former employees, and its pensioners.
Over the last 20 years, a combination of government policies, increasing life expectancies, and the recession has pushed many schemes into showing a deficit because their liabilities exceed their assets, and last month the National Association of Pension Funds reported that the total accumulated deficits of British pension schemes had hit an all-time high of 312 billion pounds.
How these deficits arose
Final-salary schemes have been under pressure ever since the 1990s, when successive governments first restricted and then eliminated their ability to reclaim the tax credits on their dividend income. It didn't help that the Treasury had changed the rules to tax surpluses if they exceeded 5% of the liabilities, which caused many companies to take contribution holidays and underfund their schemes.
But in the last few years, things have become much worse, because the interest rates paid on gilts and corporate bonds have fallen sharply as the Bank of England has been buying gilts through its quantitative easing program.
The problem is that the interest rates that are used to value a pension scheme's liabilities are based upon gilt and corporate bond yields. So when those fall, the scheme's liabilities rise, and the poor performance of the world's stock markets over the past decade has meant that the assets haven't kept pace with the liabilities. As a result, large deficits have appeared.
A worked example
Let's consider the hypothetical company Metal Bashers, which has a large pension scheme that's worth more than the company. This is a slightly exaggerated example to demonstrate just how the pension scheme tail can wag the corporate-profits dog when there's a change in interest rates. Note that Metal Bashers' policy is to pay 50% of its profits as a dividend.
Stock Market Value
900 million pounds
88 million pounds
44 million pounds
The table below summarizes Metal Bashers' final-salary pension scheme, which has a small deficit.
950 million pounds
960 million pounds
10 million pounds
The Bank of England then engages in a massive quantitative easing program and buys a fistful of gilts. This causes the interest rate used to value pension scheme liabilities to fall by 0.5%.
To simplify the calculation, I've used the Pensions Regulator's Purple Book 2010 "funding sensitivities approximation," where a 0.1% cut in interest rates increases the typical scheme's liabilities by 2% and its assets by 0.4%. So an interest-rate cut increases liabilities by five times the rate at which the assets increase, worsening the funding position, which is now as follows:
969 million pounds
1,056 million pounds
87 million pounds
So the 77 million pound increase in the deficit causes Metal Bashers' true profits to fall to 11 million pounds, and the dividend is thus cut to just 0.6%. Note that even though the trading position of the company was not affected, its profits collapsed because of how the interest-rate cut affected its pension scheme.
Fudging the accounts
Even so, Metal Bashers' accounts still report a profit of 88 million pounds -- not 11 million pounds as above. This is because the accounting rules allow the company to keep changes in the value of the pension scheme out of the profit and loss account! All its balance sheet shows is that the deficit is now 87 million pounds, and there's no mention of the total assets and liabilities until you get to the notes to the accounts.
However, a company's ability to hide the effect of changes in its pension scheme's financial position should be restricted from January 2013, when the new accountancy standard IAS19 should take effect.
In theory, every company with a final-salary pension scheme is exposed to this problem. One of the more extreme examples is Avon Rubber (ISE: AVON.L) , which had pension scheme assets (and liabilities) of about three times its stock market value when I last looked at it.
Looking at the JLT report, where the figures are quoted as of Dec. 30, 2011, some very large companies are in a similar boat. For example, BAE Systems had scheme liabilities of 220% of its market value. The same metric was 265% for BT and 209% for The Royal Bank of Scotland. Meanwhile, Marks & Spencer was much better off with liabilities of a mere 106% of its market value.
Where a pension scheme is this large, it exerts a major influence upon how the company is run. Fortunately, most companies aren't yet in the position where the tail wags the dog. So although Royal Dutch Shell (ISE: RDSB.L) had a whopping 42.8 billion pounds in liabilities, this represented just 28% of its market value. Similarly for Rio Tinto, the liabilities were just 23% of its market value. For one of Neil Woodford's favorite companies, GlaxoSmithKline, the figure was only 18%.
Some large companies have tiny pension schemes. The ones that stood out for me in the report were British Land, at just 2.4% of its market value, and Sage Group, at a mere 0.8%. So these two companies' finances are barely influenced by their pension schemes.
Are we being too pessimistic?
A company with a pension scheme deficit has to come up with a plan whereby it will reduce it over a reasonable period of time. This involves paying more money into the scheme, which reduces the money available to pay dividends and reinvest in the business, damaging its growth prospects.
However, there's a persuasive argument that we are in exceptional times because gilt and corporate bond yields are artificially low due to the combination of quantitative easing and the global recession. So if the valuation interest rate used for Metal Bashers' scheme rose by 0.5%, using the Purple Book approximation, its liabilities would fall to 864 million pounds while its assets dropped to 931 million pounds. This would turn a deficit of 10 million pounds into a surplus of 67 million pounds.
A decent performance by its equity portfolio will improve its asset value, which would further boost its surplus. Eventually, this would mean that HM Revenue & Customs would tell Metal Bashers its scheme is overfunded, so it should stop paying into it -- but that's another story!
Should you want to look at JLT Pension Capital Strategies' full report, you can download it from this web page, along with similar reports for the FTSE 250 and FTSE 350 companies.
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At the time this article was published Tony owns shares in GlaxoSmithKline, but he doesn't own shares in any of the other companies mentioned in this article. He used to be a student actuary. The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.
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