Action needed on pension fund deficits By Neil Hume
Financial Times Published: March 27 2009 20:46 | Last updated: March 27 2009 22:39
Investors in Smiths Group received a nasty jolt this week. Presenting interim results, the industrial conglomerate revealed the deficit in its pension fund had widened from £11m to almost half a billion pounds in the six months to January because of falling stock markets. But that was not the end of the bad news.
The company then warned a review of the scheme, due to start next month, ?could cause future contributions to increase?. Together it was enough to knock 14 per cent off Smiths? share price and completely overshadow a resilient trading performance.
The significance was not lost on analysts and traders, who immediately set about identifying companies that could find themselves in the same position as Smiths. Tony Shiret of Credit Suisse said Marks and Spencer might have to increase contributions to its defined benefit scheme by £60m-£70m a year. ?The figures are potentially large in the context of M&S?s existing cash flows and given its relatively stretched balance sheet,? he warned clients.
Meanwhile, Morgan Stanley repeated its view that BT would have to inject an extra £500m a year at least into its pension fund, and Merrill Lynch said the telecoms company may be forced to cut its dividend sharply to make good a widening deficit.
The reason analysts are worried about Smiths, M&S and BT are triennial reviews ? the snapshots used to set funding levels for pension schemes. Because of the recent dismal performance of equity markets in particular, the picture emerging is likely to be grim.
?Companies due for a review are particularly at risk of needing to increase funding to their pension scheme as the valuation will be based on current asset and obligation values,? explained Citigroup in a recent note.
Other companies where revaluations, or the results of revaluations, are due include AstraZeneca, British Airways, Invensys and Yell. It is also worth noting that BA has pension fund liabilities that exceed its market value by more than 900 per cent.
The other big fear among investors is that the deficits could be made worse by the policy of quantitative easing. The worry is that the Bank of England?s efforts to combat falling demand in the economy through the purchase of gilts and corporate bonds could have a negative effect on pension deficits in the future.
This is because QE should lead to a fall in gilt yields, which in turn will force down the rate at which liabilities can be discounted. And that will increase a pension fund?s liabilities.
?Looking over the next three to six months, companies may, therefore, be using significantly lower discount rates for calculating balance sheet values,? says Citigroup. ?This could result in larger pension obligations and, therefore, larger pension deficit values (or smaller surpluses) in company balance sheets.? Indeed, Mr Shiret notes M&S used a discount rate of 6.95 per cent to calculate its pension fund liabilities in the six months to the end of September. Of course, it is worth noting that QE has yet to work ? gilt yields are pretty much where they were on the day the policy was announced.
Moreover, if QE is successful, the drop in gilt yields should be offset by a rise in asset prices. But that is something for the long term. It would also be wrong to exaggerate the danger posed by rising pension fund deficits. The UK Pensions Regulator is aware of the problems and the damage it could inflict on the sponsors. Indeed, David Norgrove, its chairman, recently said: ?There is no reason why a pension scheme deficit should push an otherwise viable employer into insolvency.? As such, the regulator is prepared to be pragmatic in applying funding rules. For example, it might be possible to set a recovery plan that seeks to eliminate a funding deficit over 15-20 years rather than 10 years. For companies seeking to retain cash, it might be possible to make good a deficit by transferring property, trade marks or customer receivables. But Mr Norgrove has made clear that pension schemes should not suffer so companies can continue paying dividends. Investors in Smiths, BT and M&S should take note of that warning. They should also be aware that, under company law, an underfunded pension scheme is an unsecured creditor. And creditors rank above shareholders.