There is a group of people who meet a few times a year and they decide whether or not you receive a dividend. It is not the board, or the senior management team, but the trustees of the company’s pension scheme.
What’s more, this body has a legal obligation to act in the best interests of other people that have a claim on the company’s money – many of whom no longer work for the group – and they are asking for ever more of it.
Does that scenario sound far-fetched? You only have to look as far as household name Aga Rangemaster (AGA) to see one such agreement in black and white: the company made an undertaking at its last triennial revaluation in 2011 “not to make dividend payments without pension scheme trustee agreement”.
The costs of pension schemes to companies and ultimately their shareholders are patchily disclosed, badly understood, and at a historic high.
This year, around 2,000 private sector companies will have to agree with trustees a triennial deal on the funding of their defined-benefit obligations. While many sponsors of defined-benefit schemes may not make the kind of agreement struck at Aga, what they find is going to be ugly.
That is because gilt yields, driven down by the flood of cheap money created through quantitative easing, as well as sustained appetite for safe assets, remain at crushing historical lows. It is these yields that are used to calculate the cost of future pension promises: the lower the yield, the bigger the liabilities.
For the average defined-benefit scheme, pensions consultancy Towers Watson estimates the amount that the company has to pay into the pension scheme following this year’s triennial check-up will have to increase by 30 per cent. Either that or the company will have to extend its schedule of payments.
“There will be a lot of frustration – a lot of employers will feel that they have done the right thing,” says Graham McLean, head of funding at the consultancy. “The recurring theme over the last three valuation cycles is you pay a lot in and the hole gets bigger – or at least it doesn’t get smaller.”
The low-rate, low-yield environment is crippling companies’ pension funding plans. The aggregate deficit of those pension schemes that are eligible for the industry-sponsored bailout vehicle, the Pension Protection Fund (PPF), sat at a whopping collective £242bn at the end of April 2015, compared with £49bn at the same point in 2014.
Indeed, this mammoth funding gap was even worse before the recent global bond market sell-off (see graph). At the end of January 2015, the deficit reached its widest point on record, with a collective gap of £368bn between the pension promises of these schemes and the money currently held to pay them.
Negotiation time
If you look closely, the fingerprints of pension issues are to be found across the corporate landscape. Analysts at Barclays recently downgraded insurance group RSA (RSA) on the basis of its ongoing funding discussions, which they think “could materially limit the dividend return”.
Around half of the UK defined-benefit schemes evaluating this year will have a valuation date at or close to the 31 March date used by RSA, according to industry data. Charles Cowling, director at pensions consultancy JLT Employee Benefits, predicts it will be a “tough time” for those employers reassessing their obligations at that time, given bond movements.
The industry data bear this out. At the end of March, the collective deficit of those PPF-eligible schemes sat at £293bn – twice as severe as the £146bn gap estimated three years earlier.
Whether this year’s spot-check will be good news for companies such as RSA will depend on how asset prices and hedging strategies have counteracted low yields.
RSA said in a statement that it has worked actively with its scheme trustees to take risk out of the pension scheme by boosting its hedging of its interest rate, inflation and longevity risks.
“While we can’t comment on current funding discussions, our schemes remain well-funded and the impact of falling bond yields has been largely offset by our prudent hedging strategies as well as strong performance from equity and property holdings,” the company says.
In 2012, RSA had a funding level of 93 per cent. This improved to 97 per cent by March 2014, as a result of cash paid in and market movements.
Until we know the outcome of the current check-up, which could take the best part of a year, Barclays analysts argue that the “concern will weigh on the stock”.
The question is how far increased employer payments negotiated this year will impact companies’ ability to pay out earnings as dividends, or to invest in future business growth.
Management teams will argue that allowing pension funding to impact dividends is self-defeating: if dividends are affected, the share price will be hit, reducing the strength of the employer. A weaker employer can be required by the Pensions Regulator to provide more up-front contributions: demonstrating a vicious cycle.
Another option is to extend the current recovery plan, which is the schedule of payments to be made into the scheme to claw back the funding gap. “It is becoming more normal to have longer recovery plans,” says JLT’s Cowling, who says he has seen such plans extended out more than 25 years, and heard of examples running even longer than that.
Companies also try to structure the payments to put the larger slugs of cash in later years. They are strengthened in this push-back by a statutory objective given to the Pensions Regulator in the 2012 Autumn Statement to “consider the long-term affordability of deficit recovery plans to sponsoring employers”.
Simon Kew, assistant director in the pensions advisory team at consultancy Deloitte, says: “That will strengthen the employer’s hand in negotiation.” There may also be an up-tick in employers providing other assets to their pension schemes, rather than cash, in an attempt to close the gap.
Aggregate funding balance of UK defined-benefit pension schemes
Avoiding the potholes
The difficulty in predicting how ‘good’ or ‘bad’ pensions news hits company share prices is partly because it is unclear how much is already baked into the share price, particularly with those household names that have a well-known history of providing generous benefits. An efficient market should have priced in pensions risk, or at least the payment plans that companies are scheduled to make into their pension schemes.
“That should be somehow reflected in the prices,” says AniaZalewska, professor of finance at Bath University’s management school, discussing pensions information that is already in the public domain. “Whether that is reflected too much or not enough, we don’t know.”
Looking at recent history can be instructive here. JLT Employee Benefits runs a list of the companies most affected by unanticipated balance sheet gains or losses stemming from their pension obligations.
In 2014, BAE Systems (BA.) was top of the list, receiving an unanticipated balance sheet gain of £945m, or 6 per cent of its year-end market capitalisation. The biggest loser in the period – leaving aside Royal Mail (RMG), whose pension liabilities were transferred to the taxpayer – was J Sainsbury (SBRY), which swallowed an unforeseen loss that amounted to 7 per cent of its market cap.
In the FTSE 250, Serco (SRP) was the most positively affected with an unforeseen balance sheet gain of £30m, or 3 per cent of its year-end market capitalisation. While Mitchells & Butlers (MAB) saw a £222m loss, equivalent to a whopping 14 per cent of its market cap.
Retail investors wanting to screen for pensions risk have a couple of options. They could keep note of the stocks where the pension liabilities bear the biggest relation to the market cap (see tables).
Another way is to look at those pension schemes that are the worst funded: that means the biggest percentage gap between their assets and their liabilities. Leading this list from the FTSE 100 at the end of last year was Mondi (MND), with assets covering 41 per cent of its liabilities, on an accounting basis, or Sage Group (SGE), with a funding level of 56 per cent at that point.
Uncertain future
Many employers and schemes alike have predicted – indeed, many are banking on – a return to more ‘normal’ gilt yield levels that will bring down the present cost of their future pension obligations, and so the necessary contributions.
Indeed, there was some relief in May’s rather tepid government bond sell-off, but the market movement could not sustain its momentum.
And it is impossible to gauge the longevity of the current “new mediocre” global economy, as described by the International Monetary Fund’s managing director Christine Lagarde.
Without a substantial change to these conditions, more employers will have to grasp the nettle of their pension scheme funding as the demographics of their pension schemes mature.
Once employers feel the hit of rising annual
contributions, there could yet be further pain for retail shareholders, who are often not provided with the information that they need to gauge the full risk that guaranteed pension obligations pose to their portfolio.
Measuring the pension hole
The accounting deficit released in listed company accounts – or simply, the gap between the assets and liabilities of the scheme – often does not give a full picture of the ongoing cost to the employer.
“As far as shareholders are concerned it is not transparent whether there is an obligation that they are signing up to that is more than the number that is in the accounts,” says Charles Cowling, director at pensions consultancy JLT Employee Benefits.
That is because the company’s regular repayments, and any lump sum one-off contributions, are based on another measure. That is the ‘technical provisions’ deficit that is used by the industry regulator.
It is more conservative, often based on gilt yields rather than corporate bond yields, and gives a starker picture of the liabilities.
There is also a third, even more conservative, level that the industry uses to gauge affordability: the deficit on a ‘solvency’, or ‘buyout’ basis.
This varies from scheme to scheme, but describes what kind of balance of assets to liabilities will be needed for the scheme to be ‘bought out’, which means an insurer will take the scheme and its risks over from the employer and remove it from the balance sheet completely – for a price.
The goal of the majority of FTSE 100 schemes – which have long shut their DB schemes to future accrual and new joiners – is to offload the risk of the remaining obligations as soon as practicable. This can be done in chunks, or as a whole.
So it would be a mistake to think that the problems are remote for a company that looks reasonably healthily funded on the accounting deficit.
In reality, that company may be a long way away from securing the funding level it needs to remove its pension risk.
Aga’s pension challenge
Aga Rangemaster is a good example of a modest company with a sizeable pension problem. It was hit by a £4.1m charge for its 2014 full-year results, with its accounting deficit calculated at £72m. This is a sobering figure, given its current £78m market cap.
Deficit payments for the oven-maker will reach an annual £10m from 2016, raising serious questions about the affordability of future dividends. The company is hoping to grow its way out of this problem, by increasing its China and Germany sales and boosting its productivity at its Leamington Spa factory, which currently produces 65,000 ovens a year. It has also hired corporate adviser Rothschild to explore its “strategic” options for driving overseas growth.
If the company can push that beyond 75,000, it hopes the profitability from those sales would rise 30 per cent, as operational gearing kicks in. That would help the company towards its medium-term goal of returning cash to shareholders, as would a favourable movement in gilt yields.
Aga’s latest triennial valuation has an effective date of 31 December 2014, and it is likely to be completed at some time this calendar year.
As part of this process, the company will again discuss the prospect of dividend payments with trustees, depending on the health of the funding picture, and shareholders will be watching closely.
