A small silver lining has emerged from a worsening economic outlook: with long-term bond yields on the rise, the amount of cash that FTSE 350 companies will need to pour into their pension schemes to cover payouts has dropped to its lowest level in two years.
This is lightening the load for companies such as BT (BT.), Phoenix (PHNX), BAE Systems (BA.), FirstGroup (FGP) and AstraZeneca (AZ) – the index constituents with the largest pension deficits, according to Investors’ Chronicle analysis.
According to actuary Mercer, the 350 largest listed companies in the UK face a combined shortfall of up to £45bn in their pension schemes as of the end of April, as the £784bn expected cost of their pension payments outstrips the £739bn assets these schemes hold. This overall deficit has fallen by more than a third from £69bn a month ago at the end of March. “The main driver of the change has been the increase in bond yields,” said Tess Page, Mercer’s UK wealth trustee leader.
Yields have been surging across developed markets as central banks raise interest rates, with US 10-year Treasury yields surpassing 3 per cent last week, and the corresponding UK gilt rising to over 2 per cent, its highest rate since 2015.
Bank of America’s quantitative research team picked out BT (BT.) and travel firm Tui (TUI) as the UK companies whose heavy pension burdens mean they “could benefit in a rising bond yield environment”.
“European companies with the high pension deficits typically benefit from rising bond yields, as the increase in interest rates lowers the net present value of their future pension liabilities,” said Bank of America’s quant strategist Paulina Strzelinska.
Since pension funds typically rely on government and corporate bonds to fund their annual payments to pensioners, higher bond yields reduce the amount they need to spend to produce the same return.
Pension contributions have been a significant drain on these companies’ cash over the years. The size of BT’s pension deficit – £5.1bn at the last count in November – has led to its reputation as a ‘pension fund with a telecoms business attached’, with the telecoms giant committing to pour £2.7bn over three years to June 2023 to plug the gap.
In November, BT’s chief executive Philip Jansen set out the company’s plans to make the pension scheme fully funded by 2030, which he said would contribute to “significantly improved cash flow” and lead in turn to higher returns to shareholders.
Meanwhile, military technology firm BAE Systems borrowed and spent £1bn to fund its pension schemes in 2020, but still faces a deficit of £2.4bn – a shortfall that is equivalent to 32 per cent of its total equity.
While a smaller pension problem could free up chunks of cash for dividends, buybacks, or investment back into the business, companies’ ability to do this might be stymied by enforcement of the Pension Schemes Act, introduced in 2021.
The new rules aim to force companies to spend spare cash on paying down their pension schemes, in order to prevent Carillion-like busts where businesses choose to continue to pay dividends rather than fixing their savings shortfalls.
In any case, it may be too soon to celebrate the renaissance of companies with high pensiondeficits. Bank of America’s Strzelinska noted that thesestocks have recently “sharply undershot their relationship with bond yields”, with their price/earnings ratios relative to the market falling 20 per cent below their 10-year average.
Strzelinska blamed the falls on “weaker business activity” as companies face off against higher inflation. BT’s shares are down 7 per cent in the month to 9 May, while Phoenix’s have fallen by 8 per cent, compared with a 4 per cent drop in the FTSE 100.
