A £332 Billion Problem For UK Investors

Published in Investing on 15 June 2012

Investors should fear the vast pension deficits of these British blue-chip businesses!

The past 10 years have been a truly terrible decade for UK pension funds.

Poorly performing pensions

Thanks to falling bond yields, collapsing share prices and increasing life expectancy, pension funds have been under severe strain. As a result, the pension pots of millions of Brits saving for retirement have fallen steeply in value.

This problem has become even more acute for company schemes, partly due to accounting changes. Thanks to the guaranteed, final-salary pensions previously offered by most employers, many large companies have equally large 'legacy' pension shortfalls.

Indeed, according to the latest monthly report from the Pension Protection Fund (PPF), the combined total of UK pension deficits soared in May to an all-time high. As a result, this puts ever-greater pressure on pension sponsors (meaning employers) to make good these shortfalls over reasonable periods.

A £332 billion black hole

Thanks to a sharp drop in gilt yields and plunging stock markets, the combined shortfalls of company pension funds in deficit spiralled upwards to £332 billion at the end of May, versus £246 billion a month earlier. Thus, in a single month, this liability shot up by £86 billion, which is a leap of more than a third (35%).

Even worse, this figure was below £94 billion at the end of May 2011, so company liabilities are 3.5 times what they were a year ago, thanks to an increase of 250% in 12 months.

In total, the PPF calculates that there were 5,503 final-salary schemes in deficit at the end of May, from a total of 6,432. This means that around six in seven company pensions (86%) have liabilities greater than their total assets.

At the other end of the scale, the PPF identified 929 schemes in surplus at the end of May, down from 1,204 in April and 2,268 at the end of May 2011. In total, these schemes had a combined surplus of almost £20 billion, down from £29 billion at the end of April and £69 billion at the end of May 2011.

Pension pressure

Then again, is this £332 billion shortfall across over 5,500 final-salary schemes such a big deal for investors? After all, pension promises are very long-term liabilities and, therefore, this particular time bomb has a fuse stretching decades into the future.

Also, the National Association of Pension Funds (NAPF) blames the Bank of England's quantitative easing ('money printing') for pushing up bond prices and therefore depressing gilt yields for pension funds and other bondholders.

Alas, pensions deficits should be of great concern to private investors, not least because -- at one level -- they are hard, real liabilities. Just because pension deficits move up and down sharply in response to falling and rising gilt yields doesn't mean that shareholders can simply ignore them completely.

What's more, in a queue of creditors, pension funds are firmly in front of shareholders. Thus, when a good business is brought down by a bad pension scheme, then shareholders lose everything before pensioners forfeit even a single penny. In other cases, dividends could be slashed or cancelled in order to reduce pension deficits.

Held hostage by zombie pensions

Of course, pension trustees cannot ignore pension deficits. Instead, they must agree a medium-term plan to reduce any deficit with the scheme's sponsor, usually over a decade. As a result, British businesses have been forced to divert profits away from shareholder dividends and capital investment and direct some free cash towards paying off deep pension deficits.

What's worse is that the recent all-time lows hit by gilt yields may have wiped out the big cash injections that many big businesses -- notably BT Group (LSE: BT-A) -- have poured into their pension schemes in the past three years. Blame the eurozone crisis!

With higher pension contributions causing a drain on companies' free cash flows, investors need to be aware of the scale of pension deficits within their own portfolios. Worryingly, around one in 10 British companies (mostly small-cap firms) have pension shortfalls greater than their market values, according to JLT Pension Capital Strategies.

Pension albatrosses

Take a look at the following table, which shows the 15 FTSE 350 companies with the largest pension deficits by value at the end of 2011:

FTSE 350 firmDeficit (£bn)Funding levelMarket value (£bn)Deficit (%)
Royal Dutch Shell (LSE: RDSB)1.6896%134.61%
GlaxoSmithKline (LSE: GSK)1.2291%73.32%
HSBC Holdings (LSE: HSBA)1.8391%99.12%
Unilever (LSE: ULVR)1.2292%59.12%
Imperial Tobacco (LSE: IMT)0.7579%23.73%
BP (LSE: BP)2.9488%79.34%
AstraZeneca (LSE: AZN)1.5875%34.15%
Rio Tinto (LSE: RIO)2.1080%40.45%
Tesco (LSE: TSCO)1.3681%24.56%
Barclays (LSE: BARC)2.7487%23.612%
BT Group1.8395%15.812%
Royal Bank of Scotland (LSE: RBS)2.1891%13.716%
British Airways (LSE: IAG)0.8395%2.731%
BAE Systems (LSE: BA)3.8282%9.042%
TUI Travel (LSE: TT)0.8061%1.845%

Source: JLT Pension Capital Strategies, 31/12/11; current market values from Digital Look

I've sorted these 15 members of the FTSE 100 (UKX) and FTSE 250 using the final column. This shows the ratio of their pension deficits (as at end-2011) to their current market values.

Thus, while oil giant Royal Dutch Shell had a near-£1.7 billion pension deficit at the end of last year (now sure to be much, much higher), this is a mere 1% of its £135 billion market cap. Likewise, FTSE 100 stalwarts such as GSK, HSBC and Unilever all have large absolute pension deficits that are miniscule when set against their massive market caps.

However, at the other end of this scale are 'pension albatrosses' such as TUI Travel (45% deficit-to-market-cap ratio), BAE (42%), BA (31%) and RBS (16%).

Clearly, investors must take these relatively large pension deficits into account when weighing up the merits of these companies. Otherwise, when money is siphoned off to reduce deficits, investors will be disappointed by future profits, cash flow and dividends!

By the way, do you know which FTSE 100 firm investment genius Warren Buffett -- the world's third-richest man, with a $44 billion fortune -- has been gleefully buying into in 2012? To find out which UK brand the 'Oracle of Omaha' is backing, simply download your free copy of our latest report, The British Business That Warren Buffett Loves.

Further investment opportunities from Cliff D'Arcy:

> Cliff owns shares in GlaxoSmithKline. The Motley Fool owns shares in Tesco.

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zoolook 15 Jun 2012 , 10:28am

To what extent will this problem disappear when the bubble in gilt prices bursts?

UncleEbenezer 15 Jun 2012 , 3:53pm

zoolook, "when"?

That's an "if" question, not a "when". It's going to take the political will of a Thatcher to wean us off money-printing and accept the slump[1] that follows, to a refrain of "made in Downing Street" (or whatever Ed Balls's successor comes up with).

Do you think we'll see that kind of political will before Weimar inflation has wiped out the money we know today?

Demographically speaking, pension rates should be expected to remain depressed for anyone retiring in the next 20 years. Past economic mismanagement and bubbles in other asset classes only makes it worse.

[1] The slump being in £ terms, of course. The same real figures can look a whole lot better when measured in a devalued currency.

FunkyIndexFinger 17 Jun 2012 , 9:37am

I have a download from the internet which calculated similar figures in 2009. I have not verified these calculations, and so I will only display the change since 2009 for those with the largest deficit as a percentage of market cap.

TUI Travel had a deficit of 15% of market cap at 30/9/2009
BAE had deficit of 41% of market cap at 31/12/2009
BA had a deficit of 22% of market cap at 31/3/2009
RBS had a deficit of 11% of market cap at 31/12/2009

The extra information given in that download which was useful, was the proportion of the schemes assets in bonds.

TUI Travel had 44%, BAE had 30%, BA had 53%, and RBS 55%.

BT had a deficit of 41% of its market cap at 31/3/2009, and was invested 40% in bonds. How things have changed?

macworm 18 Jun 2012 , 1:39pm

Why am I not surprised - almost marches amount of QE issued by BoE - http://xav.cc/26240 - the government doesn't realise the effect this policy has on pensioners and savers - it does not deter them from saving more and increasing spending to boost the economy, it is frightening and destroying the confidence of those who are approaching pension age and those worried for their jobs. The money has disappeared into the banking system and to foreign investors who have sold out of UK bonds. The policy has not helped smaller companies borrow more easily as the recent announcement of special funding to try to alleviate this problem bears out. The QE policy should be reversed immediately and interest rates raised to boost pensions, reduce company defists and increase confidence

jobbones 18 Jun 2012 , 1:41pm

Does anyone remember the long pension holidays that those companies took during the Eighties/nineties. I guess that shareholders got the returns then, when pension contributions were effectively lifted from pension funds. What goes round comes round.
Not that we shouldn't seek to avoid the ill effects of historical poor political decisions.

sippquixote 18 Jun 2012 , 2:19pm

The Pension Regulator allowed the BMI pension scheme to be put into the Pension Protection Fund so that the multi-billions worth Lufthansa didn't have to make up the shortfall.
Lufthansa then got a much higher price for BMI, the proceeds of which promptly went back to Germany.
I cannot imagine the Pension Regulator doing this off its own bat, there must have been instructions from somewhere in Downing Street for this appalling action.
Once again, the taxpayer pays!

eccyman 18 Jun 2012 , 6:28pm

How come Gordon Browns raid on pension funds hasn't been mentioned?

westwinds3 18 Jun 2012 , 8:34pm

As an ex pension fund trustee, I have never understood how anyone can take seriously the predictions of actuaries. Fifteen years ago they assured us that pension schemes had massive surpluses. Today they are equally convinced that most schemes are in deficit. Over one month their calculations say that deficits have increased by £86 billion. You can't take seriously any method of calculating liabilities that gives such wildly fluctuating values. Does anyone really believe that your pension in 20 years time will depend on what happened in May 2012? Until such time as actuaries find a way of calculating liabilities that gives credible and consistent results, trustees (and Fools) should make their investment decisions paying as little attention to short term noise as they are allowed to.
PS I suggest that the crazy 105% MFR capping of pension funds by Ken Clarke did at least as much harm as Gordon.

fedupwithbanks 18 Jun 2012 , 10:15pm


Because Osbourne and the Tories are happy to carry on the raid!

Stubert100 19 Jun 2012 , 4:59pm

Jobbones, I remember the pension holidays, be interesting to know the value of the holidays taken by these companies. I bet the holiday savings would wipe out the deficits in one go.

TFG2112 19 Jun 2012 , 10:08pm

osbourne & the tories have no money to do anything but retain the dividend tax raid on pension. we are broke remember 1,000,000,000,000 in debt and still increasing.
If we could pay that off at £1 a second it would only take 32,000 years (excluding interest payments)
Once the bond bubble burst will these same pensions, forced to reduce risk by switching out of equities and into gilts, be hit for six?

andy53bom 20 Jun 2012 , 2:20am

If the generally accepted (??) Foolish view is that not only will shares recover at some point (1 to 5 years?), but actually boom, then pension deficits will also reduce. Therefore on present Accountancy Rules Company profitability improves - share prices increase - virtuous circle. At that point there will be political interference in the profitable market as in (overall beneficial) but in following case flawed Thatcher years.

If Thatcher government had not allowed "pension holidays" for company contributions (pension funds were awash with cash in the 1980's) there would be no shortfall now and there would be a move to final salary schemes for all.

In fact changes in accountancy rules could make problem disappear. (eg example of political use of payback periods for political gains). Power generation is a classic where payback period dictates best economic solution. 10 to 15 yeas Gas, 15 to 25 years Coal, 25 years and above Nuclear.

Basics above always has other issues (environmental, social, etc) that obscure the fundamentals, but fundamentals remain the same. Even debt is not real as (see Sunday Times 17/06/2012) as public sector financial policys/budgetting are a not valid models. Classic change the rules, change the answer.

brightncheerful 20 Jun 2012 , 8:35am

Pension schemes provided by companies for their employees are/were marketing a ploy to attract otherwise costly workers without having to pay as much at the time. Employees are attracted by the prospect of future income from the (collective) pension fund, whilst employers are able to defer part of the employment package, with the added bonus on possibly never having to pay out should the employee die prematurely.

Because pension fund rules and regulations are so darn complex, and the trustees of pension funds have more clout post-Maxwell, and what with pension-holidays and fluctuating stock market and other investment media, many companies now find themselves in the invidious position of being fundamentally broke.

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