There have been several recent news stories of sinkholes appearing around the world. All of a sudden the ground gives way, and it costs a lot to repair the damage.
A similar, but less visible, hole is appearing on company balance sheets as pension liabilities mushroom, and it transpires that the additional funding to fill this hole is also very expensive. It is a key risk we look out for when assessing a company’s equity value.
It has been well documented how the collapse in bond yields over recent years has created a challenging environment for defined-benefit pension schemes, as they struggle to meet future liabilities and achieve sustainable growth. With the yield from a 15-year UK gilt in the range of 2-3% over the last five years, it fell as low as 1% this August before returning to a 1-2% range in recent weeks.
Source: Thomson Reuters DataStream, Barclays Research, November 2016
How do we assess the potential risks for the stocks in our investment universe?
A promise that is hard to quantify
The promise of a defined-benefit pension from a company to an employee is something which is easy to understand, but surprisingly hard to quantify. This is because of the inherent uncertainties about the future and a lack of transparency about the schemes.
Defined-benefit pensions accounting is a very complex topic, varying by country and company. In times of distress, the fundamental issue is the bargaining power of the pension trustees in relation to other stakeholders. The final value of the benefit, and who pays for it, is ultimately a matter of negotiation.
The current value of a pension scheme’s assets is easy to measure. Assets generally comprise liquid equities and bonds, which can simply be marked to market. The uncertainty relates to the present value of the liability – the quantitative estimate of the promise. To estimate the current value of the liability, actuaries need to project the likely cash flows and then discount them back at an appropriate rate. Projections rely on assumptions for mortality, wage inflation, general inflation, the number of years of service for active members, and other specific terms of the promise. However, it is the discount rate which is the thorniest issue.
A bird in the hand is worth two in the bush
This proverb encapsulates a commonly held economic belief: in general, we value £1 in the hand today more than £1 in the future. We demand more to wait. The precise additional amount can be expressed as a discount rate, which reflects the opportunity cost of waiting per year. For example, if my discount rate is 15%, I would be indifferent as to whether I get one bird today or two birds in five years’ time.
In theory, the discount rate should take account of all the risks associated with the scheme, including the aggressiveness of the assumptions underpinning the projected outflows, the bargaining power of the trustees, the asset mix in the scheme, and the underlying riskiness of the company.
In reality, accountants and actuaries do not use a discount rate that reflects either the asset mix or the weighted average cost of capital (WACC) as these are difficult to measure. Instead, accountants in the UK use the yield of an ‘AA’ bond, whereas actuaries tend to be more conservative and use a government bond yield plus a negotiated adjustment. This is the main reason why actuarial deficits tend to be larger than the accounting deficit on the balance sheet.
These discount rates are typically very prudent, especially for a risky company (high WACC) with an equity-heavy asset mix (high expected return). Liability matching is arguably an artificial construct: it matches assets to liabilities based on the easy-to-measure bond rate, which is not necessarily a good estimate of the actual economic liability.
Rising deficit risks
Against this backdrop, what specific risks do we look for in companies with a rising pension deficit?
- Balance-sheet risks. Higher leverage as a result of an increasing pension deficit may negatively affect a company’s credit rating. The other side of the double entry for an increase in pension liability is a reduction in equity reserves, which may limit the ability to pay dividends. A further risk for banks and other financial stocks is the potential reduction in core capital.
- Earnings risks. In the US, companies typically assume an expected return of c. 7% for plan assets, which could flatter earnings in a low-return world.
- Cash-flow risks. Additional deficit funding reduces the cash available for other purposes, and may even put the company’s dividend at risk.
At Newton, assessing the risks associated with growing pension deficits is just one part of our investment process, as we seek to identify those companies that can offer solid, sustainable returns at attractive valuations. Extensive industry knowledge and analysis of annual reports and accounts, combined with regular engagement with management teams, helps us to gain a deep understanding of the risks involved as we assess each investment opportunity from a wide range of perspectives.