Do falling pension deficits create a reason to buy?

Massive pension deficits have been the biggest cloud hanging over some of the UK’s largest companies. And indeed, over many of the UK companies that are a little bit smaller. But I have some good news. I may have even more good news to follow. But is this a reason to buy?

Article updated: 13 August 2018 9:00am Author: Michael Baxter

I have two paradoxes for you today.

Paradox number one: The increases in stock market valuations, seen in recent years, have led to fears that stocks may be overvalued, but for certain well-known companies, many of which are a staple part of most investment portfolios, the higher the stock market goes, the better it is for them.

Paradox number two: As a rule, low interest rates are good for share prices. In theory, when analysts value a company, they are meant to project future dividends, and discount them by a rate of interest to create a net current value. If they suddenly decide interest rates are going to be higher than they had previously projected, the rate at which they discount future dividends goes up, and the net current value goes down. But for certain companies, higher interest rates are good for the share price.

Let me explain.

Pension Deficit

It all relates to the pension deficit. For years, these have been the curse of many broker reports. For years, normally confident investors could be turned into nervous wrecks simply by mentioning two words: ‘pension’ and ‘deficit’.

A year ago, the UK listed companies with the biggest pension liabilities were: Royal Dutch Shell, BT, Lloyds, BP, HSBC, Barclays, National Grid, BAE and International Airlines Group.

Why?

There have been multiple reasons for surging pension deficits. Among them:

  • Booming stock markets during the 1990s, pushed upwards on pension asset valuations, leading companies to contribute less to pension funds. With the stock market crashes of 2000 and 2008, pension investments did not rise as fast as they had done in the past, but companies did not adjust their investment into pension funds accordingly.
  • Low interest rates meant individual pension funds had less value when converted into annuities, hitting companies that provided final salary pensions.
  • Greater longevity meant that people were typically living longer after retiring, creating the need for larger pension funds to fund final salary pensions.

Changing

Well, we probably don’t want to change the fact we are living longer. New technologies such as CRISPR could mean that it becomes quite common to live to 100. So, if you retire at 67, that’s 33 years of retirement you have to fund. Some argue that previous generations had it easier: they needed less money to retire, but not everyone would envy previous generations’ shorter longevity!

But two other factors have come into play that have helped.

Booming stock markets of recent years have improved the performance of pension funds. And now, the expectation of higher interest rates, mean that the cost of annuities may be set to fall.

Companies have in any case been pumping more money into company pensions and have been ditching final salary schemes.

What’s happened

According to a report from Barnett Waddingham: “The position of UK firms has improved drastically since the beginning of 2017, with the deficit now accounting for 17 per cent of the 350 companies’ total pre-tax profits (£210bn), compared to 70 per cent just 18 months ago. This bucks the trend since 2011, as over this period, the deficit as a proportion of pre-tax profits has been steadily increasing, from a low of 25 per cent to a peak of 70 per cent in 2016.”

The report stated: “The aggregate pension deficit of the UK’s top 350 firms has almost halved from £62bn to £35bn in the last 18 months.”

According to a recent report from JLT Employee Benefits, FTSE 100 pension schemes have turned a £34 billion short fall from a year ago, to a £3 billion surplus.

Don’t over celebrate

This is good news for investors with exposure to companies with large deficits, but don’t over celebrate.

For one thing, many companies are still laden with excessively large deficits. For another thing, if fears over protectionism and higher interest rates lead to stock market falls, pension deficits could start rising again.

Finally, whether or not higher interest rates are good or bad depends. If central banks increase rates because they feel the economy is strong and a return to normal rates is affordable, then that is good. If rates rise because of fears over protectionism and US government unfunded spending, means that central banks fear a return of inflation and conclude they HAVE to increase rates, rather than that they want to, then that is bad, and all those good points about falling pension deficits may count for very little.


These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees

Michael Baxter portrait photo
Michael Baxter

Economics Commentator

Michael is an economics, investment and technology writer, known for his entertaining style. He has previously been a full-time investor, founder of a technology company which was floated on the NASDAQ, and a director of a PR company specialising in IT.

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