In its latest quarterly report on FTSE 100 pension schemes, JLT Employee Benefits (“JLT”) found that 53 FTSE 100 companies have the ability to clear their defined benefit (DB) Only 7 companies would need a payment of more than two years’ dividends into their DB pension scheme in order to clear the outstanding pension deficit on their balance sheet.
The research shows that only 54 FTSE 100 companies are still providing more than a handful of current employees with DB benefits (i.e. ignoring companies that are incurring ongoing DB service costs of less than 1% of total payroll). Of these, only 23 companies are still providing DB benefits to a significant number of employees (defined as incurring ongoing DB service cost of more than 5% of total payroll).
Overall, there is already significant funding being directed towards closing pension deficits. In the year to 30 June 2016, FTSE 100 deficit funding totalled £6.3 billion, up from £6.1 billion the previous year. BT led the way with a deficit contribution of £0.8 billion (net of ongoing costs), but 49 other FTSE 100 companies also reported significant deficit funding contributions in their most recent annual report and accounts.
Charles Cowling, Director, JLT Employee Benefits, comments: “There are a significant number of FTSE 100 companies where the pension scheme represents a material risk to the business, with eight companies having total disclosed pension liabilities greater than their equity market value. This is likely having a negative impact on equity prices and raises the radical question of whether it could make sense to erase pension deficits altogether by using funds that would normally go out as dividends or by borrowing from the capital markets.
“There is a long-accepted principle of corporate finance known as the capital structure irrelevance principle that the value of a firm is unaffected by how it is financed - in the absence of the impact of taxes, bankruptcy costs and agency costs.
In particular, this suggests that whilst shareholders clearly value dividends and don’t like surprises, the dividend policy of a firm should not affect its fundamental value.
“Moreover, pension deficits are in principle no different from other forms of debt finance, e.g. bank loans. However, for many companies, pension deficits are an inefficient source of debt finance, in particular, because of corporation tax relief on debt interest costs and on pension contributions. So, for many companies, it is more efficient for them to borrow in the capital markets than from their pension scheme by running a pension deficit.
“In addition, paying off a pension deficit can give the company leverage with the pension scheme trustees to encourage the trustees to carry out risk management exercises that can enhance shareholder value. These can include risk reduction strategies on the investments as well as liability management exercises. In particular, the encouragement of a generous policy on transfer values, can not only allow members access to funds tied up in their pension at a fair value, but it can also deliver a settlement of the company’s liability at a level which is far below the cost of settling the same liability with an insurance company – thus generating significant shareholder value.
“The good news aspect of all this is that it is clear that for the very large majority of FTSE100 companies, their pension deficits can be easily managed within the normal ongoing management of their capital structure – even for some of those with very large pension deficits.”
In the last 12 months, the total disclosed pension liabilities of the FTSE 100 companies have fallen from £614 billion to £586 billion. Ten years ago, the total disclosed pension liabilities were £407 billion. A total of 16 companies have disclosed pension liabilities of more than £10 billion, the largest of which is Royal Dutch Shell with disclosed pension liabilities of £57 billion.
Darren Redmayne, Head of Lincoln Pensions: “Withholding dividends where there is a healthy sponsor covenant that can afford to pay a deficit over time could worsen shareholder value, make UK plcs less investible and negatively impact the businesses supporting the pension schemes. So somewhat counterintuitively, such an approach could damage both the shareholder value and the security of the member benefits you are trying to improve. There is no requirement to clear a pension deficit as soon as possible. The requirement is to clear it over an appropriate period. The real issue here is equity of treatment - are pension schemes receiving their fair share or are companies taking too much risk by over-distributing to shareholders and not staying on top of their pension deficits. The key is properly understanding your sponsor covenant, ensuring the scheme is being fairly treated and that any deficit is being cleared over an appropriate period."
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