The scheme of things

11th August 2011 by The Value Perspective

By Nick Kirrage.

In Eye of the beholder, we commented on the market’s shifting attitudes towards corporate pension fund deficits – but how, as value investors, do we calculate the value of a company’s pension scheme ourselves? Companies publish their pension schemes’ deficit (these days surpluses are in short supply) on a fairly regular basis and a number of analysts simply then insert that number into their valuation model as debt.

After all the company owes the pension fund that money and it must be made good. Furthermore, a pension scheme ranks higher than equity holders in the pecking order should a business go into administration, General Motors was effectively swallowed up by its pension fund , it is only right that risk be considered.

However, the number that is published – perhaps every 12 months – can differ greatly from year to year and, indeed, has differed greatly over the last five years. BT is a perfect example of this: in 2008 its pension fund was in surplus, then, a year later, the deficit was roughly the same as its market capitalisation. In 2010, however, because the shortfall reduced while the group’s market capitalisation recovered with the market, the deficit was perhaps a fifth of what it had been.

In little more than 12 months, therefore, the scheme went from surplus to an enormous deficit that swallowed the entire market capitalisation before swinging most of the way back again. So the question becomes, if each year you are given a number but it might be no more real than the next, how should one calculate the real value?

A second important consideration is if that number did happen to indicate a large surplus, that is, the pension fund has significantly more assets, which was the case for many businesses 10 years ago. You would not add all that to the cash pile of the business because clearly it cannot take money out of the pension fund to go and, for example, pay off a bank loan. Essentially you are dealing with something that is considered debt when it is negative but not considered cash when it is positive, which seems a little unfair.

In many cases, therefore, a pension scheme deficit is not so much debt as an obligation. It is still very much a consideration, but what we find is that it effectively just adds leverage to a business. When times are bad, the investment environment is tough, companies swing negatively and their debt increases, but when times are good and businesses are probably doing better anyway, their deficit reduces as well.

This makes life very difficult for equity holders. A pension deficit clearly does have an impact on a business but it is a movable feast and just injects volatility. The interesting thing, as we noted in Eye of the beholder, is this situation has existed for a long period of time and it is only accounting practices and thus the market’s focus that has shifted over the last 15 years to make it a far more important consideration.

by Kevin Murphy
Schroder Specialist Value UK Equity team and co-manager of the Schroder Recovery Fund since 2006.

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