### Defensive Value Investing: A 20-week course

**5: Pensions**

“In no other managerial area can such huge aggregate liabilities – which will be reflected in progressively increasing annual costs and cash requirements – be created so quickly and with so little financial pain”

Warren Buffett, 1975 memo to Washington Post CEO

Having looked at corporate debts last week, it’s time to focus on defined benefit pensions, which are another financial liability that many companies have.

Defined benefit schemes give employees a pre-defined pension payout, typically linked to their salary in some way. The company (known as the scheme’s sponsor) is legally obliged to fund those pensions, which means all of the scheme’s future pension payments are a financial liability from the company’s point of view.

The present value of those future pension payments can be calculated by actuaries and is usually referred to as pension liabilities or pension obligations.

To offset that pension liability there will be pension assets, built up from monthly payments made by the company and its employees. The pension assets will be invested in things such as stocks, bonds, property and so on. The idea is that the total pension assets should more than offset the total pension liability.

There is always a difference between these pension assets and liabilities, and this difference is known as a surplus when assets exceed liabilities and a deficit when liabilities exceed assets.

Definitions

**Defined benefit pension liabilities/obligations** – If the company has any defined benefit pensions (it may not have any, or it may have more than one) you’ll find a figure for total pension liabilities in the notes to the accounts at the back of the annual report (not the preliminary results). It’s usually listed under a note titled *Employee Retirement Benefits *(or similar) in a table of pension assets and liabilities.

**Defined benefit pension surplus/deficit **– In the same table as the pension liabilities (or possibly another table in the same accounting note) you’ll find a figure for the related surplus or deficit. A surplus occurs when assets exceed liabilities and a deficit occurs when liabilities exceed assets.

If, for whatever reason, a pension scheme has a large and sustained deficit then the scheme may not be able to afford to pay retired employees their pensions. This is obviously not good. In those situations, the company is often asked by the pension fund’s trustees to divert cash from operations into the pension fund to increase the fund’s assets and therefore reduce or eliminate the deficit.

Of course, any cash which is paid into the pension fund is cash that cannot be invested to grow the business, used to pay down debt or returned to shareholders as a dividend. so a large pension deficit can be a serious drain on a company’s resources and is usually something to avoid.

## Avoiding large pension fund deficits

To avoid companies with large pension deficits we need to have a working definition of what large actually means.

One way to think about this is in terms of the relationship between the deficit and the company’s average profits. In other words, we could calculate a **deficit ratio **which is similar to the debt ratio we’ve already calculated. This makes sense because a pension deficit is effectively a debt which is owed to the pension fund.

Steps to calculate the deficit ratio

1) Calculate average net profits for the last ten years (which you should already have)

2) Calculate the deficit ratio as:

d*eficit ratio = pension deficit / ten-year average net profit*

Now we just need to come up with a rule of thumb which sets a limit on how large a deficit can be.

For the debt ratio, that limit was four or five, depending on whether the company was cyclical or defensive. Since a pension deficit is effectively a form of debt owed to the pension fund, I think it’s reasonable to apply the same rules. However, there’s a twist.

The twist is that since borrowings and pension deficits are both forms of debt, I think it makes a lot of sense to lump them together. In other words, I think it’s a good idea to have a rule which combines both the debt and pension ratios:

Rule of thumb

Only invest in a cyclical sector company if the combined total of its debt and deficit ratios is less than four.

Only invest in a defensive sector company if the combined total of its debt and deficit ratios is less than five.

These debt-plus-deficit rules capture a significant portion of a company’s pension-related risks, but if all we do is measure the pension deficit then we’ll be missing the bigger picture. Here’s what I mean:

Imagine a debt-free company with average profits of £1m per year, pension assets of £20m and pension liabilities of £19.5m. Given these figures, the pension scheme has a surplus of £0.5m.

If we only looked at the deficit we might assume this company’s pension scheme wasn’t a problem, because there is no deficit.

Let’s now suppose the pension’s assets are fully invested in equity markets (which in reality is unlikely to be the case). What happens if those markets fall by 40%? The value of the pension fund’s assets would also fall by 40%, from £20m to £12m. If that happened the company would suddenly find itself with a pension deficit of £7.5m (£12m assets minus £19.5m liabilities).

In a relatively short period of time the pension fund has moved from a surplus to a £7.5m deficit. This gives the company a very high debt-plus-deficit ratio of 7.5 even though it has no debts.

So looking only at the pension surplus or deficit is a bad idea. What we also need to look at is the pension’s total liabilities, because the total liabilities largely determine the potential size of any future deficit.

## Avoiding large pension liabilities

My definition of a large pension liability is one which has a reasonable chance of producing a deficit that would break my debt-plus-deficit rule of thumb.

Since the deficit ratio compares the pension deficit against the company’s average profits, and since any potential pension deficit is directly related to the total pension liabilities, it makes sense to calculate a **pension ratio **which compare total pension liabilities to the company’s average profits.

Steps to calculate the pension ratio

1) Calculate average net profits for the last ten years (which you should already have)

2) Calculate the pension ratio as:

*pension ratio = pension liabilities / ten-year average net profit*

Having defined the pension ratio, it now makes sense to think about what sort of upper limit that ratio should have. This limit will depend on a few things, but in my opinion the most important are:

- The company’s debt ratio (as this affects how much headroom the company has for a pension deficit)
- The size of deficit we might reasonably expect as a percentage of pension liabilities

On the second point, we can turn to data from the Mercer Pension Risk Survey, which collects data on aggregate pension liabilities and assets for the FTSE 350. The exact figures move around each year, but in recent the years the average deficit has moved between 5% and 13% of average pension liabilities.

Given that data, I think it’s reasonable to assume that even if a company has a pension surplus today, it might have a 10% deficit within the next five or ten years (i.e. within the expected holding period of a long-term investor).

Okay, let’s pull together a few key points:

- A debt free company is allowed a maximum deficit ratio of four or five (depending on whether it’s cyclical or defensive respectively)
- The expected potential deficit for a pension is 10% of liabilities
- Therefore, a company with a pension ratio of more than 40 or 50 would have an expected potential deficit ratio of more than four or five, i.e. one that exceeds the deficit ratio rule of thumb

For a debt-free company then, the maximum pension ratio would be 40 or 50, depending on its cyclicality. However, this simplistic approach fails to take account of some key details.

First, it assumes that the company won’t take on any (or any more) debt over the next few years. That’s a problem because pension liabilities don’t just disappear. For example, if a cyclical company’s debt ratio goes from zero to three over the next five years, it’s maximum allowable deficit ratio would go from four to one. That’s a 75% decline and in my experience there is virtually zero chance of a company reducing its pension liabilities by 75%.

In fact, pension liabilities have a nasty habit of going up over the years, and that’s the second key detail. As retirees live longer and longer, they need larger and larger pension pots. This means more pension liabilities, which means pension assets need to keep up. And if they can’t, the result will be a growing pension deficit.

So rather than allowing companies to have some sort of theoretically maximal amount of pension liabilities, I prefer to be far more cautious. After all, there are plenty of companies out there with little or no pension liabilities, so why take the risk?

That’s why I decided to go with a much more conservative rule of thumb for the pension ratio:

Rule of thumb

Only invest in a company if its pension ratio is less than ten.

With a pension ratio limit of ten, that means the expected potential deficit (of 10%) would be equal to one-times the company’s average earnings. That should leave ample room for the company to take on some reasonable levels of debt without immediately failing the debt-plus-deficit rule.

However, it’s also important to make sure that companies with large amounts of existing debt don’t also have relatively large pension liabilities. In other words, the pension ratio limit should depend on the company’s existing debt ratio. We can do this by using a pension-plus-debt rule which is similar to the deficit-plus-debt rule:

Rule of thumb

Only invest in a company if the combined total of its debt and pension ratios is less than ten.

*I’ve explained these ratios in some detail now, so let’s look at a real-world example using another company I’m currently invested in.*

## Mitie’s pension ratios

Mitie is a company which I’ve owned since 2011. It’s currently in the SmallCap index and is the UK’s leading facilities management and professional services company (which means it provides services like reception, security and maintenance, along with ‘connected workspace’ technologies to companies and the UK government) .

Mitie has a defined benefit pension plan for its employees. The plan’s total liabilities were £252.7m according to its 2019 results. The pension also has a deficit of £74m. Let’s see how those numbers compare to Mitie’s average profits:

Year | Net Profit (£m) |
---|---|

2010 | 57.17 |

2011 | 65.31 |

2012 | 71.74 |

2013 | 42.23 |

2014 | 48.23 |

2015 | 35.12 |

2016 | 71.54 |

2017 | -52.14 |

2018 | -27.35 |

2019 | 31.22 |

Average | 34.31 |

**Table 5.1: Mitie’s net profits and average profits to 2019**

We now have all the information we need, so let’s calculate Mitie’s pension and deficit ratios:

Calculating Mitie’s pension ratio

1) Calculate the average net profit for the last ten years:

*average net profit = £34.31m*

2) Calculate the pension ratio:

*pension ratio = £252.70m / 34.31m = 7.4*

Calculating Mitie’s deficit ratio

1) Calculate the average net profit for the last ten years:

*average net profit = £34.31m*

2) Calculate the deficit ratio:

*deficit ratio = £74.0m / 34.31m = 2.2*

Mitie’s pension ratio of 7.4 is a little on the high side, but below my limit of ten, so by that measure alone the pension is not excessively large.

However, at 30% of pension liabilities, Mitie’s £74m deficit is substantially larger than the average FTSE 350 pension deficit of 10%. This large deficit gives Mitie a fairly large deficit ratio of 2.2.

Neither of these ratios is excessive, but we need to combine them with the companies borrowings to get a more accurate picture of the company’s financial obligations.

Mitie has total borrowings of £265.50m according to its 2019 annual results. Using that figure we can calculate the company’s debt ratio:

Calculating Mitie’s debt ratio

1) Calculate the average net profit for the last ten years:

*average net profit = £34.31m*

2) Calculate the debt ratio:

*debt ratio = £265.50m / 34.31m = 7.7*

Mitie operates in the cyclical Support Services sector, which means it’s allowed a debt ratio of four. With a debt ratio of 7.7, Mitie is clearly overindebted according to my rules, which is not a great start. But the picture is even worse if we take the company’s pension into account.

With a debt ratio of 7.7 and a deficit ratio of 2.2, Mitie has a combined debt-plus-deficit ratio of 9.9. That’s way above the limit for cyclical sector companies of four. As far as I’m concerned this is a clear and present danger to the company’s future and debt reduction should be a top priority for management.

Turning to Mitie’s pension liabilities, the picture is similarly disconcerting. Mitie’s pension ratio of 7.4 gives it a debt-plus-pension ratio of 15.1, and that’s obviously a long way above my preferred limit of ten.

In short then, Mitie seems to have far too much debt given the size of its pension and even more so given the pension’s large deficit.

In the real world this means Mitie has to make significant debt interest payments whilst funnelling a significant amount of cash into the pension fund to reduce the deficit.

For example, Mitie’s 2019 annual results say the company has agreed a deficit recovery plan with the pension trustee, totalling £65m over the six-year period to 2025. That means payments will probably be in the region of £10m per year, which is a lot when Mitie’s average profits are only £34m.

This cash drain is exactly why large pensions and large pension deficits are best avoided, especially when the company also has a substantial debt burden.

In the next chapter we’ll switch gears and move from analysing a company to analysing its share price. We’ll do this by comparing a company’s share price to its past earnings and dividends as we try to find out if the shares are good value for money.

*But first, here is a summary of the rules of thumb covered in this chapter.*

Rules of thumb for defined benefit pensions

Only invest in a cyclical sector company if the combined total of its debt and deficit ratios is less than four.

Only invest in a defensive sector company if the combined total of its debt and deficit ratios is less than five.

Only invest in a company if the combined total of its debt and pension ratios is below 10.