Value Investing for Income and Growth
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 predefined 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 shown at the back of each year’s annual report. It’s usually referred to as pension liabilities or pension obligations.
To offset that pension liability there will be a pension fund, built up from monthly payments made by both the company its employees. The pension fund will invest in assets such as stocks, bonds, property and so on. The idea is that the pension fund’s total 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.
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 that case the company should divert cash from its operations into the pension fund in order to increase the value of 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 or paid to shareholders as a dividend, so a large pension deficit can be a serious risk 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 constitutes a large deficit.
One way to think about this is in terms of the relationship between the deficit and the company’s profits. For example, if a pension deficit was tentimes larger than the company’s typical profits, it would take at least ten years to reduce the deficit to zero, even if the company pumped every penny of profit into the pension fund (which would mean no dividends for shareholders).
I don’t know about you, but having one of my holdings spend ten years funnelling every penny of profit into its pension fund does not sound like a good idea to me. So having a pension deficit which is tentimes the company’s typical profits is very risky indeed.
Such a huge deficit would be very rare, but even much smaller deficits can be problematic. Based on a mix of research and personal experience, I no longer feel comfortable investing in a company where the deficit couldn’t be repaid within a single year if the company really wanted to. On that basis, here’s my definition for a large pension deficit:
Large pension deficit – A deficit that is larger than the company’s fiveyear average posttax profits
The pension fund surplus or deficit is recorded on the balance sheet and so we can easily perform this calculation. But there is a problem with simply measuring the deficit, which I’ll explain with another example.
Imagine a company with average profits of £1m per year, pension assets of £100m and pension liabilities of £99m. Given these figures, the pension scheme has a surplus of £1m (£100m assets minus £99m liabilities).
If we only looked at the deficit we might assume this company’s pension scheme wasn’t a problem, because there is no deficit.
But let’s assume the pension assets are invested in equity markets. What happens if those markets fall dramatically? If equity markets and the pension fund’s assets fall in value by 10%, that would reduce the fund’s assets from £100m to £90m. If that happened the company would find itself with a pension deficit of £9m (£90m assets minus £99m liabilities).
So in a relatively short period of time, the £1m surplus has moved to a £9m deficit. According to my previous definition of a large deficit, the pension scheme has gone from having a surplus to having a very dangerous deficit which is ninetimes average profits.
Hopefully this example shows that looking only at the surplus or deficit is a bad idea. What we need to look at is the pension’s total liabilities, because the total liabilities largely determine the size of any potential future deficit.
In other words, if the total pension liabilities are sufficiently small, it will be highly unlikely that the scheme will ever produce a large deficit, no matter what happens to equity, bond or property markets.
Avoiding large pension liabilities
So now we need to know what constitutes a large total pension liability. The key here is to think about how likely it might be for a particular pension liability to produce a large deficit at some point in the future.
Using the previous example of company that has average profits of £1m, if the total pension liability was also £1m then it would be nearimpossible for the scheme to produce a large deficit.
Why? Because a large deficit for that company (i.e. one equal to its average profits) would be £1m, and to achieve that the pension’s assets would have become worthless (£1m pension liabilities minus zero assets would give a £1m deficit). That is extraordinarily unlikely short of fraud and armagheddon.
A pension scheme with total liabilities equal to the company’s average profits is therefore very safe, while one where total liabilities are 100times average profits (such as in the original example) is very risky.
So what is a reasonable middle ground between those two extremes?
One way to answer that is to work out what sort of deficit we might reasonably expect to see at some point in a pension scheme’s future, as a percentage of its liabilities. From that we can produce a definition for large pension liabilities. This is less complicated than it sounds.
According to the October 2014 Pensions Risk Survey by Mercer, FTSE 350 companies had about £683bn in defined benefit pension liabilities while their pension fund assets totalled £596bn. The total deficit was therefore £87bn, or almost 13% of the value of the liabilities.
Given that data, a reasonable assumption is that it’s fairly normal, at least in recent years, for a UK company to have a pension deficit equal to about 10% of its pension liabilities. So even if a company has a pension surplus today, it’s reasonable to assume that the pension might have a 10% deficit within the next five or ten years.
From that assumption we can draw up definitions for large pension liabilities:
Large pension liability – Where total pension liabilities are large enough so that a 10% pension deficit would produce a deficit larger than the company’s average profits.
In other words:
Large pension liability – Where total pension liabilities are more than tentimes the company’s tenyear average posttax profits.
I call the ratio between a company’s pension liabilities and its average profits the pension ratio, and it’s very similar to the debt ratio we looked at last week. Let’s look at the underlying calculation and a quick example.
Calculating the pension ratio
You’ll need:
 Posttax profits – Going back ten years (which we should already have at this stage in the analysis).
 Defined benefit pension scheme liabilities – If the company has any defined benefit pension schemes (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, which are at the back of the annual report (it’s not usually quoted in the preliminary results announcement). It’s usually in a table of pension assets and liabilities and is called total pension liability or total pension obligation.
To calculate the pension ratio, follow these steps:
1) Calculate the average posttax profit for the last ten years.
2) Calculate the pension ratio as:
pension ratio = pension liabilities / fiveyear average posttax profits
And here’s the rule of thumb associated with this ratio:
Only invest in a company if its pension ratio is less than 10.
In other words, the rule is that a company’s pension liabilities are not large, according to the earlier definitions.
Let’s look at an example of this ratio in action using another of my recent holdings.
UP TO HERE. !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
USE A NEWER EXAMPLE INSTEAD OF BALFOUR BEATTY. PERHAPS MENTION CARILLION, BHS, CAPITA, ETC.
Balfour Beatty’s pension ratio
Balfour Beatty is a company which has, at the time of writing, run into some problems. It’s a FTSE 250listed construction company focused on the UK and US markets and in its 2014 annual results management announced that the dividend was being suspended until 2016.
As with any large company that gets into trouble, there are many reasons why Balfour found itself in this position. In my opinion there is at least one cause that was clearly visible if you knew where to look and that is its defined benefit pension scheme.
The company has a large pension fund with a large deficit; so large in fact that Balfour needed to pay almost as much into the fund in the last ten years as it paid out in dividends. Obviously it is not a good idea for so much cash to be flowing out of the company, especially when the payments are like debt interest payments in that the company is obliged to pay them come rain or shine.
Table 4.8 shows just how much cash had to be paid into the pension fund relative to the company’s profits and dividends in recent years.
TABLE 4.8
Table 4.8: Balfour Beatty’s deficit funding payments for the five years to 2014
Here’s the calculation for Balfour’s pension ratio:
 Calculate the average posttax profit for the last five years:

average posttax profit = (£ 179m + £ 186m + £ 248m – £ 2m – £ 310m) / 5 = £ 60.2m

 Calculate the pension ratio for 2014 (in 2014 the company had defined benefit pension obligations of £ 3,518m):

2014 pension ratio = £ 3,518m / £ 60.2m = 58.4

Clearly Balfour Beatty’s pension ratio is way above my rule of thumb maximum of 10. You could argue that the company has made losses in recent years, which have reduced its average profits, and that the average profits figure should in fact be considerably higher to reflect the true earnings potential of the company.
However, even if we were incredibly generous and said that Balfour’s average profits were in fact equal to the highest profits the company had made in the last five years, i.e. £ 248m, its pension ratio would still be above 14 and still above my preferred maximum.
In my opinion Balfour Beatty has a pension fund which is far too large for the company, to the point where the primary function of the company today is to feed cash into the pension fund to reduce its deficit.
Combining the debt ratio and pension ratio
One final check, which I’ve recently added to my conservative financing checklist, is to put a limit on how much interestbearing debt and pension liabilities a company can have in total.
The idea is simple: if a defensive sector company has a debt ratio of 4.8 then its debts are acceptable according to the debt ratio rule of thumb, but only just. If that same company also has a pension ratio of 9.2 then that is also acceptable, but again, only just. Both of these relatively high ratios represent risks to the business, but they are not independent risks. If a company has to pay out a large portion of its profits as debt interest payments then it will be far less able to pay off a large pension deficit at the same time, and vice versa.
So a defensive company with a debt ratio of 4.8 may – just about – be carrying an acceptable amount of debt, but that won’t be true if it also has a large pension scheme.
To avoid the risks that come from a combination of large debts and large pension liabilities, I have one final rule of thumb for conservative finances.
Defensive value rule of thumb
Only invest in a company if its combined debt and pension ratio is below 10.
To combine the debt and pension ratios I just add them together. So, for example, a company with a debt ratio of 3 and a pension ratio of 5 would be okay according to this rule, while a company with a debt ratio of 4 and a pension ratio of 8 would not.
In the next chapter we’ll compare a company’s share price to its past earnings and dividends as we begin to think about whether or not 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 conservative pension liabilities
 Only invest in a company if its pension ratio is less than 10.
 Only invest in a company if its combined debt and pension ratio is below 10.