Introducing The New Pension Deficit Ratios

29th Sep '16 by Tom Firth

36 comments 22312 reads

Runaway pension deficits have long been a problem for equity investors. In this age of low interest rates and long lived work forces the problem is exacerbated further still. Many plans now struggle to earn the returns they need to stem the flow of operating profits into the so called ‘pension black hole’. Many investors have stressed the impact they can have so it is important that we have a way of assessing them.

As you (hopefully) all know by now, at Stockopedia our mission is to take the pain out of this kind of process so we’ve come up with a new set of ratios to make this as easy as possible for you. So, allow me to introduce...

The New Pension Deficit Ratios

Pension Deficit

What does it tell me?

This is simply the value of the pension deficit or surplus on the company’s group level balance sheet. A positive value indicates that there is a deficit - i.e., that the pension is underfunded. A negative value therefore indicates the opposite - that there is a surplus.

A neat trick with this metric in the screener is to combine it with other ratios via the ‘Ratio vs. Ratio’ rule builder. This allows you to compose your own pension deficit ratios and compare a deficit against sales or tangible assets, for example.

How is it calculated?

It is quite simply the value of the deficit or surplus as displayed on the company balance sheet.

Where can I find it?

You can find the metric in the screener under the name ‘Pension Deficit’. You can also find this figure on our balance sheets as a component of ‘Other Liabilities, Total’:

Pension Deficit to Market Cap

What does it tell me?

This metric is intended to give a sense of the scale of the pension deficit relative to the market capitalisation of the company. Due to the seniority of pension liabilities over other forms of debt and equity, a large pension deficit can prove especially troublesome for equity investors.

If there is a deficit, then it must be paid off somehow and there are only two options available to a company. Either sufficient returns are earned on plan assets to close the gap, or contributions are made from operating profits at the expense of shareholders. Generally, the latter of these two options is how things play out so it is critical to keep an eye out for an oversized deficit.

This ratio…

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Tom Firth

30th Sep '16

Exactly...Reuters generally are only uploading the main financial statements and then making use of data in the notes to perform normalisations etc. There are quite a few companies which they have uploaded pension assets/liabilities but even for a large cap like BT, for example, they were missing it for a recent report.

Thank you for your analysis in your first comment, though, it is always very helpful to get a better idea of what people want out of the numbers and how they interpret them.

Have a good weekend for now!

Point taken, it is a little hidden away currently...perhaps it would indeed be better as a traffic light. We'll have a think.

We do appreciate the comments (from many in the community in fact, not just yourself!) about the accounting for balance sheet strength in the StockRanks too. We are researching and reading to try and come up with something good...we're just hesitant to do anything rash when performance is already so strong.

Thank you very much for the feedback anyway, we always appreciated it :). Have a great weekend for now.

Tom

DWit199

I exported the 625 companies in the FTSE All Share index to a spreadsheet . I then excluded those with a null value of pension deficit/mkt Val %, a pension deficit of <1% and any cases without a stockrank. For the remaining 165 companies I performed a simple correlation analysis between ValueRank and pension def/mkt cap%. There is a weak (0.36) but positive correlation. There is a tendency for companies with a large pension deficit to have a higher value rank. I would anticipate that a high pension deficit makes a company less valuable rather than more, so this correlation is the opposite of what I would expect.
Two possible explanations for this anomaly spring to mind and there are probably more.
Perhaps the market is identifying the pension deficit and reducing the share price accordingly. Since the deficit is not included in the book value or enterprise value used to calculate the value rank, the "value" of the company is overestimated and the value rank is therefore too high. Alternatively, perhaps the market is over reacting to the pension deficit and reducing the price excessively, leading to the high value rank.
It is interesting to note that in this same sample there is a weak positive correlation between yield and value rank and a weak negative correlation between p/e and value rank. This is as expected and helps confirm the feeling that the pension deficit finding is genuinely anomalous.

cig

1st Oct '16

What about using the deficit's 5- or 10-years volatility as a proxy? It mght even end up more informative than gross assets when estimating risk, as it captures to some extent the degree of liability matching in the scheme.

BIACS

3rd Oct '16

The null value (" - ") seems to cause difficulty with using the new ratios as part of a screen. If you wanted to ensure screen results do not include any companies with a deficit of say 10% or more of market cap, then you would expect putting in a value of less than 10 in this ratio as a new screen 'rule' would do the trick. However, the screener then also filters out every stock with a null value as well - which, as has been pointed out, could mean the info. just wasn't there rather than that the stock does not qualify for the screen. Is there a way of fixing this quirk and/or adjusting the screen to get around this so that it shows stocks with the "-" null value as well?

Hi David - glad to see you're doing the data work! That relationship is what I would expect to observe however, as a high ValueRank indicates that a company is priced more cheaply than a counterpart with a low ValueRank.

As such, if you observe a positive correlation between the size of the pension deficit and the ValueRank, this does indeed suggest that a company becomes less valuable (is priced more cheaply) as the pension deficit grows. Does that make sense? My apologies if I've misinterpreted your point!

This same logic is what explains the correlations with the yield and PE metrics that you describe.

That's an interesting idea actually, thanks for that! You're right that this should provide some insight into how well liabilities were matched over the period in question, though skewed by cases where companies have had to contribute. Ideally, we'd like to see that liabilities were matched consistently and paid for out of plan assets only...do you agree? Will have a think anyway.

Tom,
Assume two companies with a book value of 2, CoA with a pension deficit of 1, CoB without a deficit.
If the share price is 2 then the p/b is 1 for both companies and all else being equal they will have the same value rank. However CoA has a large liability which should be subtracted from the book value leading to a corrected p/b of 2. Since the same market price buys less value, CoA should have a lower value rank than CoB.
In general, if all other factors are equal then a pension deficit should lead to a lower value rank.
However, in our observations it doesn't. In our simple example the actual market price of CoA would be lower because investors recognise the liability. Unfortunately, because the liability is not included in the calculation of the value rank, the company is awarded a spuriously high rank. Stockopedia subscribers believe it to be undervalued but there is no way of knowing whether this is because the market has over-reacted to the deficit, we have calculated the value rank incorrectly, or some combination of the two.

Ramridge

David -
I think there is a slight flaw in your logic. You say:
" However CoA has a large liability which should be subtracted from the book value leading to a corrected p/b of 2 "

My understanding is that a pension deficit appears under "non-current liabilities" in the balance sheet account. So a book value figure is net of a pension deficit. You seem to be subtracting it again.

Happy to be corrected.

I thought there may be a flaw! You are correct that the book value does include the pension liability so the value rank is allowing for this. The other factor used in calculating the value rank that could be affected by the pension deficit is the Enterprise Value used to calculate the Earnings Yield. It is not clear to me from the definition of EV whether this is included or not.

Mark Simpson

Hi Tom,

Out of interest, what is your take on how you'd incorporate the pension deficit into the earnings yield? Further, why do you think said method is a good way of assessing the impact of the deficit on valuation?

Earnings Yield = EBIT/EV

EV = Market Cap + Net Debt

So PD Adjusted EV would become = Market Cap + Net Debt + Pension Deficit

Then all ratios that use EV can be recalculated using the adjusted EV.

Reason to include an adjusted EV is that Pension Deficits are liabilities that have to be met through earnings over the long term so are very similar to debt.

The issue is that companies can vary in their asset allocation & return assumptions so that deficit numbers are not perfectly comparable. It is still better than excluding these though and net debt itself can be misleading as companies window dress to varying degrees/ have different cash flow profiles and we accept those variances.

The general point is that there may be companies out there with a large pension deficit that are so lowly rated they make good investments despite the extra liabilities they have over a company without a deficit. It is better to have a continuous measure like adjusted Earnings Yield than a discrete one like an in/out screening criteria.

Hope that helps,

Mark

It is even more complicated than I thought. If you look at a company like Hogg Robinson, it has a negative book value of £50.5m largely due to the pension deficit of £258.3m. In the value rank calculation for this company p/b is greyed out as n/a, presumably because it is negative. I can't find an explanation of how the value rank is adjusted for factors that are n/a.

pooledaniel

4th Oct '16

This is a great addition to highlight some of the issues around pension deficits. A few thoughts from me...

Firstly, how are you handling schemes with a surplus that cannot be recognised (e.g. irrecoverable under IAS19)? Is this just displayed as a nil surplus/deficit?

Secondly, and by far a more important point; I think this needs to come with a substantial health warning around the basis on which this deficit is measured. You are looking at a single measure, i.e. accounting, which is typically not a particularly important measure. In reality, the employer's commitment to the scheme in terms of monetary contributions is based on the Technical Provisions deficit (i.e. the 'Scheme Funding' position required under SFO legislation). This measure will show significantly higher liabilities than on an accounting basis, and as such a lower surplus / higher deficit. Scheme Funding liabilities can easily be in excess of 20% higher than accounting liabilities.

There is also another potentially important measure that people should be aware of; the buyout deficit. This represents the hole that would need to be filled in order to 'get rid' of the scheme, i.e. to secure the liabilities with an insurer so that the company has no further obligation to pay / fund benefits. This is also the 'debt on employer' that would arise should the sponsoring company go insolvent. This measure is higher again! I've seen buyout liabilities that are double the accounting liabilities.

I think someone has already touched on the importance of having a measure of the total liabilities / assets as well as the deficit; I appreciate this may be difficult to implement, but this would be very valuable to allow the magnitude of the pensions risk to be considered. There's no hard and fast rule to estimate the liabilities on the other measures I've noted above, but having accounting liabilities would at least give a very high level indication of the actual size of the pensions issue.

By way of a very brief example...

Assets = £1,000m
Accounting liabilities = £1,000m
Deficit / Surplus (Stocko) = £Nil

Scheme funding liabilities = £1,300m
Scheme funding deficit = £300m

In this case; the accounting position looks relatively good, but in reality the company is required under legislation to make good the £300m Scheme Funding deficit. I've seen a real example of something very similar to this, and in that case the market cap of the company was only just over £100m... the company was essentially a 'pensions zombie', where the business was totally restricted by the weight of the pensions scheme.

For what it's worth, if people are interested in this stuff, you can often get a 'Scheme Funding' number by looking in the full accounts. For companies where pensions is a big issue, they will often disclose the deficit at the previous triennial valuation and a note on the contributions that they agreed to pay to make up this deficit. This may help to supplement the stockopedia screening tools.

Again, I think the new functionality is a great addition. This post isn't meant to be slating it at all, just highlighting that it's worth people having a bit more of an understanding of the various measures of pension deficits and how these play together.

Very happy to elaborate on things I've said / chat about this stuff if it's helpful!

TraderTim

5th Oct '16

Great feature!

In my previous response I picked the wrong ratio to explain my point, overlooking the fact that book value already included the pension deficit. I will try again in simple terms.
From a value investor perspective a high value rank is a good thing for a company to have.
A high yield is considered a good thing, high yield has an observed positive correlation with value rank so companies with a high yield receive a higher value rank.
A high p/e is a bad thing, there is a negative correlation between high p/e and value rank so companies with a high p/e receive a lower value rank.
A proportionately large pension deficit is (presumably) a bad thing. There is a positive correlation between pension deficit and value rank so companies with a large deficit (bad) receive a high value rank (good).
This is the anomalous correlation that I have observed which I would like to explain.
.

Tesco (LON:TSCO) 's prelim report today shows a pension deficit of £7.16bn up from £3.2bn in Feb 2016, a whopping increase of 124%.
And yet the shares are up 12% at the time of writing this note. Why?
Well, the pension deficit issue is currently only a paper problem. The impact today is a weakened balance sheet. Net Assets have come down to £5.9bn from £8.6bn largely due to the increased pension deficit.
However, the annual deficit contribution has not changed. Tesco is due an actuarial scheme(s) revaluation in March 2017. It is at that time that the scheme trustees will take a hard look at the calculated deficit and re-negotiate a deficit reduction programme.
Today's market reaction is down to the better than expected operational performance. The massive increase in the pension deficit is potentially tomorrow's problem if the underlying economic factors haven't improved in the interim period.

sharw

Tesco's report today emphasises two points I made earlier:

1} the growing lack of credibility of IAS19 - I pointed out that Carclo had to use bond rates even though its pension scheme had moved out of bonds and here is Tesco:

"To calculate the pension deficit for accounting purposes, we are required to use corporate bond yields as the basis for the discount rate of our long-term liabilities, irrespective of the mix of our assets and their expected returns. The sharp decrease in corporate bond yields since the year-end - the biggest six-monthly fall recorded since the iBoxx corporate bond index was first introduced in 2000 - has therefore driven a rise of more than 50% in the accounting valuation of our liabilities, increasing our reported accounting net deficit from £(2.6)bn to £(5.9)bn. Our defined benefit pension scheme assets have performed well and we are progressing with our asset de-risking strategy, which aims to reduce risks from changes in interest rates and inflation".

2) the effect on the balance sheet and its distributable reserves. Carclo had to stop its dividend payment. Tesco isn't paying one at the moment but look at the balance sheet - £1.9bn added to the pension deficit in the 6 months was enough to wipe out retained earnings.

10th Oct '16

Article in the Telegraph today where consultants JLT have produced a liabilities/MCap table for the 350, This is topped by First Group at 377% followed by IAG at 204%

http://www.telegraph.co.uk/investing/funds/the-dividends-at-risk-from-final-salary-pension-promises/

Brilliant Leader

Hi Tom

Apologies for the tardy response but I had missed your reply. I think the ratios are great. Additionally, it would be great if the actual £m pension deficit figure appeared on the stock report. In an ideal world I would love to see it as a line item in the Financial Summary but failing that, maybe at the top of the screen underneath Market Cap, Enterprise Value and Revenue.

Personally, I am less interested in a ratio for screening purposes (although that is a very useful feature) and more interested in an "at a glance" sanity check for red/amber flags.

HumourMe

24th Feb '17

These are useful, but gearing can confuse matters.

Hogg Robinson (LON:HRG) is an odd example as adding pension deficit 'improves' gearing as it moves increasingly towards the negative.

Other Ratios

Leverage (ttm)		total	-intang	+pension
Gross Gearing	%	-39.6		-292.5
Net Gearing	%	-18.5		-271.4
Cash / Assets	%	7.15		50.9

Negative gross gearing (Total Debt / Book Value of Equity) in this caseis the result of a negative 'Book value of equity' http://www.stockopedia.com/share-prices/hogg-robin... not net cash (as is possible with net gearing).

Can we have a 'book value of equity' filter in order to exclude these 'false negatives'?

Introducing the New Pension Deficit Ratios

The New Pension Deficit Ratios

Pension Deficit

Pension Deficit to Market Cap

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Tom Firth

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