Seems like time for some controversy - it’s all been a bit too cosy and we need a New Year shaking up !!
Some of you may have endured a long stream of Tweets from me recently on the subject of Pension Deficits - it was my usual trick of using the excuse of “I’m thinking hard about an important subject” as an excuse to avoid getting out of Bed on a nippy January morning (yes, I know it was 11am - it was still nippy even then !!).
There seems to be a blanket reaction to Companies with a Pension Deficit - “oh, they are no good to invest in, they have a huge Pension Deficit” - so much so that it got me thinking - is this a classic example of Daniel Kahneman’s ‘Fast Thinking’ when we need to apply some ‘Slow Thinking‘? (Kahnemann’s book, ‘Thinking, Fast and Slow’ can be bought in Wheelie’s Bookshop via the WheelieDealer2 website.)
Pension Deficits being bad has almost gained the fervour of a Religion - I am probably the only person in History to question whether or not they are as bad as made out - heretic !!
It’s like Climate Change. If you question it, you are a Denier and should be burnt at the Stake. Or dunked in the Duck Pond.
The Cult of the Pension Deficit.
The other driver for me bashing out this Blog is that I have a couple of Stocks that have chunky Pension Deficits - and they are both languishing quite unpleasantly. The first is Aga Rangemaster (AGA) the Cast Iron Iconic Cooker and Fridge etc. people and the other is Molins (MLIN), the Tobacco packaging and Smoke Testing Laboratories chaps.
AGA has issues in Europe with the economic malaise but an Update last week showed that they are actually doing rather well in the UK and in the US - there may be value here. It is hard to determine if the Pension Fund issue is really holding them back, but I suspect it is. The company has been around for something daft like 120 years and has survived various Recessions and Wars even !!
MLIN has issues around delays in a US Food and Drugs Administration (FDA) Cigarette Smoke Testing Standard and also issued a recent Profit Warning as they have suffered Order delays in Tobacco Machinery and Scientific Services. So, here again, it is unclear if the Pension is causing the collapsed Share Price - obviously the Warnings have caused the big trouble here.
I guess the first bit to cover is to explain what a Pension Deficit actually is. They arise as a result of Companies offering a Final Salary Pension Scheme to their Employees in the past. There was a time when it seemed like Final Salary Schemes were a brilliant wheeze to reward and attract Employees and they did appear to be Affordable.
However, as time has gone on, and circumstances changed, they have pretty much become a Peter Pan Fantasy - very few Companies now offer them to New Employees and the vast majority of Companies have closed existing Schemes.
The problem arose for the following main reasons - I am sure there are several more:
- Gordon Brown’s 10% Stealth Tax on Dividends - this may not seem like a big deal, but when the cumulative effect of Compounding those 10%s is taken into account, it has a massive impact over time.
- Life Expectancy - people are living longer - obviously a good thing but it means that Pensions have to pay out for more years. For instance, when a Scheme was started back in, say, 1990, it was expected that the Retiring Employee would live for maybe 20 years after they left work. In practice, they are finding that these Employees are living 23 years - again, it might not sound much, but it makes a massive difference to the finances, especially if a Scheme has a huge number of Employees to pay for.
- Annuity Rates have dropped along with Bond Rates and Interest Rates. Let’s do an example. Say 20 years ago an Annuity would pay out 10% a year - so if a Company had promised £20k a year to the Employee, they could buy an Annuity for £200k. Now, if the Annuity Rate falls to 5%, the Company would now need £400k to buy the same £20k a year Payout. Scary huh? (I believe that Most if not All Company Final Salary Schemes buy Annuities for each of their Retired Employees on their Date of Leaving or close to this - it ensures the Payout is Guaranteed. I may be wrong on this.)
- There is an argument that Final Salary Pension Schemes were never affordable and it is only with time that this has really shown to be the case. It is a bit like the Mortgage Endowment Policies which were all the rage in the 1980s - they seemed a great idea at the time but after many years they just were not delivering.
A Pension Deficit arises because every so often the Company undertakes an ‘Actuarial Revaluation’ of the Pension Fund. I am not sure what the Legal Requirements on timescale for these Revaluations is, but they seem to happen every 3 years or so. An Actuary is a sort of special type of Accountant who mucks about with Spreadsheets and plays around with numbers to work out what the Pension Fund is worth and how much it needs to be worth to payout the Pensions it has promised to Employees. (Apologies to any Actuaries reading this !!).
Example time again. Let’s say the Company has committed to pay Final Salary Pensions to Employees amounting to £200m according to the Actuary. If the Pension Fund is then valued at £150m, there is clearly a ‘Deficit’ of £50m. When this happens, the usual situation as I understand it, is that the Actuary recommends an amount of Extra New Cash that needs to be paid into the Fund every year for a period, so that the Deficit is closed. The exact amount to be paid into the Fund is agreed between the Company Directors and the Pension Fund Trustees.
In our Example, let’s say that the New Payments into the Fund amount to £10m a year for 5 years (please note, this is a very simplified example). This means that £10m of Profit is being diverted away from Shareholders and is going to fund the Employee Pensions - obviously this is £10m a year that is not being paid out to Shareholders in Dividends and is not being used to Invest in the Business for future growth and enhanced Returns. Bad News clearly for Shareholders.
Very rarely, and more a thing of the past (although we might see some in future), a Pension Fund Revaluation can result in a ‘Surplus’ - obviously this is where the Fund has more money in it than it needs to payout to Retirees. It is normal that a Company pays a certain amount of money every year into the Pension Fund (this also is the case with Defined Contribution Schemes), and where a Surplus occurs, what can happen is that the Company gets a ‘Pension Holiday’ (no, the Directors do not go off to Ibiza !!) and might not have to pay any money in for a few years.
Why might the Pension Deficit issue be exaggerated?
This is quite a strange section to write, and I have tried to choose the title carefully. The truth is that I don’t really know with 100% certainty that the Pension Deficit issue is overblown, but I just think it might be. By presenting the arguments here, you can think about it also and draw some conclusions. I am really erring on the side that Conventional Thinking probably is wrong - and the Pension Deficit issue might actually be creating opportunity for Investors. It is possible that stocks are artificially under priced due to the Pension Deficit fears and over time this Pricing Anomaly could correct and we might see big Share Price rises.
The reasons for Pension Deficits Risks possibly being overstated are as follows:
- I can think of no Company that has gone bust due to a Pension Deficit. Yes, there are the odd one or two where a big Deficit might have contributed to a Collapse, but it is more likely that the Company was rubbish anyway and had huge Debt Levels - this is what kills Companies. One candidate is RSM Tenon (TNO), the Accountancy Company that went bust a couple of years ago - but this was definitely down to Debt and an aggressive expansion policy in expectation of a rise in Demand for Insolvency Services which did not arise - although, ironically, it did arise for TNO !! I asked around on Twitter the other day and nobody came up with a Company where the Pension Deficit had dragged it down. Yes, there are loads of examples where companies have had to make overpayments, but that is a different issue. It’s worth noting that even British Airways (or IAG or whatever it is called these days) has an enormous Pension Fund and no doubt Deficit issues, but even that Company has limped on (surprisingly well).
- The numbers on which Actuarial Valuations are based are incredibly ‘sensitive’. This means that small changes in the Assumptions fed into their Valuation Models (an Excel Spreadsheet no doubt !!) can produce a large change in the Final Answer. An example would illustrate this best - imagine that you have a Pension Fund worth £200m and this is Fully Funded and there is no Deficit or Surplus. Then imagine that the Input Life Expectancy changes by 2 years - you may find that the Fund is suddenly £50m in Deficit - this is how the numbers work. So, over time, you can get violent swings in the Valuation of the Fund and the Expected Payouts for very tiny Input changes.
- Final Salary Schemes have pretty much been closed for the vast majority of Listed Companies and this was often done several years ago. This means that as time passes and extra Payments into the Fund are made, the problem is diminishing - Pensioners are passing away and the liabilities are declining. So it is obvious that at some point in a few years, Pension Deficits will be unheard of. By buying into Companies with Deficit Issues now, we might be getting in nice and early.
- Annuity Rates have been falling for years and it is pretty hard to see them going much lower. This is partly because the Interest Rate cycle is most likely flat lining before a move up at some point - this could well be some years away but it is doubtful that Interest Rates will fall much more (the Zero Bound) - so at some point Bond yields will rise and this would drive improved Annuity Rates. If the Payout on Annuities rises, it would mean that Companies would need to find less Money upfront to buy an Annuity to guarantee a certain level of Income for each New Retiree - it is sort of the opposite of the Example I gave earlier in this text. Pension Funds are also finding other ways of getting an ‘Annuity-like’ Income - they are doing more Property deals for instance and Private Finance Initiative (PFI) type Infrastructure deals. This means that the Poor Annuity Rates problem might be reducing for Company Funds with Deficits.
- The Valuations attached to both the Liabilities of a Pension Fund and the Assets of the Fund are really a snapshot in time - in reality it is a moving feast (bit like a Sushi bar with one of them Conveyor Belt things.) This means that you could do a Valuation every month and you would end up with 12 very different results in a Year - so it is all a bit nonsensical.
- Where a Company has agreed terms of an Overpayment and has been making those payments into the fund for some time, it is obvious that the Deficit Problem must be reducing - in such cases, Broker Forecasts of Dividend payments and suchlike already allow for the Overpayments to the Pension Fund - I will cover this in more detail below for AGA. In addition, once the Overpayments cease, the boost to Profits and Dividends will be chunky.
- There is a Risk that further Revaluations will throw up more problems - however, for the reasons given above, it is perhaps less likely. It is also possible that the Risk is to the Benefit of the Company - it could be that a Surplus suddenly appears - this could certainly be the case if Interest Rates started to move up. It is a strange Paradox of the Pension Deficit issue whereby rising Interest Rates would actually benefit companies with Large Deficits.
- I wonder if this whole Pension Deficit issue is another example of where the Financial Services Industry is duping Private Investors by creating an image of Complexity and giving the impression they “know the hidden Secret so you can make money” - whereas in reality, they are conning you into paying them cash for a duff service. Gobbledegook to make the ’experts’ look important.
AGA and MLIN
It is clear that MLIN has big problems that are more than just the Pension Deficit - so it is probably best to stay well clear of this stock. I hold MLIN and am happy to stick with it but I would not buy more, until I see clear evidence that Trading is improving. The big prize here is obviously the FDA Testing Regime - an announcement here could really kick the Shares upwards.
However, AGA had a pretty good Trading Update on Friday 16th January 2014 and I think it is worth considering Broker forecasts and valuation in the light of the discussion we have had about Pension Deficits above.
It is worth appreciating also that AGA has a large degree of Operational Gearing - in essence, this means that a small rise in Sales can give a much larger rise in Profits - so this is something to watch for.
For 2015 and 2016, the Consensus Broker Forecasts (from ShareScope - note these are not updated after the latest Trading Update - the chances are that they will be revised Upwards) are for Earnings per Share (EPS) of 14.25p and 19.66p (and remember these take the Pension Deficit Overpayments into account).
At a Price of 108p this gives Price Earnings Ratios (p/e) for 2015 and 2016 of 7.6 and 5.5.
Blimey, that looks cheap !!
Back in August 2014 they had Net Debt of £2.4m, so the Balance Sheet seems tough in that respect.
In terms of Dividends (yes, please) the Consensus Broker Forecasts for 2015 and 2016 are 1.9p and 6.0p. These figures look believable with the EPS forecasts.
At 108p, this gives Dividend Yields for 2015 and 2016 of 1.7% and 5.5%.
When you consider the Iconic Brand and the operational gearing, this seems pretty cheap. And remember that these numbers are after the Pension Fund overpayments have been allowed for.
As you can probably tell, I am pretty sceptical on the whole Pension Deficit thing - I really am starting to think it is a Red Herring.
There have been many Dividend Cuts in the past as a result of Pension Fund Overpayments, but these are largely diminishing now and Equity Investment is all about peering into the Future with a good Margin for Error.
I am no Pension Actuary or Accountant or anything, so there are probably enormous flaws in my text above - but there is a tiny chance I might be mostly correct.
Hopefully this has opened up a whole new area to think about, and it may also have thrown up AGA as an idea to look at.
Regards, Old Sceptic Himself, wd