Milking the company

Investors abhor companies servicing large defined benefit pension schemes for employees and ex-employees, but therein may lie an opportunity.

A defined benefit pension scheme promises a specified income to members (often a proportion of their final year’s salary) when they retire, paid from a fund invested by the company they work for. The total amount of money owed to current and future pensioners by the company is a liability, and the fund from which it will be paid is an asset.

The difference, the size of the company’s deficit (if the value of the obligation is greater than the value of the asset) or surplus (if the value of the obligation is less than the value of the asset) is recorded on the company’s balance sheet.

A deficit is a debt, the company owes the pension fund money, but it’s a peculiar kind of debt.

It should be cheaper, because there’s no interest to pay, and less risky than, say, an overdraft or loan, because, depending on the age of the employees in the scheme, many of the obligations won’t be paid for years, or decades.

But a deficit is also more risky because it doesn’t have a certain value like a loan from a bank. The value of the assets in the scheme vary with their performance on the stock market, and the present value of the obligation depends on assumptions made by actuaries about salaries and mortality (to work out the size of the obligation) and the discount rate (to work out how much is required to fund the obligation now, bearing in mind the investment will grow).

The deficit next year, could be radically worse, or better, than the deficit this year purely because the stockmarket has risen or fallen or assumptions have changed. Falling stockmarkets and increasing longevity has in the last decade reduced the value of pension assets and increased the value of obligations. They’re among the reasons many companies are winding down pension schemes.

The larger the scheme in relation to a company’s size, the more dramatic the effect on its balance sheet from changes in the pension deficit. This makes life very difficult for investors, because wide deficits, or the potential for wide deficits represented by a large scheme, impacts both the value of the company’s net assets, and future earnings (if the deficit widens, the company will have to pay more into the scheme), but we don’t really know by how much because deficits are variable.

Since investors use assets and earnings as the basis for valuing a company, and assessing its financial strength, a large defined benefit pension scheme injects a strong dose of uncertainty into our calculations, which explains why companies with large pension schemes, like say, Aga the range cooker manufacturer, trade on low multiples of earnings or book value even though in other respects they look like good businesses.

While a company is doing well, pension deficits look benign but just like debt, when things go wrong a large deficit restricts a company’s options. Lenders and shareholders will balk at providing more capital, buyers of parts or all of the business won’t want to take on the pension fund, and a temporary problem could lead to insolvency. Investing for the long-term in a company with a large pension scheme requires high levels of confidence in the continuous earning power of the business.

Up until now, I’ve arbitrarily decided to ignore a company’s pension deficit if the scheme is smaller than the company (as measured by the value of its tangible assets), and ignore the company if its pension scheme is bigger.

But that’s unsatisfactory. What if the company has relatively few tangible assets, but valuable intangible assets? What if it can use those assets to generate stable earnings that can pay off a much larger pension fund?

These are the thoughts I’m having as I look at National Milk Records, which emerged from the Milk Marketing Board.  It tests milk from the majority of UK cows, and although I haven’t ascertained it yet, it could have a dominant market position.

But the tangible assets of the company are worth a little over ''6m, and its pension obligation is ''27m.

Such is our abhorrence of companies with huge pension obligations, some of them, the ones that will be able to meet those obligations and still profit, may well be hugely undervalued. But identifying those companies involves so much speculation about the ‘true’ value of the pension deficit and the ‘true’ value of  future earnings, I wonder if I’ll ever be able to do it.

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Notes

• Thanks to John McElligott, Philip O’Sullivan, and Andrew Martin for helping me think through the risks of defined benefit pension schemes on Twitter.
• Philip responded to my questions about Trinity Mirror‘s pension scheme on his blog, and linked to a salutary tale documenting how chilled food producer Uniq buckled under the burden of paying for the pensions of an army of milkmen.
• Mercer publishes a quarterly commentary on pension assumptions.
• There are more assumptions than those listed above, this document from the American Academy of Actuaries explains the basics of pension funding and accounting.