Why investors should be worried about pensions.
And WS Atkins - Tackling its Pensions Liability
Britain inaugurated a Civil Service pension scheme in 1810. Two hundred years later, the defined benefit scheme, which now includes teachers and employees of the NHS and the Armed Forces, is unfunded to the tune of 1.2 trillion pounds. This is almost as big as the National Debt. But the British state will pay it off piecemeal over decades, as it is here (so it is assumed) forever.
The East India Company inaugurated the first modern company pension scheme in 1813. The company was liquidated in 1874. In 2012, the profitable knitwear company Dawson International went into administration because it was unable to fund its pension's deficit. The CEO said, " . . .the deficits have widened, mainly due to changes in actuarial assumptions, and associated costs have risen significantly." Pension trustees and the regulator demand that companies, unlike the State, fund their deficits. Company defined benefit pension schemes are wonderful for employees, but they can be lethal for the company they work for. The Motley Fool has warned about company pension obligations for some time.
This year revised standards for pension accounting (under IAS19) come into force. Companies will have to recognize any shortfalls immediately in their accounts and new standards are set for the assumptions behind the financial figures. In 2013, Royal Dutch Shell will be forced to take an additional charge for an unrecognized loss at end December 2011 of 10 billion pounds. (Estimate by the actuaries Lane, Clark and Peacock -LCP). With 169 billion pounds equity, Shell can take this hit in its stride. Others cannot. International Airlines Group (BA & Iberia) will take a charge of 1.2 billion pounds (LCP estimate), which is 30% of the company's market capitalization. LCP calculates that the proposed European Pensions Directive, by requiring solvency reserves for pension funds similar to insurance companies, would cost the FTSE 100 companies 200 billion pounds.
The following table gives an idea of the sensitivity of pension deficits to bond yields and to the Stock Market. The figures are LCP estimates for the 84 FTSE 100 companies with such schemes at May 2012, when the FTSE 100 was at 5,320 and corporate bonds yielded 4.5%. As pension schemes invest in the Stock Market, the higher the market, the higher the value of the scheme's assets. Future liabilities for pension schemes are discounted by corporate bond yields; the lower the bond yield, the lower the discount rate for future liabilities, giving a higher value for their present value:
(Table from Lane Clarke & Peacock: Accounting for Pensions 2012)
Inflation and longevity are two further variables when calculating pension scheme liabilities. Assumptions vary considerably by company: insurer Resolution expects its pension equity investments to increase by a conservative 5.0% p.a., while retailer Kingfisher expects a return of 8.5%.
Defined contribution pension schemes greatly reduce the risk for companies. The company no longer carries the uncertainty of what the employee's final salary will be on retirement, or the rate of inflation thereafter. Pension asset volatility and returns is carried by the employee, not by the company.
When reviewing a company, the wise investor will ask:
1. Does the company have a defined benefit pension scheme on the books?
2. Does it remain open to new employees?
3. Is the scheme in surplus or deficit?
4. If there is a scheme in place, do the directors address its financing in their report?
5. Are the assumptions for inflation, longevity, return on investment of the fund's assets and the discount rate to calculate its liabilities reasonable?
6. Does the company have the financial strength to pay off its future pension liabilities?
WS Atkins - Tackling its Pensions Liability
The Investors Chronicle recommended WS Atkins as a 'Buy' at 649p in November. The engineering consultancy has a growing worldwide business; it is consistently profitable and has net 30 million cash in the bank, as of September 2012. It is a well managed company. At last night's price of 811p, the stock is on a PE ratio of 10 and yields 3.8%.
In financial terms, WS Atkins is a pension fund with a sideline in engineering consultancy. Pension plan assets, at 1.1 billion pounds, exceed the company's other tangible assets of 0.8 billion. Pension plan liabilities, at 1.4 billion pounds, dwarf other liabilities of 0.65 billion. The management has taken measures to 'de-risk' the defined benefit pension plan. They have persuaded some members to move to a defined contribution plan and they no longer offer a defined benefit plan to new employees (they offer a defined contribution plan instead). They transferred some benefits out of the plan and removed the link with future salary increases of those within the plan. And they agreed to pay 32 million pounds a year into the pension fund for the next 7 years, a sum that exceeds the annual dividend payment to shareholders.
Yet the deficit in the defined benefit plan rose from 251 million pounds at 31 March to 317 million at 30 September (both prior to deferred tax). As a result, the company's reported equity fell from 119 million to 80 million pounds in this 6-month period. As Dawson International's CEO said in April about his own company's demise, " . . .the deficits have widened, mainly due to changes in actuarial assumptions, and associated costs have risen significantly." WS Atkins' plan suffered a 73 million pound actuarial loss in the period.
What holds for the future?
While WS Atkins's longevity assumptions are conservative compared to its peers, other assumptions appear to be optimistic. The company uses 2.7% for Retail Price Inflation and 1.7% for Consumer Price Inflation; if the rate turns out to be 1% higher, the pension deficit would be 200 million pounds higher. The chosen rate for discounting future liabilities at 4.6% is considerably greater than the current corporate bond rate that is recommended. A decrease to 3.6% would lead to an increase of 280 million in the deficit. This shows that two wee changes in actuarial assumptions and the company's balance sheet is hit with a 480 million pound charge, equivalent to 59%of its market capitalization.
Now, any actuarial change, say for example the 480 million mentioned above, is not a non-cash item that can be ignored. The pension plan trustees will demand that this sum be paid off over a period of years, as they have done with the current deficit. In the case of the current deficit, WS Atkins is paying it off over seven years. Any such period for the hypothetical 480 million would mean that the company would have to pay out 69 million pounds more every year to the pension fund. This is a very large sum when compared to the company's adjusted pre-tax profit of 101 million pounds for 2012.
Should the company be placed in this situation of having to pay large sums annually into its pension fund, it is hard to see how it could afford to maintain any dividend payment to its shareholders.
WS Atkins admits that it "has yet to know the full impact of the amendments to IAS19". Not to mention the proposed European Pensions Directive.
Any investor in WS Atkins must take into account the risk of its pension fund liabilities. The more prudent will choose to wait for its next annual report, by which time it will have been obliged to implement the amendments to IAS19, if not the European Pensions Directive. And watch those assumptions about inflation and the discount rate.