Are Pension Deficits Real Money? Yeah, but no, but yeah, but…

The fall of BHS has triggered an almost hysterical reaction amongst the leftist commentariat, not because they ever shopped there (they go to Zara and Gap), but because they think it provides first-hand evidence of how the system leaves honest occupational pension scheme members in the lurch. I don’t know how many times the figure of a £571 million pension fund deficit for BHS has been mooted in the media – but, there you are. If a statistic is repeated often enough with sufficient conviction, it becomes true.

And the real villain of the piece is apparently not the bunch of ninnies who bought BHS for the princely sum of £1 a year or so ago but the man who sold it to them. Sir Philip Green; or, if you believe Private Eye, Sir Philip Greed – the man behind Arcadia Group, a privately owned UK retail giant.

And then there is Tata Steel UK. We are told – and remember the poor old politicians mostly follow the media on these things – that one of the major factors which is stymieing a deal is the pension deficit which is normally mooted at £500 million. Again, where this figure comes from – Tata Steel is a wholly owned subsidiary of the mighty Indian conglomerate Tata Group – is obscure. But the popular wisdom is that it is the deficit which is the deal-breaker.  (Or could it be that potential buyers are hyping this up? And could you blame them if they were?)

Of course, if no buyers with deep pockets step forward (Mike Ashely?), then these poor, needy pension funds (most of whose members – beneficiaries – are hugely better off than the average state-only pensioners) will ultimately be bailed out by a state agency called the Pension Protection Fund. This was another product of Blair-Brown largesse which basically entails that the most advantaged occupational pensioners get an ultimate state guarantee on their retirement incomes. It reminds me that what is normally called prudential regulation means the bill will be passed down the economic pecking order…

Anyway, if pension fund deficits are indeed becoming a major factor in company bankruptcies, it is sanguine to reflect that some of the FTSE-100 flagships have been running pension fund deficits more than ten times bigger than those of BHS and Tata Steel for some time. BT Group (LON:BT.A), BAE Systems (LON:BA) and International Airlines Group (LON:IAG) are amongst the leaders in this unfortunate league table – all, be it noted, Thatcher-era privatisations which inherited huge pension liabilities from their state-owned previous incarnations.

According to the FT[i], the size of BT’s pension fund deficit amounted to £7 billion at the end of 2014. Royal Dutch Shell (LON:RDSA) came second with a deficit of £6.7 billion and BP (LON:BP) third with £5.5 billion. Tesco (LON:TSCO) (£3.2 billion), Unilever (LON:ULVR) (£2.3 billion) and RBS (LON:RBS) (£2.3 billion) also have massive pension headaches. The aggregate pension deficit for the top 6,000 defined benefit pension schemes amounted to £250 billion in March 2015[ii].

Some commentators have played with the fact that BT’s total pension liabilities (£47 billion) are greater than its market capitalisation (£44.3 billion). Should we panic? I don’t think so. The BT pension deficit has been apparent for many years and I remember British Airways (as IAG once was) being described as a pension fund with wings way back in the 1980s and 90s. Yet somehow, they still seem to have prospered (I would rather be IAG than Air France right now – but that’s another conversation).

What are these pension deficits anyway? Are they real money owed, as in a bank loan? I think a sophisticated economist, or accountant, will give you the same answer as Vicky Pollard: Yeah, but no, but yeah, but…

As my distinguished economist colleague Felipe R. Costa explained on these pages recently, pension deficits are a function of the discount rate applied to the stream of future pension liabilities (outgoings). This is derived from the risk-free rate associated with the yield on government borrowings of equivalent maturity plus an appropriate risk premium (which, since pension funds are highly exposed to government securities, is very small). In a normal world that may have been reasonable. In a zero interest rate, or near-zero interest rate, world those pension fund liabilities have ballooned to extraordinary levels.

Forgive me for going into the mechanics of this calculation. You estimate all your pension pay-outs for each year going forward until at least the last retiree who is currently a recipient of your pensions (and future pensions) is dead. (Often spouses receive reduced pensions after the beneficiary dies, so you have to take them into account as well.) And you add all the new retirees each year with the estimated pensions that they will receive. Don’t forget to subtract, for each year, the estimated number of mortalities. And then you take this stream of future cash flows and you discount it. (Come on, readers, you remember big sigma, one over one plus r to the power of t, surely?) Assuming an appropriate value of r – which is the discount rate. And which is the daft discount rate applying NOW: regardless of what it has been in the past of what you think it might be in the future…

Now the lower the discount rate, the higher the value of future liabilities; indeed if the discount rate were zero then future liabilities would zoom to infinity. According to one commentator[iii] a one percent rise in the discount rate would wipe out most of these pension deficits overnight. (Though I could not see the source of that assertion, it sounds credible to me.)

These pension deficits have also been exacerbated by changing actuarial assumptions about life-expectancy. Unfortunately for Tata Steel, since the good old days of British Steel, more steel workers are making it to retirement and are enjoying it for longer.

Only academic economists and self-serving accountants could have dreamed up a system as potty as this. And only the modern breed of bleeding-heart leftist politicians (who are often Conservatives, these days) could have enshrined this nonsense in law and then guaranteed it all with taxpayers’ money (when, as usual, most taxpayers are worse off than the beneficiaries of the generous state guarantee).

Of course the ultimate guarantee offered by the Pension Protection Fund (funded by us taxpayers) is itself notional since it would not kick in until all of the assets of the pension funds in question had been exhausted (and Sir Philip has not done a Maxwell and consumed the pension fund assets to save his own neck). So the politicians should calm down.

So back to the question – is this real money? The pension deficit represents the present value of all future liabilities (calculated as above) minus the CURRENT (market) value of all pension fund assets. As such it is a notional and hypothetical estimate of the amount by which a pension sponsor might have to subsidise that pension scheme over an indeterminate period stretching well into a highly uncertain future. It’s a very long-term contingent liability based on highly questionable assumptions.

So is it real money or an accounting fiction? Well, to the extent that it is booked as a liability on the company balance sheet it impacts the book value of the company. This is not, of course, the market value – or the market capitalisation for a listed company. Though, whichever valuation model you use to determine a company’s worth you are left with the awkward multiples that arise between book and market value. Ultimately, however, valuations are driven by earnings projections. The reason why BHS or Tata Steel are having problems finding buyers is not because they have pension fund deficits but because they are losing money hand over fist.

So no, pension deficits aren’t real money.

I don’t suppose Sir Philip Green needs any advice from me, but in the unlikely event that he were to ask me how to play his upcoming grilling by the Parliamentary Committee, I’d tell him to point out three things.

Firstly, when you sell a company you sell both its assets and its liabilities. Caveat emptor – buyers are expected to be wary – or, in modern parlance, to undertake their own due diligence. Both Sir Philip and the rickety outfit to which he sold BHS understood the pension deficit issue perfectly – the buyers were taking a punt that they could turn the business around, and had they done so, no one would have heard about the putative missing £571 million. Second, if the Monetary Policy Committee of the Bank of England could be coaxed out of their delusional ZIRP[iv], then much of this deficit could be magicked away overnight. Third, occupational pension schemes were another sop to the over-indulged baby-boomers. If you think about it, they are basically Ponzi schemes where the pay-outs to new retirees are paid for by the ever-increasing contributions of new young members coming in. Once the scheme is closed to new members, assets grow slower than liabilities (especially in a world where yield is hard to find).

You could call it Vicki-nomics[v]. By making a song and dance about pension fund deficits, the politicians are hammering more nails into the occupational pension scheme’s coffin.

I know that this all sounds harsh – especially since I am going to explain soon why Mr Osborne’s successor will have to unpick the “triple lock” on state retirement pensions. If you are under 35, you will probably have to work into your 80s before you get a meagre state pension. But look on the bright side: dementia care will be state-funded.

All the more reason why you need to invest wisely before it is too late. I am sure that Vicky would agree.

[i] See Big Pension Deficits weigh on UK Listed Companies, FT  06 September 2015, available at: http://www.ft.com/cms/s/0/9c50f8f8-5323-11e5-b029-b9d50a74fd14.html#axzz47WEAb9pn

[ii] Source: Pension Protection Fund “Purple Book”.

[iii] Jeremy Warner writing in The Sunday Telegraph, 01 May 2016, page B2.

[iv] Zero Interest Rate Policy

[v] I am referring to Matt Lucas in his incarnation as Vicky Pollard – Vicky Price is a highly respected economist.