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Over the years, I had several grim meetings with management at the now defunct Uniq dairy food company. We should have been talking about cream cakes. Instead, most of the meetings seemed to be about its huge, badly underfunded pension fund. Pension fund concerns have soured many a company meeting subsequently.
Britain’s long history of paying low wages but extraordinarily generous final salary — or “defined benefit” (DB) — pensions has left a painful legacy. It has been made worse in some cases by chief executives who are nearing retirement opting to receive less in bonuses in favour of a higher salary, knowing they were locking in the income for life. In some schemes it is a handful of these big earners who are responsible for much of the deficit.
Too often, cash needed to be injected to fill the chasm between a scheme’s obligations and what was in the coffers. This money could have been spent on the business, improving returns for investors. I am afraid you have to get your head around this if you buy UK shares, but I think it is worth the effort.
Some history, briefly. The pension problem became even more apparent in about 2000 when, among other regulatory changes, an accounting standard was introduced that required a company to state any shortfall in its DB scheme as a financial liability on its corporate balance sheet.
Many companies responded by closing their DB schemes and moving to de-risk their pension schemes to avoid swings in reported shortfalls. This meant selling down equities and buying gilts — not the best idea, it transpired.
Successful investment is about managing risk, not eliminating it. Without risk, returns are meagre. And these companies could not afford meagre returns. In the years after the rule change, deficits often worsened as interest rates fell and liabilities increased, because scheme members were living longer than expected. In 1990, for example, we expected men in the UK to live to nearly 73 and women to over 78. By 2018 it had risen to 79 and 83, according to the Office for National Statistics.
There were other unintended consequences of the collective de-risking. The headwind for UK equities of pension funds selling down their exposures meant the relative cost of capital for UK companies increased — issuing shares no longer raised the same amount as it had. All this meant less capital for productive investment. It helps explain under-investment by UK companies and its relatively poor productivity.
Some company bosses, weary of the responsibilities and distraction of the whole thing, transferred out their pension funds to an insurance company. However, change is happening. And here is where investors should prick up their ears.
With interest rates higher, many schemes are now moving from deficit to surplus. Ten years ago the average pension deficit across the FTSE 100 was 6.2 per cent and across the FTSE 250 nearer 16 per cent, according to stockbroker Liberum. Today that has become a 3 per cent surplus for the FTSE 100 and a 1.1 per cent surplus for the FTSE 250.
Longevity is no longer increasing either. It has actually fallen slightly. A pension fund in surplus might now prove an asset to a company that does not jettison its scheme.
The new Pensions Funding code comes into force this month. This allows increased flexibility for pension funds to dial up the risk on the surplus element, allocating a bigger portion to equities. This will happen only if the company retains control — not if it passes a fund on to a large insurance company. Equities generally generate greater returns over the long term than gilts, strengthening fund positions further and enabling beneficiaries to be given better inflation protection or other enhancements.
It will, quite rightly, remain very challenging for companies to simply take surpluses back, but with the support of pension fund trustees they can use surpluses to reduce contribution costs for the current workforce, now in defined contribution schemes — improving employee satisfaction and helping with recruitment.
Meanwhile, I believe this improving position should benefit many investors. An example may illustrate why. In 2018 NatWest agreed to pay up to £1.5bn in additional contributions into its pension fund. It paid an additional £1bn between 2020 and 2021. Today it has a surplus. In fact, as much as £45bn may now be sitting as surplus in FTSE 350 company pensions.
I expect these improving numbers to feed through to share prices. We saw this with Premier Foods in April 2020, when it merged three schemes — one in surplus and the other two in deficit — enabling it to nearly halve deficit contributions and invest in its first TV ads for Bisto gravy granules in six years.
Between the beginning of May and mid-July that year its share price doubled. Its other brands, like Sharwood’s and Mr Kipling, have also seen more investment recently, with exceedingly good results, if its latest trading update is anything to go by — 9 per cent sales growth for groceries in the first quarter.
Intriguingly, some of the UK companies that have attracted cash bids this year, like our former holdings Wincanton and Royal Mail owner International Distribution Services, have pension surpluses. So I am watching these numbers very closely within company reports, as I am not sure the market is fully awake to the potential benefits.
I also believe we are past the lows of equity allocation by pension funds and might be seeing a reversal of a 20-year trend. You may think I am venturing into fantasy land now, but we might even see an increase in pension fund allocations to UK equities. The pensions bill announced in the recent King’s speech needs to work through parliament, but it will be interesting to see if the new Labour government pursues the idea of encouraging and even forcing more UK pensions and savings to invest in British companies.
Individual investors may not need such incentives. The economy here appears to be strengthening, wages are growing faster than inflation for the first time in years and UK shares still look relatively cheap.
James Henderson is co-manager of the Henderson Opportunities Trust, Lowland Investment Company and Law Debenture. He owns NatWest stock.