Rising pension deficits: should income investors be worried?

The pension deficit of the UK’s top 350 public limited companies grew by a £12 billion in 2016, according to a study carried out by the actuarial consultancy Barnett Waddingham titled Impact of Pension Schemes on UK Business.

The funding gap for defined benefit pensions has soared for public companies in the past few years, it was found. As of 2016, the collective pension deficit for public companies stood at £62 billion. By way of contrast in 2011, the collective pension deficit stood at £54.4 billion.

Most striking, however, is the growth of pension deficits as a proportion of pre-tax profits for UK companies. The study found that in 2016 the collective pension deficit accounted for 70 per cent of UK plc pre-tax profits. In contrast, even in the midst of the recession in 2009, pension deficits as a proportion of profits were considerably lower than now, standing at 60 per cent.

Even in years the pension deficit receded, the deficit as a proportion of profits has increased. Most worryingly, the study found, even if between 2017 and 2019 profits remained stable, a 0.7 per cent fall in bond yields could push the pension deficit to exceed annual profits for UK companies.  

This increase in the pension deficit, particularly as a percentage of pre-tax profits, has left many investors fearing how companies will respond. The biggest concern is that UK companies will attempt to cover costs by scaling back dividend pay-outs.

Last year, Neil Woodford, manager of CF Woodford Equity Income announced that he was divesting from BT, BAE Systems and Royal Mail, owing to fears over pension deficits. At the same time, speaking to Money Observer in October 2016, Simon McGarry, senior equity analyst at Canaccord Genuity Wealth Management, said that companies with large pension deficits are the ‘unexploded bomb in investment portfolios’. 

That bomb, however, may end up never going off. According to Nick Griggs, Partner at Barnett Waddingham, companies are hoping that ‘the pension deficit problem could solve itself.’ And this, he notes, is a possibility if ‘equity returns continue at the levels seen in the last few years, long-term interest rates rise more than expected and longevity increases do not provide any nasty surprises’.

As a result, firms, ‘are not rushing to clear deficits quickly with additional cash contributions.’ That means investors are less likely to face major dividend cuts for companies looking to fill the pension gap anytime soon.

However, he underlined: ‘unless companies are profitable over the long term, they can’t generate enough cash to meet their liabilities, including the pension deficit.’  

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