What is a Pension Deficit?

Pensions deficits are often not understood by investors because they can be highly complex in nature, and they are not directly related to the business' operations. However, a company with a large pensions deficit (relative to its market capitalisation) can be a major deterrent, and usually means the company trades at a discount to its peer group.

To understand what a pension deficit is, you have to recognise what a pension is. A pension is a regular income that an individual receives upon retirement. Pensions are created through participating in pension schemes - these may be either personal schemes, schemes through an employer or through other means. It is the employer pension scheme that causes problems for companies and investors if it meets certain criteria that means cash must be injected on an ongoing basis. Furthermore, that cash is put into a pension fund 'pot', where it is invested in order to try to boost the fund further - after all, cash does not generate material returns. The problem is that with investment, comes risk.

Main Types of Pension Scheme

Generally speaking, there are two main types of pension schemes:

- Defined contribution scheme = This scheme involves an employer paying a defined (specified) contribution into a pension plan. The benefits upon retirement are based on the returns on the cash invested, the amount of cash that the employer pays into the scheme, and mortality rates within the members of the scheme. The benefits upon retirement are therefore not fixed.

- Defined benefit scheme = This scheme is structured differently. This is a pension plan where the benefits upon retirement are defined, unlike with the contribution scheme. The benefits upon retirement are based upon a pre-set formula that is reliant on a number of factors. The main difference in this scheme is that the employer takes on the risk associated with the pension scheme and any problems that could crop up. A few of those risks include investment risk, inflation risk and mortality risk. Defined benefit schemes are either funded or unfunded. A funded scheme sees the assets within the scheme held separately and they are safeguarded in the case of bankruptcy. On the other hand, no assets are held separately in an unfunded scheme and the pension benefits are released as demand for them arises

When do problems arise?

Problems with pension schemes often crop up for defined benefit schemes. That is because the employer of the company has to ensure that there are enough assets in the pension fund pot, to be able to cover the benefits required when the employees retire. For example, if £100m is required for the employees upon retirement, the employer needs to ensure that, when the £100m is required, there is £100m in the pension scheme. The employer needs to ensure that there is no deficit. If the value of the assets in the pension scheme is lower than the value of the benefits that need to be paid, then there is a pension deficit. Pension funds are the largest investors in the stock market, with one of the most famous being Standard Life. They collectively manage hundreds of billions of pounds worth of money each year. In reality, corporate pension funds tend to be much smaller, but they can still be very significant.

Since the assets within pension funds often consists of stocks, bonds, cash and other financial instruments (of varying degrees of risk), then it is the performance of these underlying products that dictates the value of the assets within a pension scheme. If stock and bond markets are performing well, and interest rates are high, then the value of the underlying assets rises, and that aids companies in either reducing a deficit or producing a surplus. Deficits require funding, hence companies who run an extensive deficit, often meet up with their pension scheme trustees and agree upon an ongoing cash injection to try and plug the deficit.

These deficits can therefore be a drain on cash flow and the magnitude of the drain is dependent upon the size of the deficit. Deficits also tend to act as a deterrent for potential suitors for a company, and often lead to depressed price-earning ratios and other metrics - the deficit is a liability so should be treated as such. Indeed, a pension scheme in the Alliance Boots/Kohlberg Kravis Roberts M&A deal back in 2007 led to KKR having to inject well over £200m of cash over a 10 year period to settle concerns over the pension scheme in place. The big risk is if a company is struggling to pay its agreed annual contributions and the value of the underlying assets falls (as a result of weak stock markets or other reasons). At that point in time, it represents a material risk to future cash flows. Ideally, companies to invest in should either have no pension deficit, or at least one that is manageable (relative to the market cap).

An Example: Nationwide Repair Services (LSE:NARS)

Unfortunately, not all companies disclose the full terms of their pension deficits on their Final Results and balance sheet statements. Importantly, for the vast majority of companies, pension schemes are not actually even worth considering, either due to size, or the type of scheme in place. The quickest way to check whether it is an issue is to check the company's latest Annual Report. Simply doing a CTRL+F for Pension and skipping through the results, should tell you whether or not there is a pension deficit in place, and what the terms of it are. Note that it may be written down as "Retirement Benefit Obligations" or other similar terminology

As a quick example, I have drawn upon Nationwide Repair Services (LSE:NARS) using their 2013 Annual Report.


As above, NARS' pension deficit totals £18.7m. That is highly material to their market cap, which stands at £31.1m as at 29/07/14. For that reason, investors should apply a discount to any valuation metrics they apply, even though the company has a healthy cash balance. Notice that the company has net liabilities too. That all combines to mean that any valuation should be conservative, and it could help explain why NARS is trading on a low forward price-earnings ratio. The balance sheet is not in great shape on that front, even though the deficit fell by circa £4m year-on-year.

What part of this was formed by cash injections from Nationwide, to try and plug the deficit? As per the picture on the right (click to enlarge), NARS notes that they paid £2.6m into the pension scheme during 2013, and have agreed to pay the same level for the immediate future. That will continue to cause a drain on cash so is worth factoring into any calculations.

Taking pensions deficits into account when making forward valuations is essential, and being able to distinguish between those that are material and those that can be discarded is an important value judgement. As a loose rule, if a company has a pension deficit that is larger than 15% of the market capitalisation, then it's definitely worth investigating further to see the terms of the deficit in case there are any unwelcome details. In any case, it is always worth at least checking to see whether there is a material pension scheme in place.