Jonathan Stapleton looks at research from Llewellyn Consulting, which analyses the impact of DB liabilities on the share price of FTSE100 firms.
- There is broadly a 1:1 effect of deficits on the market value of firms when measured on a ‘risk free’ basis
- This is equivalent to an additional risk premium of 20% of disclosed pension obligations
- The negative impact on FTSE100 market valuations is around 7% to 9%
Defined benefit (DB) pension schemes continue to be large and extremely volatile elements in company balance sheets.
In August 2016, PwC's Skyval index showed DB schemes as a whole had liabilities of around £3trn compared to assets of only £1.5trn on an insurance basis - a shortfall that has significant negative effects on the market values of FTSE100 companies.
But what is the evidence for these negative effects and how large are they?
Research published last week - The ongoing influence of DB pensions on the market valuation of the Pension Plan Sponsor, published by Llewellyn Consulting with support from Pension Insurance Corporation ¬- looks at the impact of DB pension schemes on the share price of FTSE100 sponsoring companies in the financial years between 2006 and 2013, extending similar research done in 2014.
Llewellyn Consulting says the findings provide further evidence of the significant and ongoing downward pressure that DB pension liabilities and pension deficits exert on the market value of FTSE100 companies.
Its study confirms the findings of the earlier report of a broadly one-for-one effect of pension deficits on the market value of companies, when measured on a consistent ‘risk free' basis, also consistent with the market attaching an additional risk premium equivalent to an average 20% of disclosed pension obligations.
It also shows that companies with larger pension liabilities are likely to be penalised the most by investors, even relative to those with similar percentage deficits, but which are based off lower overall total pension liabilities.
The study found that even those FTSE 100 companies that report a pension fund close to being fully funded, or even in surplus, are likely to be subject to a higher cost of capital directly correlated with the total size of their pension liabilities.
Commenting on the study, Llewellyn Consulting consultant Pete Richardson, one of the authors of the report, explains: "The negative impact of DB pension liabilities and deficits on FTSE 100 market valuations is estimated to have been around 7% to 9% by the end of the 2013 financial year, considerably higher than might be suggested by reported pension net deficits alone and higher than their pre-crisis levels.
"These impacts are now likely to be considerably higher given the direct effects of continuing low and falling interest rates/yields on estimated liabilities."
Macro sector impact
The study also analyses the impact of DB schemes on market valuations across broad macro sectors. It found the estimated relationships appear to be most well-defined for companies in the non-financial sectors compared with those in the financial sector, which were subject to greater volatility and risks during the financial crisis.
Within the non-financial sector, the study finds companies in the industrial sector appear to have been more adversely affected than those in the consumer sector. This reflects generally higher pension liabilities built up during Britain's industrial heyday.
The importance of size
The study also looks at how important size is to pension related risk. Its analysis across size groups suggests that pension risks and impacts are largely independent of company size as represented by levels of company assets, while the level of pension liabilities in relation to company assets also matters most for companies with the highest liability rates.
Overall however, it finds it is the scale of pension liabilities in relation to market values which have been most important, with negative impacts on market valuations which are currently large and greater than in their pre-crisis levels, for all but those companies with the lowest rates of exposures.
Pension Insurance Corporation head of strategic development David Collinson says the research has significant implications for those firms considering de-risking. He noted the results suggest the market is both pricing in some de-risking costs and saying businesses injecting significant amounts of money into a scheme as part of a de-risking exercise could well find it ends up having a neutral or even positive effect on share prices.
Llewellyn Consulting says the results of the study also suggest a number of useful areas for future analysis and research - examining what happens to pension deficits and also asset returns as gilts and other rates fell, to see which investment strategies might have provided a better hedge against falling interest rates and ballooning liabilities.
It also believes key extensions could include examining a larger sample of FTSE firms, including FTSE250 companies, to see whether such an analysis supports or undermines the current results, and why.
For the FTSE 100 companies as a whole, the chart below summarises the key estimates of DB pension impacts using a range of models.
The solid yellow and burgundy and dashed burgundy lines correspond respectively to the estimated impacts given by the basic net asset (NPA), the ‘rule of thumb’ (NPA/PL) and Risk Free (RFNPA) models.
The dashed yellow line (NPA=1) corresponds to the theoretical impact given by a relationship where there was a simple one-for-one effect of pension deficits on market values.
The basic pension net assets model uses a simple residual income approach, relating the market value of each company to the book values of its pension and non-pension net assets and corresponding pension and non-pension earnings and costs.
The ‘risk free’ liabilities (RFNPA) model aims to eliminate variations in the discount rates used between FTSE100 firms, and is based on discounting the liabilities at a risk-free gilts rate that matches their duration profile.
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