Pension fund trustees have been a thoroughly frustrated lot this summer. Sliding equity markets have widened many scheme deficits, in some cases unwinding years of careful reduction work.
Yet according to a small body of optimists, the time is ripe for a cheerful re-think of the value of pension schemes for listed companies. Bluntly put, their arguments are that market conditions cannot get much worse and that the allergy of many investors to companies with struggling pension funds masks surprising amounts of value in the schemes.
For Richard Jones, managing director of Punter Southall Transaction Services, this all amounts to a "golden opportunity" for eagle-eyed investors.
He argued at a recent Punter Southall seminar that drops in stock prices have left pension schemes' equity holdings undervalued by 30% against the historical average price-to-earnings ratio. As a result he feels "current pricing is pretty attractive in the long-term view, which is one you obviously have to take as a pension fund. It is not an unreasonable expectation that equities will out-perform bonds significantly in the future as they have done for most historical periods."
Naturally, the current global economic turmoil does not bode well as far as the short-term health of funds is concerned. However, the importance of what goes on in the short-term is reduced by the fact that even closed defined benefit (DB) schemes will be holding assets for several decades hence.
While low equity returns have hit funds' assets over the past decade, low real yields have also pushed up scheme liability projections. After 20 years of declining real yield rates, these are currently hovering around the meagre 0.3% mark.
Should this rate eventually return to the historical average (2-3%), pension schemes would automatically be in line for significant funding improvements, it is suggested. Fears have been raised of a negative real yield punishing pension schemes further, but Jones challenges the economic logic of that and says "real yields can't really get any worse – so even if we don't get any positive news on that it can't be much more negative."
Regulation has been responsible for the souring of investors' attitudes to firms with large DB schemes, but Jones sees little chance of the negative trend continuing in this area either. He says that "regulation has been stable for six years and there is no way that the government can make the obligations more severe.
"The government has begun to recognise that excessive regulation has strangled pension schemes and their sponsors and have made some concessions to redress the balance, such as the recent change from RPI to CPI indexation."
It seems hard to believe now that there once was an era – not so long ago - when investors viewed healthily performing pension schemes as a giant positive for a company rather than a liability. Jones firmly believes this former sentiment could return in the future, should market conditions regain their previous strengths.
Crucially, Jones argues that a lean period has left funds now better positioned to make the most of what the market serves up, meaning they could easily seize the positive affects of a future boom. This is due to improved practice in mortality assumptions, prudent cash flow projections and the development of de-risking tools.
Some sceptics would question whether there would be any DB schemes left around to enjoy this theoretical future golden age. Yet Jones argues that as 20% are still open, time will reveal all.
Don't stop believing
Con Keating, head of research at BrightonRock, is another optimist. He argues in a new report that investors have gained a false sense of pessimism on pension funds because of the quirks in accounting methods that have drawn so much criticism from sections of the pension industry.
Keating argues that pension schemes' inter-temporal nature means they are better valued on an 'income and expense approach' than the prevailing mark-to-market method. He criticises current accounting methods for exposing pension funds unfairly to volatility due to interest rate changes.
Keating says that current accounting standards are on the whole "not fit for purpose" and badly understate the health of schemes and their true strength. The standards, he says, "introduce spurious volatility to scheme financial statements and those of their sponsor employer with real and very costly effects."
What's more, Keating believes that the good health of UK companies could inspire further confidence in their pension plans.
He says that "with UK corporates more profitable than ever, it is important for people to appreciate that companies have never before been in a better position to pay pensions".
This assessment is supported by new KPMG research. The auditing group indicates that in three years time over 75 per cent of FTSE 100 companies will be in a position to close their pension deficit using cash flow alone, should they want to do so.
The optimists imply that in the unpredictable world of pensions, any trustees who - aside from any de-risking initiatives - have found themselves hoping for divine intervention to recover their funding position may just be rewarded. Eventually.
First published: 29.09.2011
dbillingham@wilmington.co.uk
