Pension deficits are no longer a matter for shareholders to be relaxed about

Pension fund deficits are a problem for potential acquirers – shareholders and investors take note

The discord between Ryanair and Aer Lingus is the latest in a series of problems facing large companies to focus shareholders on the growing pension deficit problem in Ireland.

Aer Lingus, and others, made generous pension promises to employees without putting enough money aside to meet these obligations. Ryanair, as a significant shareholder of Aer Lingus, has warned that it will resist attempts to pass the shortfall onto shareholders.

UK independent pension consultant John Ralfe believes pension deficits are a concern. "There are thousands of large and small UK companies which have made pensions promises they simply cannot pay over the next few decades."

He adds: "In the last 10 years, many companies have recognised the real cost of new pension promises and have closed their schemes."

Shareholder issues
For shareholders there are two issues. Dividend payments will suffer as a recent paper* from Bath University reveals.


It examines how companies are reacting to stricter pension regulation and the financial pressures that brings. And it suggests that regulatory requirements will have a significant effect on dividend payments.

The inability to “smooth” pension scheme deficits is creating a significant strain on cash flow for companies. The authors note that the extra funding requirements must come either from increased borrowings, reduced capital investments or reduced dividends.

It finds that most companies see themselves as optimally financed. Seeking additional finance to meet the cash strain from pension deficits will likely be seen as more risky, and therefore more costly.

Firms therefore rely heavily on cutting dividends and, to a lesser extent, reducing capital investments to fund the increased pension contributions. Their paper concludes: “We found that the dividend and investment sensitivities to pension contributions are more pronounced . . . indicating that these regulations have had a significant effect on corporate expenditures.”

There is also a corporate finance problem. Shareholders often hope that their company will become a takeover target, with the acquirer prepared to pay a premium on the current market share price. What has become clear is that pension deficits are a problem for potential acquirers: the hidden risks from the deficit alone can be enough to walk away from any deal.

The UK government has recognised this. As part of its plans to privatise its postal system – the third time a UK government has gone down this path – it has assumed responsibility for Royal Mail’s pension obligations (which has a deficit of £10 billion). The hope is that, with a major risk factor gone, investors are more likely to support a flotation.

Of course, there are some who would argue that a pension deficit at Aer Lingus might suit Ryanair since it discourages other potential bidders for Aer Lingus apart from Ryanair.

Wider deficits
Pension trustees have seen their deficits widen in recent years, mainly owing to circumstances outside their control. Apart from retirees living longer, a low interest rate environment has the effect of increasing the present value of future liabilities. Falling stock markets have not helped either.

More recently, governments have used pension funds to help them achieve certain economic objectives. Ireland, for instance, introduced a 0.6 per annual levy on private pension funds over four years to fund an employment initiative. It was the first time in the history of the State that a government had introduced retrospective taxation, an indication that governments can find funds a compelling target for new Exchequer fundraising.

Another worry is the trend for some banks to force their pension scheme to buy assets, such as complicated securitisations on US sub-prime debt. Banks will do this because they cannot sell them on the open market. According to Aon, the reassurance brokerage**, there is an aggregate pension fund deficit of £86 billion among the top FTSE 350 firms.

Someone of course will have to foot this bill. Either the employees must accept reduced benefits or shareholders take a hit. It emerged over the weekend that staff at Independent Newspapers will receive only around half their accumulated benefits due to the hole in its fund.

But trade unions have said they will fight to the utmost to protect employees. Thus a firm with a strong trade union and a significant pension deficit will give shareholders something to worry about. This is more of an issue currently in the UK than here, where employers are not free to walk away from pension scheme deficits. However, following the recent OECD report*** into the Irish pension system, there is a growing clamour for similar restrictions here.

Read footnotes
Paying close attention to the footnotes in published accounts that deal with pension obligations is important. While the International Accounting Standards Board (IASB) has suffered criticism for failing to reveal losses in financial institutions, it has improved accounting rules so that shareholders clearly see the size of the deficit. Some companies may disguise their deficit by making assumptions about how long retirees will live (longevity risk), but they are constrained. For instance, their assumptions must be in line with national statistics.

Ralfe, who advised the accounting standard setters on pensions, says: “The IASB is tightening its requirements further. From this year, companies will no longer be able to spread the deficit into future years. Neither can they boost reported pre-tax profits by their choice of expected returns on assets.”

Perhaps, like the Millennium bug, the pension crisis is over-done. Stock markets may make a recovery, indeed during May this year many deficits narrowed because of stock market gains.

Some argue that if there is sufficient cash coming into the fund (from current employees) to finance annual payments to retired employees a deficit doesn’t matter. Ralfe strongly disagrees. “Using contributions from current employees to pay liabilities on existing pensions is double counting and may amount to a Ponzi scheme.

“What happens when a company closes its scheme to existing members and there are no contributions coming in?”

One thing is for certain. More pension regulation is on the way. The Government was recently reprimanded by the European Court of Justice for failing to protect members of the Waterford Wedgwood pension scheme.

So severe was the deficit that employees were warned they would only get 28 per cent of what they were promised. Under European Union rules, the Government is obliged to guarantee that employees get not less than 50 per cent and more likely close to the 90 per cent awarded in a similar UK case.

Increased regulation is likely to prevent shareholders like Ryanair from attempting to walk away from deficits.


Cormac Butler is the author of Accounting for Financial Instruments and has led training seminars for bank regulators and investors on financial risk. He has traded equities and options