MARKET COMMENT
Digging A £1b Pension Hole

By Maynard Paton (TMFMayn)
March 4, 2003

"We are consulting with our employees with the objective of limiting the financial impact of the current pension fund deficit"

When underlying profits have just fallen 46%, the last thing a company needs is a gaping hole in its pension fund. Yet that is what Rolls-Royce (LSE: RR.) now faces. Alongside a dire operational performance, the venerable engineer today admitted its UK pension pot was £1.1b in the red. To put the shortfall into perspective, Rolls made £255m in 2002 and has a market value of £1.35b.

Estimates from Dresdner Kleinwort Wasserstein suggest the aggregate pension deficit within the FTSE 100 is £100b, with BT Group (LSE: BT.A)(NYSE: BTY) and Royal & SunAlliance (LSE: RSA)(NYSE: RSA) among the guilty parties.

So what should investors do with firms whose profits are dwarfed by a pension deficit? Simply avoid them. You see, successful investment is all about minimising the unknown and the unpredictable. And as any Equitable Life customer knows, making substantial long-term financial promises can -- at some point down the road -- throw up all sorts of unforeseen issues.

Indeed, pension fund calculations themselves are anything but straightforward. Numerous assumptions must be made about salary inflation, stock market growth and so on, leaving boardrooms (and their actuaries) with plenty of scope for unrealistic optimism. Remember: rosy forecasts caused many large companies to mistakenly take pension holidays during the 1990s.

Of course, you could argue any pension difficulties could be priced into the shares. For instance, on today's figures, Rolls (at 82p per share) stands on a price to earnings ratio of 7 and offers a dividend yield of 10%. Yet profits at Rolls are likely to suffer over time as additional pension contributions mount up, especially if the employees don't play ball. Far better to be safe -- and out of Rolls -- than sorry.

More: Companies With A Pensions Problem | What FRS17 Means For Your Shares