Are you investing in a company or a pension fund?

Investors shouldn't just look at a company's pension deficit, they should also consider its total pensions liabilities.

Since the introduction of FRS17, investors have become used to seeing pension fund deficits on the balance sheets of some of the companies in which they invest. Many investors are treating these deficits as debt; after all, they incur interest charges and need to be repaid from cashflow (cashflow which therefore will not be available to shareholders).

However other than this, most investors do not look too deeply into the extensive notes on pensions which form part of many company accounts.

This is a shame because if they did look more closely at these notes they might discover that they are not investing in what they think they are.

Under pension law, a company has responsibilities not just for the deficit of its final salary pension schemes but the entire liabilities. These liabilities are covered, wholly or partly, by the investments of the pension fund; usually a combination of equities, bonds, property and cash.

The performance of these investments determines whether the scheme will be able to fund its liabilities. If it can't, then the company will have to pay up and that clearly has significant implications for the valuation of the company.

An alternative way of treating the pension fund might be to include the gross assets and gross liabilities of the scheme separately on the balance sheet of a company. The result can be dramatic. A number of high profile companies have pension liabilities significantly in excess of their market capitalisation.

These pension liabilities are remarkably like debt. Because of the way they are calculated (basically they are discounted cashflow values) they effectively bear an interest charge which rolls up into the existing liabilities.

Of course, on the other side of our alternate balance sheet is a large asset, comprising the investments of the pension fund. If the returns in the investments are greater than the interest on the liabilities then the company will benefit either through reduction in the deficit or ultimately through reduced pension contributions.

If asset returns fail to keep up with pension liabilities then the company is going to have to divert cashflow into the scheme as additional contributions.

So a company with very large pension liabilities is a riskier investment than another company with smaller liabilities, even if the size of their deficits are identical -- all other things being equal. That's because greater liabilities mean there's a greater chance that the deficit will grow substantially in future.

Fair enough you might say, but for an investor who is bullish on the stock market, isn't the potential upside an additional benefit?

The real question is though, what are you really investing in? Is it a company involved in airlines, telecommunications, or engineering or is it a closet investment fund?

In the case of the companies above, it is clearly more the latter than the former.

So would you really want to be an investor in such an investment fund? They are run by Trustees entirely for the benefit of members, do not disclose what they are invested in and provide little if any historic performance statistics.

If you really do want to invest in a collective fund, there are plenty of large or specialist quoted investment trusts to select from, all of which are more transparent and many of which can be bought at a discount to the value of their assets. Some of them might even be invested in airline, telecommunications or engineering companies!

More: When Pension Deficits Help Earnings | Spotting Pension Black Holes | Investment Trusts Deliver Big Rewards