QUALIPORT
Spotting Pension Black Holes

By Maynard Paton (TMFMayn)
July 19, 2005

Pension deficits still matter. City analysts believe the FTSE 100's aggregate pension scheme shortfall has barely moved in the past year and remains around the £60b mark. Furthermore, according to Company Reporting, 74% of blue-chip companies have yet to adopt FRS17 in full and still hide away all their pension details in a bookkeeping footnote. With new international standards about to bring the full cost of retirement schemes into the main accounting statements, many shareholders will be soon facing up to the ongoing costs of plugging pension 'black holes'.

What to spot

So how can investors spot a company with an onerous pension scheme? One way is to dig into an annual report and compare the reported FRS17 position to underlying earnings. Clearly a relatively large shortfall could mean a reduction in future profits as the company's contributions are hiked to fill the gap. This is how the Qualiport's watch list matches up:

Company	Year end	FRS17 surplus/ (deficit) (£m)	Underlying earnings (£m)	Surplus/(deficit) as a % of underlying earnings
Associated British Ports (LSE: ABP)	Dec 2004	22	97	23
Vodafone (LSE: VOD)	Mar 2005	(81)	6,892	(1)
Emap (LSE: EMA)	Mar 2005	(15)	148	(15)
Gallaher (LSE: GLH)	Dec 2004	(63)	384	(16)
GCAP Media* (LSE: GCAP)	Mar 2005	(5)	17	(18)
London Stock Exchange (LSE: LSE)	Mar 2005	(13)	63	(20)
Imperial Tobacco (LSE: IMT)	Sep 2004	(171)	736	(23)
GlaxoSmithKline (LSE: GSK)	Dec 2004	(1,020)	4,302	(24)
Ulster Television (LSE: UTV)	Dec 2004	(5)	13	(40)
Johnston Press (LSE: JPR)	Dec 2004	(49)	108	(46)
Renishaw (LSE: RSW)	Jun 2004	(8)	16	(52)
Rotork (LSE: ROR)	Dec 2004	(14)	21	(65)
Halma (LSE: HLMA)	Mar 2005	(29)	35	(82)

(*Reported earnings for year to Mar 2005. FRS17 information extracted from Capital Radio accounts year to Sep 2004 and GWR accounts year to Mar 2004)

The list can be divided broadly into three groups:

* Safe: Associated British Ports (with a surplus) and Vodafone (with a minor deficit) should not worry shareholders.

* No immediate worries: Emap, Gallaher, GCAP Media, London Stock Exchange, Imperial Tobacco and GlaxoSmithKline appear to have manageable deficits.

* Further investigation required: Ulster Television, Johnston Press, Renishaw, Rotork and Halma.

With any relatively large deficit, it's worth considering if temporarily depressed profits are giving a misleading impression of the shortfall. Sadly, this is not the case with the five watch-list shares in the latter group.

Assumptions

So the next step then is to assess the make-up of the pension scheme and the assumptions used. Unfortunately, directors and their advisers are at liberty to apply aggressive assumptions in order to present a more favourable pension position and lower the associated funding charge within the profit and loss account (which will be levied under new international accounting standards).

There are two popular areas for boardroom flexibility: future stock-market returns, since most schemes have a large proportion of their funds invested in shares, and the discount rate, which is used to determine tomorrow's retirement liabilities in today's money.

This table lists the proportion of equities held in each watch-list scheme and the assumed equity growth rate (used to calculate today's scheme contributions from the company):

Company	Year end	Percentage in equities	Assumed growth rate (%)
Renishaw	Jun 2004	97	8.5
Halma	Mar 2005	84	7.75
Ulster Television	Dec 2004	81	7.5
Johnston Press	Dec 2004	69	7.5
Vodafone	Mar 2005	67	4.3-7.7
GlaxoSmithKline	Dec 2004	75	7.75-8.5
Rotork	Dec 2004	61	7.9
Gallaher	Dec 2004	61	7.4
Imperial Tobacco	Sep 2004	59	6.3-8.2
Emap	Mar 2005	49	7.7
Associated British Ports	Dec 2004	48	7.5
GCAP Media*	Sep 2004	46	7.0
London Stock Exchange	Mar 2005	27	7.9

(*Capital Radio only. GWR pension asset proportions were not disclosed)

To provide some sort of comparison, a recent study undertaken by Company Reporting discovered the average equity growth rate used by FTSE 350 firms to be 7.75% and the average pension equity weighting to be 62%.

It's not that surprising to discover the four watch-list companies with the greatest exposure to equities in their pension funds -- Renishaw, Halma, Ulster Television and Johnston Press -- are also among the watch-list members that have relatively large deficits compared to their most recent underlying earnings. Clearly they expect the stock market's historic outperformance to continue and help reduce their shortfalls. Furthermore, two companies -- Renishaw and Rotork -- apply above-average equity growth rates to calculate their FRS17 pension costs and these higher rates may in time flatter their actual funding requirements. (Indeed, Renishaw upped its equity growth rate from 8% to 8.5% in 2004!).

This next table lists the discount rate applied by each watch-list company to determine the value of its future pension liabilities in today' money. Other things being equal, a high discount rate lowers the calculated liabilities and therefore gives a more favourable pension position:

Company	Year end	Discount rate (%)
Renishaw	Jun 2004	5.8
GlaxoSmithKline	Dec 2004	4.25-5.75
Imperial Tobacco	Sep 2004	4.5-5.6
GCAP Media*	Sep 2004	5.5
Emap	Mar 2005	5.4
Halma	Mar 2005	5.4
London Stock Exchange	Mar 2005	5.4
Vodafone	Mar 2005	2.3-5.4
Rotork	Dec 2004	5.32
Associated British Ports	Dec 2004	5.3
Johnston Press	Dec 2004	5.3
Ulster Television	Dec 2004	5.3
Gallaher	Dec 2004	5.2

Despite FRS 17 dictating the discount rate should be assumed to equal the rate of return from a high-quality bond, there is some variation on the watch list. According to Company Reporting, the average discount rate used within the FTSE 350 is 5.47%, so obviously Renishaw's 5.8% -- one of the highest in the FTSE 350 -- stands out somewhat.

All in all, Halma, Renishaw and Rotork appear to be the watch-list companies with greatest pension-scheme risks. They are the three companies that possess the largest watch-list deficits when compared to profits, with Renishaw and Rotork also prompting some questions over their FRS 17 assumptions.

However, other features in the accounts can reduce the risk of an underfunded pension significantly -- not least a healthy bank balance! From their latest set of results, net cash at Renishaw was £23m, net cash at Rotork was £24m and net cash at Halma was £12m. If worst came to worst, the cash hoards could be used to reduce or even eliminate the current shortfalls.

Summary

It should be remembered that pension funding is a long-term commitment and that scheme assets are subject to short-term fluctuations. Given the relatively low level of the stock market, it's fair to say many of today's pension deficits will reduce in the years ahead. However, the deficits are an economic reality and a story yesterday about ITV (LSE: ITV) once again highlights their importance.

According to the Financial Times, a consortium considering a possible bid for the television broadcaster "fell apart amid concerns about the size of the... pension fund deficit." ITV's 2004 annual report shows a net pension deficit of £448m -- some 73% greater than underlying earnings of £259m. Thankfully, none of the Qualiport's watch-list members has a pension situation anywhere near as bad as that at ITV.

(Last year, takeover approaches received by WH Smith (LSE: SMWH) and Marks & Spencer (LSE: MKS) also came to nothing when their respective suitors baulked at the funding gaps. Read more.)

Indeed, ITV has by no means the worst pension deficit in the market. The following five FTSE 100 names each have funding shortfalls of nearly £1b or more, with reported profits just a fraction of the size of the deficit. These truly are pension black holes:

Company	Year end	FRS17 surplus/ (deficit) (£m)	Underlying earnings (£m)	Surplus/(deficit) as a % of underlying earnings
BAE Systems (LSE: BA.)	Dec 2004	(2,990)	550	(544)
British Airways (LSE: BAY)	Mar 2005	(1,338)	251	(553)
BT (LSE: BT.A)	Mar 2005	(3,347)	1,821	(184)
ICI (LSE: ICI)	Dec 2004	(998)	210	(475)
Rolls-Royce (LSE: RR.)	Dec 2004	(976)	245	(398)

Finally, the best route to sidestep a pension deficit is to select firms that have no retirement obligations whatsoever. Eagle-eyed readers will have spotted a lack of reference to Games Workshop (LSE: GAW) within the earlier tables; it's the only watch-list company that does not operate a defined benefit scheme for its workforce!

Where next? Company Reporting | Why Pension Deficits Matter | FREE Annual Report

Maynard owns shares in Associated British Ports, Games Workshop, GlaxoSmithKline, Halma, Johnston Press and London Stock Exchange.

Portfolio value

Holding	Number of shares	Closing price 18/07/05 (p)	Value (£)
Associated British Ports	681	475.25	3,236.45
Emap	372	814	3,028.08
Halma	1,920	142.75	2,740.80
Johnston Press	1,608	483.25	7,778.70
London Stock Exchange	2,018	500	10,090.00
Cash			345.54
Total			27,253.45