Take a closer look at how the link between pension fund risk and share prices really works

Citation

Robinson, B. (2004), "Take a closer look at how the link between pension fund risk and share prices really works", Balance Sheet, Vol. 12 No. 1. https://doi.org/10.1108/bs.2004.26512aab.001

Take a closer look at how the link between pension fund risk and share prices really works

Bill RobinsonDr Bill Robinson is Head UK Business Economist in Financial Advisory Services at PricewaterhouseCoopers. He is a former Special Adviser to the Chancellor of the Exchequer.

Are you aware of how much risk you are running in your pension fund? Do you know what the pension fund risk is doing to your beta? Or what the increase in beta implies for your cost of capital or the value of your company?

There has been no shortage of publicity surrounding the pension fund deficits revealed under FRS17, and there is a fierce debate about the extent to which these deficits are, or should be, factored into the market price. But there is still remarkably little understanding about the implication of these deficits for risk, and ultimately therefore for the share price. The fact is that pensions promises are a fixed liability which increases risk just as taking on debt increases risk. The risk can be neutralized by funding the pensions promises with debt. But if the risk is not neutralized in this way, the company is exposed.

The effect of this exposure on the beta of the underlying company is potentially large. It depends on two factors: the proportion of equities in the pension scheme; and the size of the deficit. The point is illustrated by the two tables below.

Table I shows the effect of equity funding, with no deficit. Consider a company with no debt and a stream of expected profits valued at 100. If there is no pension scheme, and the beta of the company is 1, then a 10 percent fall in the equity market will reduce the value of the company to 90. But now suppose that there are pension liabilities valued at 50, entirely funded by equities also valued at 50. In this case a fall in the market of 10 percent will reduce the value of the business by 10 and the value of the pension fund assets by a further 5, so that the company, including its pension scheme, will see its value fall by 15 percent. Its beta is no longer 1 but 1.5. Its cost of capital increases by 1.5 percent assuming an equity risk premium of 3 percent. The effect on value is substantial (Table II).

But look at the figures

Now imagine another company in which unmatched pension liabilities are 100 and equity assets still only 50, so the company has a deficit of 50. The underlying value of the stream of expected profits is still 100, but the market now values the company at only 50 because of the pension fund deficit of 50. A 10 percent fall in the market hits this company dramatically, because the cash flows still fall in value by 10, but this is now 20 percent of the value of the company. Moreover this comes on top of the fall in value of 5 in the equity assets in the pension fund. The bottom line is that a loss in market value of 15 now constitutes 30 percent of the value of the company. So the equity funding strategy, and the associated pension fund deficit, has raised the equity beta of the underlying business from 1 to 3, increasing the cost of capital by 6 percent. The effect on value is dramatic.

There is a group of large companies for which these illustrative numbers are in the right ball park – if you believe the FRS17 methodology. Pension fund deficits for some companies lie between 30 and 60 percent of their market capitalization.

Those companies face a dramatic increase in beta, and hence in risk and cost of capital – subject to the same proviso that the market believes the FRS17 measure of the pension deficit. The increase in cost of capital lies between 3 and 5 percent.

What is the implication of these large increases in beta? There are three possible stories: the optimistic story, the pessimistic story and the no-story story.

The optimistic story is that the market has already fully factored both the pension fund deficit, and the implied loss of value due to the higher beta. This means that the underlying value of these companies is much greater than the market capitalization. The share price is being dragged down to present levels because the markets are building in a substantial risk premium. If the betas could be reduced by eliminating the risk from the pension fund (e.g. by plugging the deficit and by switching from equities to bonds in the pension fund), there would be a large increase in the share price as the risk premium became unnecessary, and the underlying value fed through into the share price. On this view the financial strategy outlined above would boost the share price and render the company much less sensitive to a market downturn.

The pessimistic story is that the market has not yet woken up to the risk aspect of the pension fund deficits, and when it does there will be a major collapse in share prices. On this view the only hope of preventing the collapse in share prices is to eliminate the pension fund risk by undertaking the strategy outlined above.

The no-story story is what most practical men appear to believe. On this view, the FRS17 accounts exaggerate the pension fund problem, which is much more accurately represented by the old SSAP 24 numbers. So there is no need for urgent action to tackle the deficits.

Discount that idea

There is one important piece of evidence that suggests the practical men may be wrong. The share prices of seven companies with large pension fund deficits have dramatically out-performed the market in the rally that has been under way since March. Some of them have seen their share prices double and some have risen by a half compared with a rise in the market of only 23 percent. That suggests that the gearing implied by the pension fund deficits is influencing the markets.

As long as markets are rising, there is no incentive for these companies to do anything other than enjoy the ride. But when the downturn comes, companies with large pension fund deficits will, if the above analysis is correct, see an equally sharp fall in their share price. This will make it clear to everyone how great is the risk inherent in these companies. But it may by then be too late to adopt the risk-reducing financial strategy outlined above.