Why pension surpluses should make investors prick up their ears

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Over the years, I’ve had some grim encounters with management at the now-defunct dairy company Uniq. We should have been talking about cream cakes. Instead, most of the meetings seemed to be about his huge and badly underfunded pension fund. Concerns about pension funds have dogged many subsequent company meetings.

Britain’s long history of paying low wages but extraordinarily generous final pay – or “defined benefit” (DB) – has left a painful legacy. It’s been compounded in some cases by CEOs nearing retirement opting to take fewer bonuses in favor of higher pay, knowing they’ve locked in income for life. In some schemes, a handful of these big winners are responsible for most of the shortfall.

Too often, cash had to be injected to bridge the gap between a scheme’s liabilities and what was in the coffers. This money could have been spent on the business, improving returns for investors. I’m afraid you have to think about this if you’re buying UK shares, but I think it’s worth the effort.

A bit of history, in short. The pension issue became even more apparent around 2000 when, among other regulatory changes, an accounting standard was introduced requiring a company to report any shortfall in the DB scheme as a financial liability on the corporate balance sheet.

Successful investing is about managing risk, not eliminating it. Without risk, the returns are poor

Many companies responded by closing DB schemes and moving to de-risk their pension schemes to avoid changes in reported deficits. This meant selling shares and buying gilts – not the best idea, it turned out.

Successful investing is about managing risk, not eliminating it. Without risk, the returns are poor. And these companies could not afford poor profits. In the years after the rule change, deficits often worsened as interest rates fell and debt rose as scheme members lived longer than they expected. In 1990, for example, we expected men in the UK to live to nearly 73 and women to over 78. By 2018, this had risen to 79 and 83, according to the Office for National Statistics.

There have been other unintended consequences of collective risk reduction. The headwind for UK shares saw pension funds sell their exposures as the relative cost of capital for UK companies rose – issuing shares has not raised the same amount as it did then. All this meant less capital for productive investment. It helps explain the underinvestment by UK companies and its relatively poor productivity.

Some company heads, tired of responsibilities and distractions, have transferred their pension funds to an insurance company. However, change is happening. And here is where investors should perk up.

With interest rates higher, many schemes are now going from deficit to surplus. Ten years ago, the average pension deficit in the FTSE 100 was 6.2%, and in the FTSE 250 almost 16%, according to stockbroker Liberum. Today, this has become a 3% surplus for the FTSE 100 and a 1.1% surplus for the FTSE 250.

Longevity doesn’t increase anymore either. In fact, it decreased slightly. A surplus pension fund could now prove an asset for a company that does not abandon its scheme.

The new pension funding code comes into effect this month. This allows increased flexibility for pension funds to offset risk on the surplus element by allocating a larger portion to equities. This will only happen if the company retains control – not if it transfers a fund to a large insurance company. Shares generally generate higher long-term returns than gilts, further strengthening fund positions and allowing beneficiaries to be better protected against inflation or other enhancements.

It will rightly remain a challenge for companies to claw back surpluses, but with the support of pension fund managers, they can use surpluses to reduce contribution costs for the current workforce, now in defined contribution schemes — improving employee satisfaction and helping with recruitment.

In the meantime, I think this improved position should benefit many investors. An example may illustrate why. In 2018, NatWest agreed to pay up to £1.5 billion in additional contributions to its pension fund. It paid out another £1 billion between 2020 and 2021. Today it has a surplus. In fact, up to £45 billion could now be surplus in the FTSE 350 company’s pensions.

I expect these improving numbers to feed through to share prices. We saw this with Premier Foods in April 2020 when it merged three schemes – one in surplus and the other two in deficit – enabling it to almost halve deficit contributions and invest in its first TV adverts for Bisto Gravy Granules in six years.

Between early May and mid-July of that year, the stock price doubled. Its other brands, such as Sharwood’s and Mr Kipling, have also seen more investment of late, performing extremely well, if the latest trading update is anything to go by – a sales increase of 9 % for food products in the first quarter.

Intriguingly, some of the UK companies that have attracted cash offers this year, such as our former holdings Wincanton and Royal Mail, owner of International Distribution Services, have pension surpluses. So I’m watching these numbers very closely in the company’s reports because I’m not sure the market is fully aware of the potential benefits.

I also think we have passed the lows of equity allocations by pension funds and we may see a reversal of the 20-year trend. You might think I’m venturing into fantasyland now, but we might even see a rise in pension fund allocations to UK equities. The pensions bill announced in the recent King’s speech needs to work its way through parliament, but it will be interesting to see whether the new Labor government pursues the idea of ​​encouraging and even forcing more UK pensions and savings to invest in British companies .

Individual investors may not need such incentives. The economy here appears to be strengthening, wages are rising faster than inflation for the first time in years and UK shares still look relatively cheap.

James Henderson is co-manager of Henderson Opportunities Trust, Lowland Investment Company and Law Debenture. He owns NatWest shares.