BT still has a big problem with pensions

John Ralfe is an independent pensions consultant.

BT watchers were stunned last week by the revelation that Indian billionaire Sunil Bharti Mittal is buying a 24.5% stake in BT Group from Patrick Drahi’s Altice.

Speaking to reporters, Mittal said:

I’ve been looking at BT for many, many years, it’s a company that has a glorious past, it’s got national status, it’s got this huge amount of physical infrastructure in the UK.

Unfortunately, a holdover from BT’s “glorious past” is its huge pension scheme. With over 250,000 members, it’s a reminder of just how many people the group used to employ.

Unlike other European telecommunications companies, BT’s pensions were not left to taxpayers on privatization in 1984. Underlying IAS19 pension liabilities in March 2024 were £40bn: the largest of any UK company and roughly three times its market cap of £13.5 billion. With pension assets of £35bn, it has a deficit of £4.9bn, up from £1.1bn in 2022.

BT’s latest actuarial assessment – ​​June 2023 – showed a deficit of £3.7bn and fixed annual contributions to the deficit at £780m by 2030, £670m in 2031 and 180 million pounds from 2032 to 2034.

According to BT, this would mean “works completed” – fully funded by 2034 – but we should be a little skeptical.

“Full funding” is a moving target – as a pension scheme approaches 100%, a stricter discount rate is applied, increasing the value of the liabilities. In addition, the Regulator has just introduced a new ‘Long Term Objective’ for mature schemes such as BT (where over three quarters of members are already pensioners), which requires liabilities to be measured assuming a low-risk asset allocation, so ‘reliance low”. ” per sponsor.

On this basis, BT estimated that its assets in June 2023 would cover 80% of its liabilities. Applying this to March 2024 gives a deficit of £7bn to £8bn. It will need to keep finding cash to pay for this – either diverted from operating cash flow or by adding to its £19.4bn of net debt and leases.

BT seems keen on pension fiddling. The shortfall payments include £80m a year secured by EE shares in what BT calls an “asset-backed facility”. This is recognized as an asset of £1.2 billion in BT’s pension scheme accounts, but not in BT’s consolidated accounts.

Such a guarantee is certainly good for pension scheme members, but bad for bondholders. BT’s medium-term covenants do not prevent the transfer of securities to the pension scheme, and the rating agencies do not appear to have noticed this structural subordination.

Another fiddler: in 2018, BT put £2bn of BT bonds into the pension scheme. Running this through a Scottish limited partnership – always a red flag – avoided breaking the rules on pension schemes making loans to their sponsors. Those bonds have a final maturity in 2042, pushing the “fully funded” date well beyond 2034.

BT’s asset/liability matching is still very risky. About 60% of its assets are in liability-matching assets, but 40% – £13bn, almost the same value as the market capitalization – are in what BT calls “growth assets”: shares, PE, property, funds speculative, infrastructure. and non-core credit.

BT’s analysis says a 15% drop in the value of “growth assets” – which it optimistically calls a “1-in-20-year event” – would increase the deficit by £1.7bn. In economic terms, holding £13bn of ‘growth assets’ is like BT borrowing £13bn and then buying these assets outright – not quite what you’d expect them to do a telecommunications business. Almost all of the £13bn growth assets are unquoted and BT’s auditors rightly flag their valuation as one of their five key audit issues.

The good news is that BT has not suffered liquidity problems from the “leveraged LDI crisis” since October 2022. The bad news is that its leveraged swaps are still a hidden risk to shareholders because BT chooses not to disclose them in its consolidated accounts. .

BT pension scheme accounts show interest rate swaps worth £50bn, a large part of the non-interbank market. Some of these swaps are “covered” by the exchange, say fixed payments on the underlying bonds for indexed proceeds, but some are “naked” – effectively off-balance sheet loans.

BT’s accounts show a ‘cash negative’ pension asset of £4.9bn, on ‘derivative contracts’ (cash collateral paid to change counterparties) again huge against its market capitalisation.

Despite the hype after the 2022 gilt crisis, not much has changed in accounting or regulation for leveraged liability investments. The IASB does not yet require companies to disclose LLDI leverage in their accounts, which they should do immediately. The pensions regulator now requires schemes to report their LLDI positions in full, but it is unclear how it will use the information.

Many people still don’t distinguish between LDI (just a fancy name for simply matching pension assets and liabilities) and leveraged LDI, which borrows to keep betting on “growth assets”. Or, like the Bank of England, they assume that LLDI is a natural state rather than a choice of pension schemes and companies, and consultants continue to promote LLDI.

I wrote for Alphaville in 2022 that BT had a pensions albatross around its neck, which certainly hasn’t changed since. But in the past two years, higher real interest rates have transformed the pension position of almost all UK companies, and BT’s relative position is now worse.

Of the 40 or so FTSE 100 companies with DB pensions, only three, besides BT, are in deficit – and their deficits are all trivial compared to their individual market caps. AstraZeneca, for example, has a market capitalization of £200bn and a deficit of $230m – barely a rounding error.

All the pension measures we could use — liabilities, deficit, asset/liability mismatch, hidden leverage — are all huge relative to BT’s valuation and will act as a drag for many years.

Let’s hope Mr. Mittal doesn’t get buyer’s remorse.