Pensions – How are investors reacting to UK rule changes?

The UK government has handed a huge Christmas present to companies with large pension schemes by allowing the inflation measure to change from the more inflation prone Retail Price Index (RPI) to the Consumer Price Index (CPI). This was worth 27p a share to British Telecom (LON BT.A) alone. This did not receive that much attention but given a prevalent investment theme of “big is beautiful” it is worth looking into since big firms tend to have big pension schemes and deficits. Stocks include BT’s (LON:BT.A), Rolls Royce (LON:RR.).

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With so much attention this year on deficit reduction, sovereign default risk, BP’s oil spill and the commodities boom, people seem to have forgotten about how we can manage what we can call “longevity” risk. Governments and companies continue to struggle to meet their pension liabilities while the former are looking to spend less rather than more in many countries.

BT’s (LON:BT.A) share price is at a 52 week high, helped in part by this inflation change that reduced their liability by GBP 2.9bn. Combine this with the decision that the UK Government will underwrite their pension scheme if they were to default and it is no surprise to see very low short interest at 1.2% of total shares. Less optimism is being shown by US investors, however. They have borrowed 55k shares which is up from near zero only 2 weeks ago. Some don’t care about the 5% yield and may just think the price has over reacted.

Adding to the current debate is the new approach to looking at pension liabilities from PensionsFirst. They are encouraging people to not talk about the size of the deficit but the likelihood, and scale, of this changing due to the various forces at work – namely the risk. For instance, the October 1 month Value-at-risk (VaR) figure (on an IAS19 basis) was GBP 25.4bn across all FTSE 100 pension schemes. The overall deficit is GBP 43.5bn. This is to say that there was a 1 in 20 chance that this deficit could have increased by 25.4bn or more in November this year. What is driving this? If long term inflation increases by 1% then the deficit would increase by 60.8bn.

There would need to be some stellar fund management returns to make up for this. It is not clear how this will affect the fortunes of large cap companies with big pension funds like British Airways (LON:BAY), Rolls Royce (LON:RR.), BP (LON BP), Marks and Spencer (Lon: MKS) etc. It is too early to tell but it is of huge importance. At the moment, this does not seem to concern investors as short interest in both Rolls and BP is negligible. Only 1.9% of total shares are on loan in M&S and short interest is clouded in British Airways due to its convertible bond and other factors affecting the stock.

Methods for pension funds who earn money without taking risk are therefore crucial. A high risk adjusted return can be achieved from securities lending in comparison to the various investment and inflation risks. We estimate pension funds earned around GBP 700m for lending their shares in 2010 for instance. This is not a big number but of use nonetheless in a business where every little helps.