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Given a choice, the media will always pick the most sensational numbers

12/01/2017

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Sir Philip Green an unfairly maligned soul? Contrarian as we may pride ourselves on being, here on The Value Perspective, that may be an argument too far even for us – and so we will leave such a judgement to others. Still, see if your opinion has shifted at all by the time you finish reading our thoughts on the exciting topic of pension fund deficits and, specifically, how they are calculated.

When we say ‘exciting’, clearly this cannot be sarcasm – after all, if pension fund deficits were dull, surely there would not be three different ways of calculating them? There is the pension fund trustees’ valuation, the accounting valuation and the buy-out valuation, all of which come to very different numbers and all of which are based on different sets of fiendishly complicated assumptions.

Since each situation involves different stakeholders with, let us say, different priorities, they make different assumptions surrounding the whole piece. Central to a significant proportion of these assumptions, however – and the biggest ‘swing’ factor in each instance – is what the pension fund’s ultimate liability to its members is worth in today’s money, also known as the ‘discount rate’.

The reason we mention all this is that the buy-out valuation is by far the largest number of the three. That is because, as the name suggests, the situation involves somebody buying the pension fund, and they are only going to do so if they are protected against every single risk that might conceivably happen – with a small cherry of profits added on top to boot.

This makes the buy-out liabilities significantly higher – with the magnitude of difference well illustrated by this blog from The Pensions Regulator dated 29 September 2016. As you might expect, the piece studiously avoids mentioning any names but, as it happens, this was bang in the middle of the media storm over Green, his sale of BHS for £1, its pension fund deficit and – the focus of much press attention – Green’s yacht.

The blog points out that, while the great majority of pension schemes were well-placed to meet their so-called ‘deficit recovery contributions’, schemes representing “around 10% of the headline deficit figure – in other words around £35bn to £40bn” were struggling. It goes on to highlight, however, “media headlines” quoting a figure of around £1 trillion to £1.5 trillion.

Magnitude of difference

Quite some magnitude of difference, then, and the blog indeed goes on to explain this is down to the media using buy-out valuations while it is working on “a ‘scheme-specific’ basis”. Getting scheme-specific with BHS, therefore, we know that when it was sold by Green to the consortium of investors led by Dominic Chappell in March 2015, the pension deficit was some £100m.

Clearly that is not an insignificant amount of money but neither, given what had happened to pension fund discount rates over the 15 years BHS was owned by Green, is it an especially surprising one. Indeed, while it is hardly a cause for celebration, there are plenty of businesses in the UK that have pension fund deficits a good deal larger than this.

Fast-forward to April last year, when BHS went into administration, and people were talking about the deficit now being some £570m. Of course this sounds like the scheme had a horrific 13 months or as if, to use a phrase that cropped up elsewhere in this episode, someone had their fingers in the till.

The reality, however, was much more prosaic – as the company had gone bust, by law the regulator now had to apply the scheme’s buy-out valuation, which as mentioned is calculated on a different basis, for a different stakeholder, with different priorities and, as a consequence, was a much bigger number.

A couple of months later, after the UK’s vote to leave the European Union, the Bank of England cut interest rates to an all-time low of 0.25%, which also took 10-year gilt yields to new lows, which moved discount rates and so matters looked even worse for the BHS pension fund. At this point, its deficit was estimated at £717m and Green, his yacht and the question of whether he should keep his knighthood had become front-page news.

And clearly there was, and remains, a very important story here – that a lot of former BHS employees will not receive the pensions they once believed they would. While we would in no way wish to downplay that point, we would suggest the story the media chose to run with – the big numbers, the dividends, the offshore arrangements, the yacht, the title and so forth – did not wholly reflect the underlying reality of the situation.

Green may or may not be a thoroughly odious individual but he is the exact same individual now as he was when he was given a knighthood, with the same dividends, the same offshore arrangements and the same yacht. So it just seems a little odd that, in the space of a year, he could go from knighted to, well, benighted, when he, his business and indeed its pension fund deficit had not materially changed.

True deficit

That deficit is not £717m nor is it £100m – the truth is, it is probably somewhere in the middle. Certainly it is worth bearing in mind that, at the height of the media coverage of the larger number, the 10-year gilt-yield stood at 0.6%. Today it is closer to 1.4% and, by itself, that small change is likely to have wiped out a very significant part of BHS’s pension scheme deficit.

That, of course, is purely hypothetical now – sadly, the BHS pensioners have been ‘locked in’ – and yet the same logic holds true for the other struggling schemes referenced in that Pensions Regulator blog. By their nature, pension schemes involve big numbers and sometimes these will be negative but even small upward moves in gilt yields can have meaningful consequences for the discount rates used.

To put this into an investment context, there are a number of big UK companies that have seen their share prices marked down because of the size of their pension scheme deficits – and yet it is likely buy-out liabilities today are at exceedingly onerous levels and, with bond yields still towards the lower end of their historical range, very conservative indeed.

For those prepared to take a longer-term view, therefore, that issue should diminish significantly but then, as The Pensions Regulator’s blog archly concludes: “That doesn’t make for such a good headline, does it?” For our part, we will finish by underlining once more that we are not explicitly defending Green, here on The Value Perspective – merely making a point about media headlines and public perception.

Objectively speaking, Green is neither the corporate hero some once held him out to be nor the pantomime villain others portray him as today. The rather less sensational reality of this story is he is a businessman who sold a business and, because of his dividends, his offshore arrangements, his yacht and so forth, people were looking for an opportunity to stick the knife in. In the end, the weapon turned out to be pension fund accounting. As we said, who knew it could be so exciting?

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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