Every little helps – Tesco could benefit from even a small rise in how its pension scheme is valued


Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

The so-called “black hole” (© all media outlets) within Tesco’s staff pension scheme has led to a fair amount of comment in the press of late, with particular consternation provoked by the idea it could take 30 years to pay off this deficit. However, as regular visitors will be aware, here on The Value Perspective we tend to view these sorts of long-term assumptions and predictions with great scepticism. 

According to Tesco, as of the end of February 2015, the company’s pension scheme had a deficit that – in accounting terms, at least – stood at £3.8bn, net of deferred tax. Not only is that, obviously enough, an uncomfortably large number in its own right, it is also significantly up on the £2.5bn at which the deficit stood only 12 months previously. 

As we have discussed before, in articles such as Works both ways and Stamp of disapproval, pension fund deficits have in recent years proved a major headache for many businesses, including the likes of BT, Royal Mail and Trinity Mirror. On closer examination, the source of the pain more often than not turns out to be what are known as discount rates. 

Essentially an attempt to gain some idea, in today’s money terms, of how much a pension scheme will ultimately have to pay out to its members, discount rates are linked to bond yields. What that means is that, like bond yields, they have broadly been declining since the early 1980s and, again like bond yields, they now stand very much at the extreme lows of their historical range. 

The discount rate now being applied to the liabilities of Tesco’s pension scheme has dropped from 4.7% a year ago to 3.7% today – hence the spike in the deficit. An arguably more interesting and important disclosure from Tesco, however, is that its pension scheme’s “obligation” would decrease by £340m for every 0.1% tick upwards in the discount rate applied. 

As our quotation marks imply, the key word there is “obligation”. Nobody is suggesting the deficit itself would be wiped out were the discount rate to rise by a little over one percentage point – the net impact will be determined by where the trustees have invested their assets. Our point is that, unlike so many investors and other market watchers who have been fretting over widening pension scheme deficits, we should not think about how they look today, but entertain the notion that discount rates might one day go up. 

And is that really so inconceivable? Surely it is a good deal less likely that discount rates, having fallen pretty consistently for more than 30 years, will now plateau for a further 30 as Tesco makes modest annual payments. From these historically low levels, one might reasonably expect some upward movement and, if that were to happen, pension fund deficits would cease to be a concern for Tesco. 

For others too. Tesco makes for a topical example but, as we suggested earlier, there are plenty of other household names with painful pension fund deficits that would look materially different if discount rates were to normalise over the coming years. To those already mentioned, one could add BAE Systems, British Airways, Taylor Wimpey or indeed most companies with a large number of employees.           

Here on The Value Perspective, whenever we see anyone extrapolating the future from the current environment, it is like a red rag to a bull. Nevertheless, we will continue to remind investors that the future is uncertain and tough to predict and there is always the possibility things could change materially going forward – and that includes for the better. 


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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