By Alexis Xydias
May 18 (Bloomberg) -- The 220 billion pound ($334 billion) hole in U.K. corporate pensions may push companies to cut dividends, damping the recovery in Europe’s largest stock market.
The 1.17 percentage point drop in corporate bond yields since October is forcing companies from BT Group Plc to BAE Systems Plc to set aside more cash for future obligations. London-based BT slashed its dividend by 89 percent last week to support a plan for more than 340,000 current and retired employees.
More will follow, adding to the biggest dividend reductions in Europe since at least 1997, according to data compiled by Paris-based Societe Generale SA and UBS AG in Zurich. U.K. companies are the most susceptible because English corporations typically run pension funds, unlike the rest of Europe, where the state is responsible for retirees.
“Pension managers are caught in the perfect storm,” said Chetan Ghosh at Investment Solutions Ltd. in London, which oversees more than $13.8 billion. “Bond yields are falling and stocks have not recovered from last year’s sell-off. This will increasingly be a problem through 2011.”
Dividend reductions would add pressure to share prices already battered by the global recession and the region’s first annual net gain in equity sales since 2005.
‘Under-Funded’
BT, the U.K.’s largest phone company, and BAE Systems, Europe’s biggest arms maker, rank with British Airways Plc and Dusseldorf, Germany-based ThyssenKrupp AG, Germany’s largest steelmaker, as having a “high risk” of using cash to shore up pensions, Societe Generale said in a report last month.
BAE Systems plans to contribute an additional 200 million pounds to help cover its U.K. pension deficit and $250 million for its U.S. plan. London-based British Airways, Europe’s third- largest airline, may have to set aside more money for its growing pension deficit, analysts at Paris-based brokerage Oddo Securities wrote in a March 6 report.
“Markets underestimate the extra funding needs for companies’ pension obligations,” said Claudia Panseri, a strategist at Societe Generale in Paris. “Unless the equity markets rebound significantly during 2009, pension funds will remain significantly underfunded, which will result in high contribution requirements in 2010 and 2011.”
Discount Rate
International accounting rules require pension plans to calculate the amount of money they need today to meet future payments. The total is increased or reduced by an amount proportional to yields on corporate bonds, reflecting what a company will earn in interest before benefits are due. The lower the yield, the more money must be pledged now.
The deficits are in part an unintended consequence of the Bank of England’s efforts to pull the country out of the steepest economic contraction in at least three decades. The central bank cut its benchmark interest rate to a record 0.5 percent and said it would spend as much as 125 billion pounds to buy debt securities in an attempt to push down borrowing costs. The U.K. economy shrank at a 1.9 percent rate in the first quarter, the biggest contraction since Margaret Thatcher came to power in 1979.
Yields on 15-year corporate bonds in pounds rated AA have dropped to 6.55 percent from 7.72 percent in October, according to Markit Group Ltd. The decline may continue, according to Mark Bon, a London-based fund manager who helps oversee about $750 million at Canada Life Ltd.
Worst Case
“Yields are still falling and it will become increasingly difficult to fund pensions,” Bon said. “The worst-case scenario is depressed equity markets and deflation which keeps interest rates very, very low for a long time.”
A Bank of England spokesman said the central bank hasn’t commented on the effect of lower yields on benefit plans.
Deficits for companies in the FTSE 350 Index almost doubled to 61 billion pounds in the first three months of 2009, according to Mercer Ltd., a consulting firm. The “technical” funding needs as reported by pension trustees, a more accurate indication of shortfalls, climbed to 220 billion pounds at the end of March, said Matt Collinson, a Birmingham, England-based consultant at Mercer.
European equity benchmarks have recouped their 2009 losses since early March on speculation the worst financial crisis in seven decades is easing. Britain’s FTSE 100 is down 2 percent for the year after rallying 24 percent since March 3. The measure, which has retreated 35 percent from a seven-year high in June 2007, advanced 0.3 percent to 4,360.44 as of 8:43 a.m. in London.
Median Allocations
FTSE 350 pension managers had a median of 46 percent of their assets invested in stocks as of March 31, Mercer estimates. The allocation to bonds, whose value has increased as rates declined, was 40 percent.
BT slumped 9.4 percent last week as it cut its final dividend to 1.1 pence a share from 10.4 pence and said its pension deficit as of March 31 was 4 billion pounds before taxes compared with a 2.8 billion-pound surplus the year before. British Airways may scrap its payout after distributing its first dividend since 2001 last fiscal year, according to Bloomberg data that compiles analyst estimates and trading in options markets.
Laura Goodes, a spokeswoman for British Airways, said the company is working on a three-year review of the pension and estimates the deficit has grown. Goodes said the company can’t comment on the dividend before its May 22 earnings statement.
About 30 percent of European companies may reduce their dividend in the next 12 months, according to UBS, the most since the Swiss bank’s data started in 1997. Companies in the region may raise 300 billion euros ($405 billion) selling shares this year, excluding financial institutions, New York-based Goldman Sachs Group Inc. estimated in February. The gain would end three years in which buybacks and mergers outpaced equity sales.
‘Severe Peril’
The total deficit for all British companies narrowed to 189 billion pounds last month from a record 242 billion pounds in March, when the FTSE 100 fell to a six-year low, the Pension Protection Fund, an insurance plan financed by members’ levies, said on May 12. A year earlier, retirement plans had a 27 billion-pound surplus.
Companies struggling with obligations to retired workers have flexibility to revise funding arrangements, according to the Pensions Regulator, the Brighton, England-based agency that oversees retirement plans for the government.
“Though pension deficits are a long-term issue, it does concern us,” said Richard Champion, London-based head of U.K. equities at Principal Investment Management Ltd., who helps oversee about $1.2 billion. “Some of these schemes look in severe peril.”
To contact the reporter on this story: Alexis Xydias in London at axydias@bloomberg.net.
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