John Ralfe is an independent pension consultant.
There has been plenty of digital ink spent on last month’s “LDI meltdown”, but little exploring the impact on specific companies. But BT has now offered some insight into how it coped with recent extraordinary events.
The UK telecoms company published its half-year results and its June pension scheme accounts last week, and they bear close reading. BT isn’t just any old company — it has the largest IAS19 accounting pension liabilities of any UK company, calculated using a AA corporate bond rate — and has been in the pensions spotlight for two decades.
So what happened to BT?
The good news is that the much higher AA corporate bond yields from March to September shrank BT’s IAS19 liabilities by a quarter from £54.3bn to £40.6bn. And because it has hedged all of its interest and inflation exposure pretty well through matching bonds and long-dated interest rate swaps, assets fell by a similar amount — £53.5bn to £39bn — leaving the IAS19 deficit virtually unchanged at £1.6bn.
Crucially, even though BT’s pension scheme has a whopping £50bn of interest rate swaps with maturities over 40 years, it had no liquidity or collateral problems. BT’s actuarial deficit — calculated on a tougher basis than IAS19 — which fixes deficit contributions, remained at about £4bn at September, which it plans to pay off by 2030. The next three-year actuarial valuation is at June 2023.
BT’s interest and inflation hedges have certainly done what they were designed to do, but this doesn’t mean shareholders can stop worrying about pensions.
Although 60 per cent of pension assets were in matching bonds, cash and “secure income”, 40 per cent of assets at June 2022 (about £19bn) were in what BT describes as “equity-like assets” — public stocks, private equity, property, hedge funds, infrastructure and “non-core credit”.
The £19bn in “equity-like assets” is much larger than BT’s £12bn market capitalisation. BT is on the hook for all pension deficits, so in economic terms, holding £19bn of “equity-like assets” in its pension scheme is identical to BT borrowing £19bn long term, and then buying those assets directly.
Quoting the adage, “BT looks likes a badly-run hedge fund which just happens to own a phone network”. BT’s market cap is therefore sensitive to movements in the value of “equity-like” pension assets — as a matter of arithmetic, a 10 per cent fall in their value hits BT’s market cap by about 10 per cent after tax.
About £15bn of these assets are unquoted, and BT’s auditors list “the valuation of unquoted plan assets” as their first “key audit matter”. Much of BT’s £50bn book of interest rate swaps are leveraged swaps — effectively borrowing — allowing it to continue betting on equities, and run a huge asset and liability mismatch.
We all know from corporate finance 101 — the Modigliani-Miller theorem — that increasing leverage through borrowing does not create any first-order value for shareholders. Only the tax break on debt interest payments creates shareholder value. Equally, leverage in the pension fund through leveraged swaps does not create first-order value for shareholders. And there is no tax break for pension fund leverage.
Because pension fund leverage reduces the company’s capacity to borrow, and debt creates shareholder value through the tax break on interest payments, pension fund leverage isn’t neutral, but destroys shareholder value.
Although BT plans to pay off its £4bn actuarial deficit by 2030, in practice, being “100 per cent funded” is a moving target for any pension scheme. As they become better funded a tighter discount rate applies, increasing the present value of liabilities.
New UK rules on funding and investment strategy will also require mature schemes to have a “Long Term Objective”, using a tight discount rate, adding several billion to BT’s deficit.
BT was privatised with great fanfare in 1984, and unlike other privatised European telcos, pensions were not left with taxpayers. But over the last two decades BT has suffered a long-term “double squeeze” — its market cap has shrunk, while lower real interest rates have increased pension liabilities. Furthermore, it has £20bn of debt and lease liabilities, and a credit rating of just BBB.
Now with a market cap of just £12bn, and £40bn of pension liabilities, BT is a small business supporting a huge pension scheme. BT continues trying to reinvent itself for the 21st century, but like Samuel Coleridge’s Ancient Mariner, it has a very 20th century pension albatross hanging around its neck.