When BT announced its full-year financial results for the 12 months ended March 31 2009, it confirmed to many that the UK incumbent is grappling with a three-headed monster: an unsustainably high cost base, an underperforming Global Services division and an enormous pension fund deficit, writes Ken Wieland.
The pension deficit may well look the scariest to BT shareholders. According to BT, the pension fund shortfall was a substantial £2.9 billion as of the end of March 2009. If different accounting assumptions are used, however, BT’s pension liabilities could be as high as a whopping £11 billion.
BT’s pension problem appears to be worse that that of other European incumbents — though all result from the time when they were state-owned. However, BT’s position means it is at a disadvantage to rival companies. BT’s deficit is in a European league of its own.
Public sector companies in the UK would typically offer defined benefit pension schemes where pensioners are paid a proportion of their final salary. It was one way to compensate public sector workers in difficult and relatively low-paid occupations, such as the National Health Service and the armed forces. BT, as a state-owned company, got caught up in the defined benefit trend.
Yet even after BT was privatised in 1984 it continued to offer defined benefit pension schemes to new employees until April 1 2001. It then introduced defined contribution pension schemes where the employee, rather than the employer, takes the risk since the size of the pension is broadly based on how well the pension fund has performed.
But BT still has a lot of people connected to its defined benefit pension scheme. There are around 64,000 contributing members today and about 96,000 deferred members — those who have stopped paying into the BT defined benefit scheme, usually by switching jobs, but are still entitled to benefits when they retire.
There are also around 180,000 pensioners currently drawing from the defined benefit pension scheme fund.
Defined benefit pension schemes, no matter how large, are manageable if the pension fund assets are achieving adequate returns.
BT has traditionally invested in shares to fund its pension commitments and this investment strategy has historically served it well. As of March 2008, BT— using its own interpretation of UK accounting rules — reported it had a pension fund surplus of £2 billion.
Financial downturn
The subsequent financial downturn and stock price declines have changed surplus into deficit. They have also raised questions about how much extra funds BT needs to put into its pension pot to fill the funding void. In doing so, the veracity of the UK incumbent’s balance sheet is in doubt.
BT could not provide Global Telecoms Business with a spokesperson to discuss the scale of the pension fund shortfall and its possible implications for shareholders.
During BT’s 2008-09 financial results announcement, CEO Ian Livingston said an agreement had been reached with the BT pension fund trustee to increase the operator’s cash contribution to £525 million each year for the next three years. BT’s previous pension fund contributions were set in 2005 at annual payments of £280 million over ten years.
Despite the near doubling in funding many analysts believe it is unlikely to be enough, simply because BT has so underplayed the scale of its pension deficit.
“For funding purposes, BT will need to agree on a payment plan based on a larger deficit than is currently being shown on its balance sheet,” says Danny Wilding, a partner at Barnett Waddingham, an independent firm of actuaries and consultants. “BT has taken a less prudent interpretation of the accounting standards than perhaps some other companies would have done.”
The pension accounting standard that all UK-listed companies must adhere to is FRS 17. Within the FRS 17 standard, however, there is scope for some interpretation.
As the size of the pension liability is worked out on future financial promises, and because a sum of money is worth more now than that same sum in, say, a year’s time, the value of those future promises have to be discounted to give their current value. The higher the discount rate used, the smaller the liability (or bigger the surplus) becomes.
So, one key factor in determining the size of the pension liability is the discount rate applied. But that, says Wilding, is only “partially prescribed” by FRS 17.
According to FRS 17, companies should base their discount rates on the yields of AA-rated corporate bonds in UK pounds. “The problem here is that there is a much greater spread of yields of AA-rated corporate bonds than there was a few years ago,” says Wilding. “Financial institutions, for example, now have a much higher yield to reflect the greater risk than bonds issued by non-financial institutions.”
Within the FRS 17 framework BT uses international accounting standard IAS 19, which allows a wide spread of yields to be used. As IAS 19 pegs AA-rated corporate bonds at 6.85%, and taking into account inflation of 2.9%, BT currently applies a 3.95% discount rate to its pension scheme fund.
John Ralfe, an independent consultant advising company and trustee boards on pensions, is quoted by Reuters as saying that 2.5% is a much more realistic discount rate after inflation, which would increase the size of BT’s pension shortfall to around £8 billion.
Live long and prosper
Then there’s the question of how long pensioners will live. Add another two years to BT’s assumptions on the life expectancy of pensioners drawing from its fund — which Ralfe believes is reasonable — then the BT pension scheme deficit balloons to £11 billion. FRS 17 gives no specific instruction to companies and pension trustees on what longevity assumptions to use.
The scale of BT’s pension shortfall is not seen among other incumbent telcos in Europe. This is due in part, argues Wilding, to tighter regulation. “Most of continental Europe has much stricter funding rules than the UK,” he says. “There would be more intervention from regulators to make sure deficits didn’t become so big, and there is much less scope for negotiation between trustees and employers [to agree on the levels of funding contributions].”
For accountancy purposes, however, the same principles do apply outside the UK, the main difference being the use of AA-rated corporate bonds in euros — as opposed to pounds — to calculate the discount rate.
Wilding further points out that it is a more commonplace requirement of mainland European companies to put aside reserve funds as an insurance against pension asset devaluation. “If the BT pension scheme were based in the Netherlands, where regulation is much tougher, it would have needed to be funded to a much higher level than it has been,” he says.
Employees in mainland Europe also have a much greater reliance on state-funded pensions than in the UK. Moreover, defined benefit pension schemes, according to Lesley Browning, a partner in the pensions team at law firm Norton Rose are not so widespread in other EU member states — with only a couple of notable exceptions.
“Ireland has a defined benefit pensions system similar to that in the UK, while the Netherlands also has defined benefit schemes, although they are established differently from those in the UK and Ireland,” she says.
“BT’s problem cannot be seen as part of a pan-European problem, which means it has an operational disadvantage.”
Eircom, Ireland’s incumbent telco, reports that its defined benefit pension scheme had a deficit of €433 million as of December 31 2008. This compares to a surplus of €20 million as of June 30 2008 and a surplus of €422 million on June 30 2007.
Like BT, Eircom has been affected badly by sharp declines in stock market prices. In terms of scale, however, the BT pension fund — and its associated deficit — is in a European league of its own. With the market value of its pension scheme assets standing at £29.3 billion as of March 31 2009, it is the biggest private sector pension fund in the UK. And because of its sheer size, the UK Pensions Regulator is now starting to give BT some extra attention.
Funding evaluation
While UK companies and their pension company trustees are allowed to agree on fund contributions when using the ISA 19 accounting standard to calculate annual pension deficit figures, an independent actuary is required for triennial funding valuations. The UK pensions regulator has told both BT and its pension scheme trustee that it wants to see the results of the triennial valuation of the pension fund liability, and the assumptions lying behind it, before anything is made public. The process of the triennial funding evaluation is now at an “advanced stage”, says BT.
“It is unusual for the UK pensions regulator to have so much involvement,” observes Wilding, “but, conscious of the scale of the problem, it looks like it will use its power to intervene if necessary.”
If BT is saddled with a much heavier pension funding obligation after the triennial review, the UK incumbent will no doubt ramp up its efforts to receive financial assistance from the UK government.
“Another unique aspect about BT in regard to its pension funding obligations is that it has been having an ongoing discussion with the government as to what exactly was promised, when BT was privatised, as a way of guarantee on the defined benefit pension scheme,” says Browning from Norton Rose.
“BT will assert that the government guaranteed the benefits of its scheme pension members at the privatisation date. There might even be a suggestion from BT that the government guaranteed pension benefits accrued beyond privatisation.”
To de-risk their defined benefit schemes, some firms choose to hand over their liabilities to an insurance company, which is then responsible for meeting the pension scheme obligations.
Prudential deal
Cable & Wireless sealed such a deal with Prudential in early September 2008. For a mixture of £10 million in cash plus some assets, Cable & Wireless exchanged half of its defined benefit liabilities, worth around £1 billion at that time, in exchange for annuity payments from Prudential.
It was the biggest UK pension buyout of 2008, but since the collapse of Lehman Brothers the same month as the Cable & Wireless deal many insurers have stepped back from the buyout market, making it unlikely that this could be a viable course for BT.
“Pension buyouts are now relatively more expensive than they were last year,” says Browning.
Failing financial assistance from the UK government and the lack of viable de-risking options, BT shareholders face the unwelcome prospect of large amounts of operating cash flow going towards plugging the pension deficit hole — which, in all likelihood, is much bigger than the £2.9bn shortfall calculated by BT as of March 31 2009.
This will probably mean lower dividends and the trimming down of capex, which could affect major strategic initiatives such as BT’s £1.5 billion plan to roll out fibre to the kerb in the UK.
BT’s existing defined benefit pension scheme members might be planning for a happy retirement — but the future for the UK incumbent looks much more uncertain.
Global Telecoms Business will be continuing to look at the pension liability of operators in the near future