The final salary pension bombshell that could hurt your investments

Investors: ignore a firm's pension liabilities at your peril.

Last week BT saw its shares drop to the bottom of the FTSE 100 leader board. Its share price fell after it revealed a £7 billion shortfall in its giant pension fund.

As a result, BT said it will be paying £2 billion into its now-closed final-salary pension scheme over the next three years.

BT's pension fund is one of the largest in the UK and, despite being closed to new members since March 2001, still has over 300,000 members. BT blames the current low interest-rate environment and reduced bond yields for dramatically increasing its pension deficit to the current shortfall of £7 billion.

As an employer, BT has to make good on this pension black hole, so the £7 billion gap between its pension assets and liabilities will act as a drag on BT's share price until it is finally extinguished. What's more, with such large scheduled contributions, BT's pension could harm its core business, such as preventing it from winning sports-broadcasting rights in future auctions.

Low rates send shortfalls soaring

Of course, BT is not the only employer to agree multi-billion-pound top-ups with its pension trustees.

Thanks to lengthening lifespans and the record low interest rates, the vast majority of UK pension funds are currently running at a deficit. This means that most funds' liabilities (what they must pay in future benefits) usually exceed their assets (what they own).

Another critical problem for pension funds is that their actuaries over-estimated the potential long-term returns on offer from their assets, particularly bonds. For example, the yield on the benchmark 10-year US Treasury - one of the world's widest-held bonds - has plunged from around 6% in 2000 to roughly 1.7% today.

With pension funds holding a sizeable proportion of their total assets in bonds, collapsing bond yields have hit these schemes hard. Struggling to hit target investment returns of around 8% a year, pension funds have had no choice but to bite the bullet by increasing one-off and ongoing contributions until their asset-liability gaps have been closed.

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A headache for British business

When you add up the deficits of all major UK pension funds, the sums involved become truly staggering.

According to the Pension Protection Fund (PPF), the total assets of the 6,057 UK pension schemes it monitors were £1,237 billion at the end of 2014. However, at £1,503 billion (£1.5 trillion), their total liabilities were £266 billion greater than their assets.

This means that a typical UK pension fund has an average deficit of just short of £44 million. But as we've seen with BT, pension shortfalls can run into billions of pounds at big firms. With companies liable to pay off these deficits (just as they must do with bank loans and corporate bonds), investors should be wary of investing in businesses with dangerously large deficits.

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The hidden shortfalls of Footsie giants

Financial consultant Lane Clark & Peacock (LCP) produces a yearly report into the pension deficits of all FTSE 100 members. LCP's latest report, published last August, gives us a snapshot of the pension-funding situation of FTSE firms at the end of 2013.

In the table below, I have combined the pension deficits of the FTSE 100's 20 largest members (taken from LCP's latest report) with each firm's market value. I have then divided each firm's deficit by its market value, to show how big a problem each pension deficit presents. The table is sorted from the largest percentage deficit, down to two schemes that were actually in surplus in 2013.

Sources: "Accounting for Pensions 2014" by Lane Clark & Peacock; share data from Yahoo! Finance UK

As you can see, pension deficits at some FTSE 100 mega-caps are far from trivial.

For instance, BT's pension deficit of £5.9 billion in 2013 was equal to more than a sixth (17.4%) of its current market cap. What's more, we know this figure has since increased to around £7 billion, so BT's pension deficit has since swollen to more than 20% of today's market value. Frankly, BT shareholders ignore this fact at their peril.

Elsewhere among the FTSE's top 20, things look considerably rosier. After BT, the next-highest deficit versus market cap is at National Grid (5.4%) and BP (4.4%). Completing the top six, Barclays, Unilever and Rio Tinto all have deficits above 3% of their market values.

At seven of the firms, deficits are below 1% of market caps. This makes them of little concern, even to cautious investors. Remarkably Prudential (1.6%) and HSBC Holdings (0.1%) had modest pension surpluses in 2013.

Now for some bad news for investors. Since 2013, bond yields have plumbed new depths in the UK, US and other major economies. This means that the above deficits are likely to have swelled by tens of billions of pounds in 2014 and even further this year. BT is unlikely to be the only blue-chip business to have to inject extra billions of pounds into its pension scheme in the near future.

When investors evaluate listed (or private) companies of any size, they would be foolish to ignore company pension deficits. Otherwise, they could find that share prices are weighed down by bloated black holes in legacy final-salary pension schemes.

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