Pension Gap Widening to $334 Billion Forces U.K. Dividend Cuts

(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 Index is down 1.9 percent for the year after rallying 24 percent since March 3. The measure has retreated 35 percent from a seven-year high in June 2007.

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