Woodford: Why UK's huge pension deficit is bad for investors

Part and parcel of being an investor is keeping a close eye on headwinds - events that have the potential to blow financial markets off course.

Some are easy to spot, for example political risk, with the upcoming presidential election in America this November a current key concern.

Other risks, however, can be much less widely anticipated and cause ructions in the financial markets.

China's Black Monday last August, which triggered a sharp sell off in global equity markets, is one of many examples that have taken investors by surprise.

Pension deficit concerns

A risk that has been apparent for some time, but arguably has not been on many investors' radars, is Britain's ballooning pension deficit. At the end of July, number-crunching by actuarial firm Hymans Robertson found the deficit of defined benefit pensions had reached a record high.

Neil Woodford, manager of CF Woodford Equity Income, outlined Britain's pension deficit problem as an issue that spells trouble for income investors.

In a blog post, Woodford explains that one of the factors behind his sale of holdings in BT, BAE Systems earlier this year and Royal Mail last year was concern about their pension deficits.

Woodford says: "For a variety of reasons, defined benefit schemes have come unstuck over the past 20 years.

"Not only are people living longer than had initially been expected, but asset returns have not, in broad terms, lived up to expectations, with gilts outperforming UK equities for much of this period."

Nothing to do with Brexit

The biggest problem, notes Woodford, is the progressive decline in bond yields. Since June's Brexit vote the benchmark 10-year UK government bond yield has slipped below 1% for the first time. Prior to the vote the yield as 1.37%, but it now stands at 0.66%.

Woodford, however, adds that the UK's pension deficit has been building in the background for years and has nothing to do with Brexit.

On the question of why the Britain's big pension deficit matters, Woodford explains that companies may have to sacrifice dividend payments in order to fund deficit shortfalls.

"At the stock level, an increasing number of companies face mounting challenges in tackling their pension deficits. In particular, previously nationalised businesses have substantial amounts of unfunded pension liabilities on their balance sheets," he says.

"The presence of a substantial pension deficit is therefore a consideration for investors and could put further pressure on the cash available for distribution via dividends, particularly in an environment where the balance between deficit reduction and shareholder returns is being called into question."

This article was originally published by our sister magazine Money Observer here

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.