Cashing in. Pensions, rising interest rates and the implications for UK Media and Tech

Sometimes the more boring topics can be the most important ones fundamentally, mainly because, while dry, they tend both to have a major impact on decision-makers' actions and incentives and are important when it comes to areas such as rules-making (as the phrase goes: "People do not do what you expect, they do what you inspect"). This is the case when it comes to pensions and particularly for the UK market. The FT did an excellent Big Read piece on what is happening in the UK pensions sector post-the rise in interest rates (here: https://on.ft.com/3O8J6Pb) and, while it is a dry topic, I think it is important to read and I will go through my thoughts on what it means for the UK Media and Tech sectors. I realise some of these points can get quite technical so reach out as necessary.

1. I will not go through the technical details in this article (the piece explains them well) but one area where the rising UK interest rate environment is having a major positive impact is when it comes to UK companies' pension deficits. In summary, rising rates mean declining future liabilities for the pension schemes and, as a result, UK pension deficits are rapidly tumbling as these liabilities are now being discounted back at a much higher rate. To put in context, pre-the rise in interest rates, the net number of pension schemes in deficit (i.e. those with a deficit minus those with a surplus) was roughly just under 1500. That figure has swung now to a net number in surplus of over 3,500. In total, the total aggregate of the schemes has gone from a deficit of ￡132 Billion in 2020 to a surplus of ￡431 Billion in May 2023.
2. While rising interest rates has an impact on pension schemes everywhere, the UK is particularly impacted because of the rules around protecting company pension schemes, put in place post-the Robert Maxwell and Mirror Group Newspaper pension scandals of the early 1990s. Put simply, company directors have very strict requirements when it comes to their pension schemes (hence the point that companies do what you inspect) and pension trustees are ultra-cautious when it comes to their view on funding pension deficits. This has meant that, in an ultra-low interest rate environment, many companies - particularly long-standing ones that had company schemes in place - have had to make substantial cash payments every year into their pension schemes. The rapidly rising interest rate environment will mean that will change over time (note pension scheme requirements are not updated in real time, the usual process is every three years).
3. What does therefore mean for UK Media and Tech companies? Note many of the points will be applicable to all UK companies who are impacted in terms of their schemes.
4. Firstly, as should be obvious, they are likely to see significant reductions in their pension cash flow payments, which means that cash cam be used for other areas. This should be the case more for the media companies (given their long heritage). For example, #itv paid ￡137m in cash pension contributions in 2022 and, while that was inflated, expects to pay ￡62m in 2023. #Pearson had a ￡66m net operating profit impact from its pension requirements.
5. Often, smaller companies can be disproportionately impacted, particularly if they are in declining and / or stagnating areas where there are large historic liabilities. #Reach (which is the successor of the Mirror Group Newspapers) paid out ￡55m in pension payments in 2022, a large percentage of its ￡126m adjusted EBITDA for 2022. It is not just declining companies though. Scottish media group #STV paid ￡9.5m in pension contributions in 2022, a large proportion of its ￡11.5m operating cash level.
6. Needless to say, reducing cash pension contributions would be a positive, allowing them to redirect that cash elsewhere - to investments, dividends, share buybacks etc (there is a separate debate about the merits of such use of cash). Note that firms will not get benefits all at the same time and / or some are locked into long-term agreements that would have to be renegotiated. Needless to say though, this should be a positive.
7. Secondly, and leading on from this point, as companies across a variety of sectors will also see such benefits, it should mean there is a general redistribution of cash from pension payments to other areas. That means that many of the buyers of Media and Tech companies' services should have more cash to spend.
8. There are some obvious caveats here. As mentioned in point 6, many firms may decide to spend the extra cash on increased dividends and / or share buybacks. Given the general UK corporate mentality, I think that is a given. Many companies will also face increased interest payments from floating - as opposed to fixed rate - interest rate debt repayments, especially if they are heavily indebted (which is what is causing the issues with Thames Water) although these are likely to be in sectors that are not heavy media sectors (such as utilities). The principle of higher interest rates will also, of course, apply to Media and Tech companies although the former in particular have generally sought to de-lever their balance sheets over time.
9. From a spending standpoint, Tech may benefit more than Media here. The reason for this lies in the accounting standards. Advertising spend is expensed onto the Profit & Loss while IT and software investments generally tend to be capitalised (i.e. the cash payment is recorded in the cashflow statement but they are generally written down over a number of years via depreciation and amortisation charges). Given the main benefit for many firms is likely to be on the cashflow, not P&L side (although there will be benefits there), that may weight management behaviours towards extra investments.
10. Thirdly, and also benefiting Tech, is that - as the article points out - as money is transferred across from company run pension schemes that have a regulatory requirement to invest in safe investments i.e. Government bonds in the UK and markets such as the US, to insurers who will be looking for higher returns. That is likely to mean a shift of funding into areas such as Venture Capital and Private Equity, and / or areas seen as offering potential long-term growth. Arguably, equities should also benefit and so there is an argument whether such moves could provide a catalyst to the London IPO market.
11. Fourthly, it may stimulate M&A activity, including in Media and Tech. One reason historically that has put off potential buyers of firms that have large pension deficits is that the pension trustees usually demand a large contribution to the pension scheme as a condition for approving any such bid (pension trustees have to give approval for such a bid). Particularly for VC and PE firms, but more generally, such payments can be a disincentive to bid. As schemes are transferred across from pension trustees to insurers, that requirement is likely to be come less onerous adding to the benefit that comes from lower liabilities due to higher rates.
12. Fifthly, a knock-on effect - and conversely negative for Tech and for those companies with heavy borrowing costs - is that the changes may lead to higher interest rates which have a negative impact on the Discounted Cash Flow valuation models which are the consensual model for valuing companies (it is too long to explain here but ask for more details), as well as more interest payments. That relates to point 10 where pension trustees no longer buy Government debt. I think - for now - this is not as important as the other points but it may grow in importance.
13. In conclusion, while this is a dry and seemingly boring topic, it could have noticeable implications - maybe positive - for the space. As such, it is worth keeping an eye out on what happens and it may, more generally, be a major positive for the UK generally IF that cash is spent on investment both by insurers and corporates (I have some obvious doubts on the latter).

As usual, this is not investment advice.