Corporate Britain is dying. But it is not a natural death. By forcing inherently uncertain long-term pension promises to become – at least notionally – certain huge damage has been inflicted on UK capital markets and done to the country’s corporate sector. It is too late to undo the damage of opportunities foregone. It is not too late to stop inflicting more harm in the future.
I have written several columns on UK pension arrangements, the most recent in June. Present and prospective public sector pensioners and the current generation of private sector pensioners enjoy secure, income-related pensions. Younger generations of private sector workers will rely on uncertain returns from their own (mostly inadequate) savings. It is a huge generational inequity. Yet, argues Michael Tory, co-founder of advisory firm Ondra and a co-author of a recent pamphlet on pensions from the Tony Blair Institute, the damage to capital markets and the corporate sector is an equally big issue.
The ratio of price to earnings of the FTSE 100 has collapsed, from roughly 17 times in 2006 to 11 times today. Investors’ valuations should reflect the present value of expected cash flows. Cash flows can be divided, on a rolling basis, into the actual dividends and buy-backs made, or expected over the subsequent 10-year period and the cash flows thereafter – or the “terminal value”. A company that creates more value than it is distributing is building terminal value, while a company that distributes more than the value it creates is depleting it. According to Tory, the terminal value of UK corporations has collapsed from $1.6 trillion (€1.52 trillion) in 2006 to $0.9 trillion today. Yet, while the terminal value of UK large corporates is shrinking, that of their US equivalents rose more than 300 per cent and even that of German and French companies rose over 50 per cent.
As Warren Buffett said, “in the short run, the market is a voting machine but in the long run it is a weighing machine”. It has duly weighed UK corporates and found them emaciated.
Why has this happened? The answer starts with the dumping of UK equities by UK pensions and insurance companies. The share of their portfolios invested in UK equities has shrunk from more than 50 per cent to 4 per cent in the past three decades. Companies have also been forced to make £250 billion (€288bn) in pension contributions to fill fictitious deficits. Just how fictitious was shown by the £1 trillion fall in their liabilities after the recent jump in interest rates. The shrinkage of the investor base has dramatically reduced the amount of capital raised by UK corporates.
All this has reduced corporates’ ability to invest and so grow. The resulting decline in the prospects for growth in earnings and so capital gains has then forced higher payouts, which have further reduced cash for investment. The shrinkage of the UK investor base has also increased the claims of non-UK investors. In 2004, 65 per cent of distributions stayed in the UK. By 2022, this was roughly 25 per cent. This, then, is a self-reinforcing vicious cycle of corporate self-liquidation.
None of this matters in fantasy financial economics, in which national borders are irrelevant, investment can be funded from anywhere in the world and markets are rational and far-sighted. But in reality US companies benefit hugely from favoured access to American capital markets, just as US investors benefit from superior connections to American corporates. Location matters. As UK businesses come to be increasingly owned by foreigners, the interests of the UK will come second.
A revival of UK capital markets is essential. This will require the recreation of large pools of local equity capital, which would enjoy the advantages of familiarity and contacts that come with residence. Such funds should not be forced to invest in the UK. But they should be able to see – and seize – local opportunities far better than outsiders.
Part of the answer is consolidation of surviving defined benefit funds. A tested solution – the Pension Protection Fund – is already established and proven. It has a successful consolidation record, with more than 1,100 funds absorbed so far. It can kick-start the process. Another part of the answer is a move towards collective defined contribution funds, in place of today’s plethora of smaller funds, of which there are over 3,000, according to Citi. Again, consolidation is essential.
The onslaught on the UK’s pensions sector and capital markets is among the greatest intergenerational injustices of all. Today’s prosperous old have destroyed the intergenerational pensions compact by imposing the ludicrous aim of absolute security. In the process they have also starved the capital markets, and so the corporate sector, on which their children and grandchildren will depend. This is a tragedy. It is also a call for immediate action. – Copyright The Financial Times Limited 2023
