Kotak rates Tata Steel as ‘Add’, says UK pension pact a step forward

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Published: December 12, 2016 6:43:38 AM

Tata Steel and trade unions have agreed to close defined benefit scheme for future accruals and move to defined contribution scheme, and de-link the existing defined benefit scheme from the steel business.

Tata Steel and trade unions have agreed to close defined benefit scheme for future accruals and move to defined contribution scheme, and de-link the existing defined benefit scheme from the steel business. The proposal will require employee approval. The de-risking of pension liabilities from steelmaking operations will improve the prospect of a JV with ThyssenKrupp or other strategic tie-ups. The steps towards improving competitiveness of Europe operations remain key drivers for our positive view on the stock

Tata Steel and trade unions agree on moving to defined contribution pension scheme

To improve the sustainability of UK operations, Tata Steel and trade unions have agreed to proceed towards closure of defined benefit pension scheme for existing employees (from future accruals) and instead move towards a defined contribution scheme. Note that the company’s liability in case of defined contribution scheme will be limited to fixed annual payments unlike defined benefit scheme where the company (as sponsor) was required to fund any future deficits in case of adverse movement of liabilities with respect to the scheme assets. The company will start consultations on this proposal with the employees now which will decide the final outcome. This move will essentially ascertain future pension liability for 14,000 employee members of Tata Steel of the total 130,000 members (existing & deferred pensioners).

Existing defined benefit scheme—to work on structural de-risking/de-linking from business

The existing liability for the defined benefit pension scheme, however, does not change due to this move towards defined contribution scheme for future accruals. The company will also work towards de-linking steelmaking operations from existing defined benefit scheme. The British Steel Pension scheme was in deficit of GBP 50 million per latest media reports (the deficit was GBP 485 million in March 2015 and GBP 90 mn per March 2014 triennial valuations). Given small changes in interest rate can have large impact on scheme liabilities, the defined benefit scheme remains fragile for the comfort of the sponsor given thin margins in the UK steelmaking operations. We highlight that cash flow impact on the scheme sponsor (Tata Steel) is through the payment plan that it agrees to make the deficit good.

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BSPS trustees had earlier discussed various alternatives

The trustees of British Steel Pension Scheme had earlier discussed two alternatives for restructuring of the existing pension scheme including taking the scheme to Pension Protection Fund (PPF), or staying out of PPF but modifying scheme benefits (preferred). The de-risking of pension scheme from UK steelmaking operations will improve financial sustainability of these operations. Tata Steel has also agreed to continue to use the existing blast furnace till 2021 and invest across the UK site. We believe the de-risking of pension liabilities from UK steelmaking operations also improves the prospect of a JV with ThyssenKrupp and other strategic tie-ups.

Understanding the issues pertaining to defined benefit scheme (in force to date)

Tata Steel, UK is the sponsor to the British Steel Pension Scheme with 130,000 members including 14,300 employees. As the sponsor of the defined benefit scheme, the company is required to fund any deficit arising out of excess of pension liabilities over the scheme assets (investments).

How does it affect Tata Steel’s cash flows? The BSPS has remained in deficit for the past many years due to a fall in interest rates. The decline in interest rates since 2008 has led to much higher increase in liabilities relative to the scheme’s return on investments; this essentially reflects use of lower discount rates to value future liabilities. As for example, the scheme had a deficit of GBP 553 million in 2011 post which Tata Steel agreed to a recovery plan spreading 2012-2026 which required agreed annual payments to be contributed by Tata Steel UK. However, in the triennial valuations of March 2014, the reported deficit declined to GBP 90 million from GBP 553 million in 2011 and a new recovery plan was agreed upon.

The scheme is very sensitive to interest rate movement, returns: The scheme liabilities are quite sensitive to interest rate movement and lower interest rates over last few years has led the scheme falling to deficit from surplus in 2008. The narrowing of the deficit now (compared to 2015) likely reflects hardening in interest rates as well as the impact of weakening GBP:US$ (asset re-pricing).

How closing of defined benefit scheme improves sustainability of UK operations: Given a small movement in interest rate can have large impact on scheme liabilities, the scheme remains fragile for the comfort of the sponsor given thin margins in operations. Even if one takes the view that interest rate may harden (which may be good for the scheme, but again depends on asset returns), the weak margins may not warrant such a risk appetite.

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