In this workout, we're going to look at pensions within the industrial sector.

We're looking at Rolls-Royce.

We have some footnotes which enable us to look at the pensions in detail.

We've been asked to come up with the overall pension liability or asset that would hit the balance sheet.

We've also been asked to identify which schemes are funded or unfunded, which will help us understand those concepts.

First off, we have the UK schemes.

Okay, so the UK pension funds, these are funded.

You can tell because they have a sizable asset in fair value of scheme assets.

You can see I've transferred the assets and obligations for the UK funds or schemes down here into row 23.

You can see that in 2020 there's also overseas schemes and that these are analyzed in more detail.

In this part of the footnote down here.

I'm now going to transfer the assets and obligations from the footnote into here.

Now, I just did that while the video was paused, just in case you're wondering how I did that so quickly.

Uh, just to save a bit of time and to save you watching me type it out.

You can see there's the uk, which I did type out, and then we've got Canada, okay, which has assets.

We've got Germany that appear to have no assets or minimal assets compared to their obligation, the us, which has assets that are roughly in line with their obligation.

And then we have opep, which is things like medical plans in the us, which appears to have no assets, and then other, which again appears to have no assets.

The first thing we can do is to figure out whether these schemes or funds are in surplus or deficit if we minus the obligation off the assets.

You can see that the UK scheme has a lot of assets. Perhaps their fund has been doing very well.

Maybe interest rates are high.

Maybe, uh, the fund has been investing very well or maybe there's other things happening like their members are not claiming as much as we expected.

There's a lot of moving parts within a pension fund, but the uh, conclusion is that the fund is in surplus.

If we copy that down, you can see that the UK is very much an outlier.

Everything else is in deficit.

Now, that means that the obligation is higher than the assets.

This is the value that you are predicting that you are going to need to pay out to your members.

This is the value of the fund and for Canada, the value of the fund is not enough to meet its obligations, so they're sitting in deficit.

This means at some point the fund will need topping up probably by paying more money in or making more wise decisions with it.

We're going to assume that it's gonna need topping up by paying more money into it.

We can now move on to the next column.

Before we think about how this all works in the balance sheet and valuation, we're being asked to identify whether the scheme is funded or unfunded.

Now we've really gone through the logic of that already.

The UK is funded because it has sizable assets.

So is Canada and so is the US pension fund.

Germany, although it has some assets, they're so low that we would say it's unfunded.

Now it's easy to get, um, confused between unfunded and underfunded.

Germany is both unfunded.

IE, it has no fund and underfunded IE it is in deficit.

In fact, the two support each other, but Canada is different.

It is funded because it has plan assets, but those plan assets are not enough to meet its obligations.

So you would say it's underfunded and that kind of terminology can get very confusing and very easy to mix up.

Now you can see that the eps are also unfunded and so are the mysterious other, okay, which are probably other benefits.

Now, you might be wondering why Germany has such high obligation compared to its assets.

Certain countries allow pensions to be unfunded and Germany is a notable example of that.

Some countries are much more into funds and so you can see Canada and the uk uh, require companies to set aside funds to meet their obligations, and so their pensions would typically be funded.

Now, let's go ahead and analyze this into what would, uh, it mean we have the pension liability.

It's tempting to add up all of the obligations, but that's not the way it's going to work.

What this is going to do is it's going to add up all of the deficits because this would be a liability or a hole that needs to be plugged.

You can see that's come out as a negative and it's neat and tidy. Then to flip the sign on that because the balance sheet would have positive presentation, we would then take the pension assets, which in this case would be a single figure, and that's the only surplus that we have, and that's confusing because the pension asset is very easy to confuse between the pension assets up here and the pension asset that would turn up on the balance sheet.

You could think about this as deficit and a surplus they would appear on the balance sheet.

Now, from a valuation point of view, what we would normally do is find out the impact on this to a prospective buyer.

That's usually the role of this in evaluation, and we would normally see the pension liability as a debt like Best not to grab it from the balance sheet because the balance sheet can do quite a lot of aggregation.

That's not very helpful, so it would be better to go to the footnote the way we have up here and find all of the funds that are in deficit, add them up, find out the debt, like, and then apply it to our valuation.

We would normally make that post tax.

Okay, so my labeled error is not the best we would need to make that post tax to make it relevant to valuation for evaluation, we would normally exclude any surplus, and that's because for valuation purposes, we would assume that any surplus would be locked in the fund and would not be accessible, and so it wouldn't represent a windfall to a prospective buyer because they couldn't take that the same way that they could take, for example, cash if the target company were cash rich, and so we would take the post tax version of that number as a debt, like okay, or even better, we would go into the footnote and analyze all the deficits and make them post tax and we would need to do a bit of work there because we'd need to understand what the tax regime would be like for every country rather than making a blanket assumption.

And so you can see a theme developing, which is that the footnote is superior to the balance sheet, and then we would broadly ignore surpluses unless there were country specific or jurisdictional rights to that cash, which is very unusual, and that's the way we would analyze pensions, which are very common in the industrial sector.

These are defined benefit pensions, just to be clear, and they're very, very common because these are big companies often have a tradition of defined benefit, or they may be ex-government owned, again with a tradition of defined benefit.