The verdict on 2014 is that it was a volatile year for pension schemes. Long-dated interest rates fell sharply, bringing with them a corresponding increase in pension liabilities. That was the headline finding from a KPMG survey of 270 companies accounting for defined benefit (DB) pension plans under International Financial Reporting Standards, UK Generally Accepted Accounting Principles (GAAP) and US GAAP.

The report’s author, Katy Edwards, a manager with KPMG, says: “Persistent low interest rates have meant that corporate bond yields were at a historical lows at the year end. This was generally bad news for pension schemes – despite equity market rallies and strong fixed-income asset performance over the year.”

 Edwards adds that this low real-yield environment has, predictably enough, pushed up liabilities by as much as a 10% in the fourth quarter of 2014 alone. “Pension disclosures are likely to continue to attract scrutiny from shareholders and analysts as the pensions exposure increases relative to the overall balance sheet,” she warns.

And Naz Peralta, a London-based KPMG director who helped crunch the numbers in the report, says: “Accounting deficits among FTSE 100 companies have generally deteriorated, but many schemes have hedging strategies in place on the asset side.” So, looking at 2014 overall, he says, once you allow for deficit contributions, many DB plan sponsors can breathe a sigh of relief since they are showing only modestly worse positions. 

 

So, what did KPMG find? The report identifies a continuation of a trend evident last year of companies clustering ever more closely around the median in many cases. For example, some 76% of companies use an inflation assumption within 0.1% of the median, while 76% of companies are within 0.1% of the median discount rate assumption. 

“I would say that the primary concern for public companies against this backdrop of low yields is not so much the accounting but rather the negotiation of triennial funding arrangements with trustees”
Naz Peralta

Looking at that detail more closely, it is apparent that the median discount rate assumption has fallen from 4.5% last year to 3.6% this year. KPMG attributes this shift to a dramatic reduction in bond yields that has forced many sponsors to review their assumptions with a view to mitigating some of the impact of falling yields on the balance sheet. 

In line with the global trend for lower price rises, median RPI assumptions have also fallen from 3.4% to 3.1%. Alongside this, mortality assumptions have remained broadly unchanged since 2013, with a pensioner aged 65 expected to survive a further 22.6 years on average. 

The current low-inflation environment has also put downward pressure on pension and salary increases. The most common pension increase reported by the KPMG study is inflation capped at 5% a year – reflecting practice in the UK – while the median salary increase remains at 0.5% above RPI inflation.

Simon Robinson, a pensions accounting specialist with Aon Hewitt, agrees that the findings in the KPMG survey are a consequence of the low-interest-rate environment. “What you are doing under IAS 19 is projecting expected benefit cash flows,” says Robinson. “So at 5% inflation, a current benefit of £1,000 [€1,381] per annum increases to £1,050 after a year, then £1,100 each year after two years, and so on.”

Lower inflation means lower benefit increases. But the key factor is the discount rate. If the discount rate is 5%, Robinson’s notional benefit of £1,050 is discounted back to get £1,000. But using a rate of 10% would mean holding only £950 now, and so on. 

But Robinson warns against interpreting the KPMG findings simplistically, noting that part of the picture is an accounting mismatch between assets and liabilities.

The market value of sterling AA-rated corporate bonds is less than £40bn – far short of the £750bn of pension liabilities held by FTSE 350 companies. “That is even before you consider duration, which is typically about 20 years for the pension liabilities, whereas most AA-rated bonds have a duration of less than 10 years,” Robinson adds.

Duration determines how the value of the pension liability moves in relation to a change in the discount rate – a one percentage point decrease in the discount rate increases a 20-year liability by over 20% but a 10-year bond would only increase in value by about 10%.

Tim Bush, the head of governance and financial analysis at Pensions & Investment Research Consultants, is quick to note that IAS 19 is a short-term measure, as is a balance sheet because it is an estimate at a single point in time. 

“Pension funds invest over the long term to cover future cash flows. The International Accounting Standards Board has started from completely the wrong place, by taking a balance-sheet approach,” Bush says. “Marking equity portfolios to market and then valuing liabilities gross bears little relation to the future cash flows. The approach can produce an incongruous surplus or deficit.”

Bush adds: “Having started with the wrong approach, that error is then compounded by discounting liabilities at the risk-free rate rather than a blended rate of expected portfolio returns. A properly independent standard setter would have realised the mistake and would rip the model up and start again.”

Looking ahead, Peralta says the challenging economic and investment landscape means that tough negotiations with trustees are in store for those schemes about to embark on a valuation review. “I would say that the primary concern for public companies against this backdrop of low yields is not so much the accounting but rather the negotiation of triennial funding arrangements with trustees.

 “Although assets and liabilities might be tracking each other, the scheme may have grown relative to the size of the balance sheet, or the sponsor may be in a sector that is under pressure in the current economic environment. This may put pressure on the sponsor covenant and cash contributions, though sponsors will increasingly look to non-cash solutions such as additional securities to provide comfort to trustees.”