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Equity gains not enough to offset bond yield changes

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UK - Equity gains in the recent stock market rallies have not been “substantial” enough to offset falls in corporate bond yields, Aon Consulting has warned, and the result for the 200-largest defined benefit (DB) schemes was an aggregated deficit of £72.8bn (€85.7bn) by the end of July.

Latest figures from the firm’s Aon200 Index showed the deficit is a fraction smaller than the £73.3bn recorded at the end of June, however Aon noted this is an improvement as in the first part of July the deficit hit £90bn - last reached in 2003 - before improvements in equity markets were seen towards the end of the month.

The continued deficit, despite equity gains, is echoed by figures from Pension Capital Strategies (PCS), which claimed at the end of June the total deficit in the DB schemes of the FTSE 100 companies had reached £90bn, against a deficit of £8bn in June 2008.

Aon warned even though the economy may start to show signs of a recovery, businesses could see their pension scheme deficit rise even further if corporate bond yields fall back to long-term, pre-credit crunch levels - with the possibility the accounting deficit of the top 200 schemes could rise by £40bn.

Sarah Abraham, consultant and actuary at Aon Consulting, warned while many employers might be expecting to see improvements in scheme funding levels following market rallies, “this will not be the case” as since the credit crunch there has been “heightened yields on corporate bonds” that have undervalued liabilities and deficits.

She warned: “Equity market gains have not been substantial enough to offset the falls in corporate bond yields, meaning that liabilities have been growing faster than assets can recover. Therefore pushing up deficits.”

Going forward, she warned that employers will have to hope that as the economy recovers equity values rise faster than corporate bond yields fall “or they may need to prepare themselves for some of the worst year end accounting results on record”.

Research from PCS into the FTSE 100 DB schemes meanwhile noted there was a continued “flight” from equities into bonds, which “appears to be accelerating”, as the average asset allocation to bonds has increased from 41% to 49%.

PCS claimed this is the “largest 12-month shift in investment strategy for more than 20 years”, and it follows an earlier shift from 35% to 41% over the previous year, so that in just over two years the bond holdings of FTSE 100 DB schemes has increased by more than a third.

Charles Cowling, managing director of PCS, said: “The massive shift of pension scheme assets out of equities and into bonds stems not only from the recent turmoil in markets but it is an inevitable consequence of successive government legislation demanding more and more guarantees and security from companies and their pension scheme.”

He added increased focus by the pensions regulator on trustees to be more prudent in their funding assumptions means that companies are now preparing to close down pension schemes for good.

“We believe that within the next two to three years the large majority of pension assets will be in bonds as companies move towards the final end game of offloading pension liabilities and the winding-up of pension schemes,” said Cowling.

If you have any comments you would like to add to this or any other story, contact Nyree Stewart on + 44 (0)20 7261 4618 or email nyree.stewart@ipe.com

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