UK - British pension funds are facing gaping pension deficits because of record falls in longer-dated index-linked UK bond yields over the past week.

The value of pension fund liabilities – which has to be shown on company balance sheets – is calculated using a discount rate based on bond yields. The squeeze on yields has increased these liabilities, and a vicious circle has emerged with pension funds buying more gilts to compensate, which in turn has forced up gilt prices and reduced yields even further.

As funds grapple to plug the gap, Bob Scott, partner with actuaries and consultants Lane Clark & Peacock, says: “There are only three places they can get money to pay benefits from – funds they already have, investment returns on those funds, and future contributions. It’s only the last two they can do something about. And companies are already putting in substantial contributions.”

Scott says that if companies want to earn extra returns on their assets, they need to take extra risks.

“That implies a greater weighting in equities than in bonds, but that goes against the trend for recent years,” he says. “It is difficult to see funds reversing that. I think it is more likely that people will say, ‘Yields can go up again, and we’re in this for the longer term.’”

He says that another option would be for companies to look at contingent assets, such as a guarantee from their parent company, a pledge against unencumbered assets or a letter of credit to be available if needed.

Although it is UK pension funds which are bearing the brunt of the problem, Scott says: “To the extent that bond yields in European countries fall to the same extent as in the UK, the impact on their funded pension arrangements will be similar.”

The countries with pension arrangements closest to those in the UK are the Netherlands and Ireland. Others, such as France, offer a much higher level of state benefits at retirement.

Andy Green, European director of investment consulting, Mercers, says that besides the problem of the deficits, there is also the issue of whether funds are running risks which leave them open to those deficits getting worse.

“They can take the risk away from the table altogether, or take more risk in the hope that they can generate extra returns,” he says. “Unfortunately, regulatory hurdles are impacting on how much risk the plan sponsors and trustees take. However, this is an area where interest rate hedging strategies might help.”

Green says: “At the moment, European longer dated bonds are still yielding more than shorter dated bonds, so the problem is less severe on the Continent. But what you have to remember is that the benefits which funds will have to pay have not changed. What has changed is the value of servicing those benefits.”