The low interest rate environment is prompting more companies to use innovative ways to discount future cash flows when valuing defined benefit (DB) pension schemes, according to KPMG.
The advisory firm’s annual survey – which looked at accounting assumptions across 230 of KPMG’s clients reporting under IFRS, UK GAAP and US GAAP last year – found that median net discount rates, when accounting for RPI inﬂation, were negative for the second year running.
Narayan Peralta, director in the pensions arm of KPMG, told IPE: “In terms of the assumptions and where things have come out, because market conditions have been fairly stable in terms of yields, there hasn’t been much change in nominal discount rates and inflation. Rates are still low.”
A number of companies were adopting “alternative” approaches to discounting he said.
“Persistent low corporate bond yields have led to more innovation in discount rate assumptions with companies looking for ways to alleviate some of the pressures of low yields,” Peralta explained.
In addition, he said, more sponsors were moving to a single agency approach to discounting, using a bond yield with a AA-rating from just one agency rather than from a majority.
KPMG’s survey found that the median discount rate across the companies surveyed was 2.5%, compared to 2.7% last year.
A separate study released last week by LCP backed the findings, saying there was “clear evidence that companies are increasingly using more sophisticated ways to set the most important assumption, the discount rate”.
Life expectancy, inflation assumptions
For the third year running, life expectancy assumptions fell among the companies KPMG surveyed. More companies were updating their assumptions annually, the survey found.
Peralta said: “The downward trend is because the assumptions for future improvement has been downgraded. Next year, we will see the 2017 figures flow through.
“Some reporters are reviewing the mortality assumption every three years following a funding valuation, while others take the view that they should update the model every year to match the [Continuous Mortality Investigation] board announcement.”
The average long-term outlook for inflation was 3.3%, KPMG found. The range of assumptions fell slightly from 0.8% to 0.7%.
At the same time, KPMG noted that asset returns were weaker last year than in 2016, although UK equities overall returned 13% – compared to a 3% gain from corporate bonds.
Taken together, the firm said, these factors meant that how well a pension scheme did in 2017 was dependently mainly on its asset allocation and its hedging appetite.
The KPMG survey also shone a light on how UK scheme sponsors were accounting for pension freedoms. Individual members have had more flexibility with how they spend their retirement pot since 2015, which has prompted an uptick in transfers out of DB schemes.
KPMG said just 3% of companies were making a non-zero assumption for transfer values in their accounts.
This compared with a separate KPMG poll of 29 large schemes, which showed transfer amounts had typically increased threefold between 2016 and 2017.
Peralta said: “Most companies have historically not adopted a transfer assumption at all in the accounts. Implicit here is that the impact of transfers on the liabilities is neutral.
“Given the complexity involved with making an assumption around future transfers, combined with the uncertainty around current trends and experience data, we don’t anticipate this to change any time soon.”