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KPMG warns of market shock for unhedged DB plan sponsors in UK

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A KPMG survey has found that unhedged defined benefit (DB) plan sponsors in the UK are at risk of major losses from a future market shock.

The key findings of the survey are that gross assets and liabilities at a historic high, leaving deficits highly geared, and that any future market turmoil could leave plan sponsors without hedging strategies in place nursing significant losses losses.

The survey also points to a substantial herd effect in the selection of key assumptions.

The report’s author, Narayan Peralta, a director at KPMG, told IPE: “KPMG has been analysing this market for 10 years now, and each year’s survey brings something different.

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“But rather than significant trend changes in the assumptions themselves, this year we have seen the influence of IAS19R’s new disclosure requirements, which has led to a tighter pack of assumptions.”

He added that increasing pension liability to market cap ratios had heightened interest among corporates about the impact of pensions on their accounts.

The KPMG survey looks at trends in accounting assumptions across 295 KPMG clients with UK DB obligations.

The report takes in companies reporting under IFRS, UK GAAP and US GAAP at the 31 December 2013 year-end.

 The sample also reflects practice among major players in the UK actuarial consulting market.

According to the report: “Many UK companies will have seen balance sheets improve over 2013 as strong asset growth offset slightly tighter real discount rate assumptions.

“Despite these improvements, balance sheets remain significantly exposed to pension risk, highlighted by the volatility seen across the year. Therefore, adopting the right risk-mitigation strategies, on both asset and liability sides, is key.

“The choice of assumptions remains as important as ever and influences not simply the company balance sheet but also pension strategy such as the impact of implementing benefit changes or member options.”

KPMG also warned that pension liabilities in the UK remain highly geared, with recent windfall equity returns masking the risk of heavy losses for unhedged liabilities in the event of a market shock.

“Real discount rates, based on the difference between AA corporate bond yields and assumed RPI inflation, reached a new low over 2013, hitting as low as 0.5% in April 2013 and finishing the year at closer to 1.1%. The corresponding rate just before the financial crisis was 3.3%.”

One the asset side, stellar returns from equities – UK equities pulled in gains of 20% during 2013 while globally returns hit 25% – have counterbalanced the negative outlook on the liability side.

KPMG said: “Since the start of the financial crisis in 2008, a typical pension fund portfolio invested in a combination of equities (UK and overseas) and bonds (both government and corporate bonds) is likely to have returned closer to 45% including reinvestment of dividends and coupons.”

It also warned that changes to UK GAAP in 2015 – largely aligning it with IAS19R – could see “some companies facing issues around distributable reserves or dividend payments”.

UK pension liabilities have increased by 65% on an IFRS basis since the financial crisis hit in 2008.

 

Change to IAS19R (2011)

For companies reporting under IAS19, the 2013 year-end marks the first full year of reporting under the new standard.

KPMG found that most of these companies “will have seen a jump up in P&L charges for 2013 due to the new requirements”.

Under changes to IAS19 unveiled in 2011, DB plan sponsors must disaggregate or split pension costs on the face of the income statement into service cost, net interest on the net DB liability or asset and remeasurements of the net DB liability or asset.

The changes also removed the corridor option, the opportunity to report in net income a credit for an expected return on plan assets and the ability to present pension items in a separate statement of recognised income and expense (SORIE).

They also mean that companies must now disclose more information about the risk and uncertainty caused by pensions on the sponsor, together with more detailed sensitivity requirements about the key assumptions.

 

Assumptions 

As for the application of the big-three reporting assumptions under the new standard, KPMG found that “the market is more closely packed around the median than it was in our survey last year”.

In particular:

  • 61% of sponsors used a discount rate within 15 basis points of the 2012 median, with the figure climbing to 81% this year
  • 75% of companies used an inflation assumption that falls within 15bps of the median in 2013 rather than 65% in 2012
  • 80% of companies used a longevity assumption within a three-year range, marking an increase of 4%

KPMG said: “Part of this apparent trend may be linked to the increased size of pension liabilities versus market capitalisations, and therefore increased scrutiny from auditors, shareholders and analysts on the disclosures.”

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