UK defined-benefit deficits are ballooning. The Brexit vote might initiate behavioural change, Stephen Bouvier writes

KPMG’s 2016 Pensions Accounting Survey reported that defined-benefit (DB) scheme sponsors are continuing to manage huge deficits. Persistently low yields mean that sponsors have made little progress on the 2015 positions. So, against that background, what might be the impact of the recent UK vote to quit the European Union?

Aon Hewitt consultant actuary Simon Robinson sees no dramatic upheaval in the future: “To some extent, we are probably not going to see big holes on corporate balance sheets because of Brexit. Over the last few years, many larger companies have been hedging. We have had a big fall in corporate bond yields, and for many companies they are well hedged and perhaps even over hedged on an IAS 19 basis.

“We have one client where their surplus has increased significantly. So although the PBO [projected benefit obligation] has gone up because of falling bond yields, the assets have gone up by more than the PBO. I think this is probably one end of the spectrum. I suspect they have probably benefited more than many companies, but overall it probably has not been as big a disaster as you might have expected from the headlines.”

But, any Brexit-driven contraction of the sterling-denominated fixed income market could prove troublesome. “If you look at the UK back in 2008, there were 250 AA-rated corporate bonds. Post-crisis, we are now down to about 70 or so. It doesn’t take much to see that those entities are almost all non-UK entities such as European banks, for example, that have issued sterling-denominated bonds,” Robinson explains.

“In total, around 70 out of 75 of them are non-UK issuers. So you have to ask what might happen in the future if we don’t have many domestic issuers of AA corporate bonds and if those foreign issuers look to other markets to issue debt. In short, we won’t have many AA-rated corporate bonds in the UK. In that case, IAS 19 says you have to default to using government bonds to value the PBO.

“If those corporates do stop issuing sterling-denominated debt, we will no longer have a deep market and the UK will fall back on using government bonds. That would usher in a fall in discount rates of around 1%, which could be a £200bn (€232bn) issue. In the short term, there doesn’t seem to be much of an issue, but longer term I can see a shortage of AA-rated sterling denominated bonds,” he adds.

But talking to pensions restructuring expert Richard Farr, the managing director of Lincoln Pensions, and you start to wonder if that collapse in yields is a bad thing. “My guesstimate is that of around 6,000 UK DB schemes, there are over 1,000 UK schemes that will definitely not survive.

“On top of that, we have another 1,000 that will be unable to pay full benefits but could go above PPF levels if they take action. I’d also say there are some 2,000 plans where the plan is pushing the company into difficulties but where it is possible to nurse the employer through the process of restructuring.”

“This crisis is a wake-up call for trustees. It is about recognising the problem and recalibrating their risk appetite. This needs a partnership over the next 20-30 years and not just the next valuation cycle. I am talking about a cultural change in the trustee mindset of allowing the employer to prosper at the same time as not allowing the employer to take the scheme for a ride”
Richard Farr

In its December 2015 report, The Greatest Good for the Greatest Number, The Pensions Institute predicted that hundreds of plan sponsors will become insolvent well before the their recovery plans conclude, with insufficient assets to pay member benefits in full. In terms of hard numbers, the Pensions Institute argued that 1,000 defined benefit schemes were at “serious” risk of falling into the Pension Protection Fund

Farr argues that Brexit has exacerbated this situation. “The underfunding comes back to trying to discount future lliabilities at a notional discount rate that is set too high. With the hangover from the credit crunch and now Brexit, rates are so low that, as Warren Buffett put it, you only find out who is not wearing trunks when the tide goes out.”

The issue might have been irrelevant when sponsors discounted at seven percentage points but now it is alarming, Farr says: “Remember, given that the cashflows are the same, the issue is the fallacy of discounting.” And so from his perspective, the collapse in yields might be no bad thing.

He adds: “Brexit will also affect debt covenants. Those who will win from it will be non-EU-dependent export businesses, but the majority of the companies who are EU-dependent will suffer. So assessing and defending covenants is more key than they were before. This means that advisers must sharpen their tools and look more closely at the real economic drivers of the employer.”

Meanwhile, the key to exiting this situation, he says, is co-operation between employers, trustees, members and government against a background of transparency and flexibility. 

He explains: “In particular, this crisis is a wake-up call for trustees. It is about recognising the problem and recalibrating their risk appetite. This needs a partnership over the next 20–30 years and not just the next valuation cycle. I am talking about a cultural change in the trustee mindset of allowing the employer to prosper at the same time as not allowing the employer to take the scheme for a ride.”

Part of that process of partnership – or managed decline – could involve individual scheme members exiting their employer’s scheme. Potentially, the new so-called pension freedoms, which give scheme members more access to their pension savings, could allow members and employers to negotiate an exit from troubled schemes. 

LCP partner Bob Scott says: “Since April 2015, when pension freedoms came in, we have seen more interest in transfer values and schemes issuing more quotations. Equally, however, pensioners might look around and decide that they are too nervous to exercise their new freedoms.” 

But, he warns, the current regulatory framework for financial advisers makes it onerous for them to give a positive recommendation to transfer. This is because advisers have to assess whether a scheme member could purchase an annuity with their transfer value to provide comparable benefits to the ones given up in order to give the transfer a green light. This is, says Scott, a high hurdle. 

But, in the meantime, what is certain is that the exercise of these freedoms could figure as an accounting assumption: “This whole area is something that has taken a while to emerge, and very few companies at the moment make an assumption for this development at the moment, but I think we might see more companies making an allowance as it becomes accepted as ‘business as usual’,” he says.

Another of those less drastic areas of negotiation between employers, trustees, and scheme members could be over inflation-linked increases. Scott thinks the issue could come to a head once judgment is handed down in litigation involving British Airways and Buckinghamshire versus Barnardo’s. “Depending on the outcome of those cases we could see a greater shift from using RPI to calculate benefit increases to using CPI,” he says.

Ultimately, it might not be Brexit but events closer to home that kick-start the process of focusing minds: “In the light of events at BHS,” says Scott, “I think we could also see the Pensions Regulator taking a greater interest in companies that pay large dividends. There have been noises that they are looking for possible new powers to help them to be a little more proactive in their regulation.”