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Impact Investing

IPE special report May 2018

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DB funding: Challenge of low interest rates

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Irish pension funds have been struggling with low average funding levels since the financial crisis

Key points

  • The estimated aggregate pension deficit for Irish listed and state companies is €3.3bn
  • There is considerable monthly fluctation in the disclosed deficit
  • Equity exposure is falling and discount rates fell in 2016

Our 2017 Pensions Accounting Briefing shows that the average funding level of Ireland’s largest pension schemes remained static at about 85% over the period 2010 to 2016. That was despite contributions of almost €10bn over the same period and stock markets hitting new highs. This was primarily the result of the sharp and prolonged fall in euro-zone bond yields over the same period. 

It is notable that the average funding level remains stubbornly low since the 2007-09 financial crisis. The average pension scheme funding level disclosed in the 2010 annual returns was 86% compared with an average funding level of 85% in the 2016 annual returns. 

Estimated deficits in the companies analysed increased from €2.6bn to €3.6bn over the 12 months to 31 December 2016. This was primarily a result of the fall in yields on high-quality corporate bonds (used to place a value on the accounting liabilities) in 2016 which increased the liabilities. This was somewhat offset by the strong rise in assets (equities and bonds) in 2016. 

Our report covered 15 of the largest companies (by market capitalisation) listed on the Irish Stock Exchange and other exchanges that have defined benefit (DB) pension arrangements in Ireland. We also covered 11 semi-state/state-controlled companies with DB pension schemes that have published pension accounting information for their 2016 financial year.

ratio of assets to funded liabilities

The accounting standards look at the pension scheme assets and funded liabilities at the accounting date. Of the 26 companies analysed in our report, only two reported that they had sufficient assets to meet their funded liabilities. 

The average funding level for the schemes analysed decreased from 88% in 2015 to 85% in 2016. Figure 1 shows how funding levels have changed over the year for the companies analysed. 

We have also considered the movement in the pension scheme balance sheet positions during 2017.

Global equities, as measured by the FTSE World index, were up approximately 8% in 2017 to the end of October. On the liability side, high-quality corporate bond yields as at the end of October 2017 were marginally higher on average than as at the end of 2016. These higher yields mean that accounting liabilities have fallen slightly to the end of October 2017.

LCP estimates that the aggregate pension deficit for the Irish-funded schemes of the companies analysed stood at €3.3bn as at 31 October 2017 (€3.6bn at 31 December 2016).

As figure 2 demonstrates, there can be significant volatility in the level of deficits from month to month as equity values and bond yields fluctuate. Indeed, when deficits hit their lowest in June 2017, it is estimated that the aggregate pension deficit was only €900m.

We have seen continuing evidence of pension liability management exercises over the year. In some cases the accrued benefits for members were cut following agreement with the pension scheme trustees, while in others the schemes closed to future accrual. There were also several examples of transfer-value exercises where members were offered transfer values to another pension arrangement in exchange for the benefits accrued.

projected aggregate pension deficit

The average level of exposure to equities fell from 43% in 2015 to 41% in 2016 (figure 3). This remains high when compared with other jurisdictions. For example, in the UK it is 26%.

The average allocation to bonds was unchanged at 36% and the allocation to other asset classes increased from 21% to 23%.

Five companies disclosed an allocation to liability-driven investment and three companies disclosed an allocation to hedge funds.

Figure 4 shows the size of the pension accounting liabilities relative to market capitalisations for the companies analysed. The total pension liability, expressed as a proportion of market capitalisation, increased over the year (from 22% in 2015 to 25% in 2016).

The companies analysed paid substantial contributions of almost €1.1bn to their pension schemes in 2016 (€1.2bn in 2015). It is clear that pensions remain one of the most significant costs for these organisations 

Our analysis shows that most companies pay contributions that are over the cost of benefit accrual under IAS 19 as attempts are made to reduce past service deficits. On average, companies paid contributions of 2.1 times (2015: 2.3 times) the cost of benefit accrual on the accounting basis. 

The discount rate is the key assumption used to value pension liabilities. Under IAS 19 and FRS 102, this assumption is based on the yields available on long-dated high-quality (typically AA rated) corporate bonds in the currency of the liability at the valuation date.  These yields, and hence the discount rates, will fluctuate from day to day in line with market conditions.

In figure 5 we have analysed the discount rate for companies reporting with December 2016 year-ends.

The average discount rate for companies reporting at 31 December 2016 was 1.9% a year – a decrease from the average discount rate of 2.5% a year as at 31 December 2015.

While, in theory, pension schemes with similar durations should be valued using similar discount rates at a particular point in time, in practice, the lack of a deep market in long-duration corporate bonds can result in different modelling techniques and some divergences in discount rates. A small change in the discount rate can have a very large impact on the balance sheet position. 

The discount rates used as at 31 December 2016 have been charted against the disclosed durations and clearly shows some divergences in approach (figure 6).

In 2015 and 2016 the International Accounting Standards Board (IASB) proposed some changes to the way liabilities are calculated under IAS 19. In short, while at present the balance sheet amount disclosed can be significantly less than the value of future contributions, the proposals would require a significant number of companies to disclose the higher amount with a potentially substantial impact on those companies’ balance sheets. 

Exactly which companies will be affected is not clear and will depend more often than not on a ‘small print legal lottery’ of the detail in a plan’s rules. It is, however, likely that a significant number of DB  pension sponsors could be affected.

Changes were due to be finalised early in 2018 and then implemented with effect from 2019. At its meeting in September 2017, the IASB agreed to hit the pause button – at least for the time being. The IASB will carry out further work to assess the potential impact. The potential changes, however, have not gone away indefinitely and amendments remain a real possibility.  

Tomás Kirrane is an actuary at LCP Ireland. The 2017 LCP Ireland Pensions Accounting Briefing is available to download at www.lcpireland.com 

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