Conor Daly and Fergus Collis outline the ways in which Irish defined benefit schemes are dealing with economic uncertainty and the pressures of regulation
The crisis in Irish pension schemes is continuing as stakeholders deal with uncertain market conditions and a demanding regulatory environment.
We have analysed the pensions disclosures in the annual accounts of Ireland’s largest private and semi-state companies. The 2012 LCP Ireland Pensions Accounting Briefing, which was published in October 2012, shows that the continuing economic uncertainty is having a significant impact on the finances of companies in Ireland that operate defined benefit (DB) pension schemes.
This has been compounded by the introduction of new legislation (May 2012) and Pensions Board Guidance (June 2012) primarily targeted at DB schemes. The key measures introduced will compel underfunded schemes to submit detailed funding plans to the Pensions Board within a short period of time (typically by 1 July 2013), require pension schemes to hold additional reserves over and above their statutory reserve requirements from 1 January 2016, and also introduce additional disclosure requirements.
Over the last year, the euro-zone has seen the continuation of a split between the core-European countries, such as Germany (where 10-year bond yields reached new historical lows), and peripheral countries such as Spain and Italy (where 10-year bond yields have attained record highs). For DB pension schemes, this has meant that liabilities, which are typically valued using core-European yields, have increased while at the same time pension scheme assets generally stayed level over 2011.
Our analysis estimates that the total deficit for the schemes analysed was €10bn in September 2012, a rise of €4bn on the previous year. This reflected the continued reduction during 2012 in the yield on high quality corporate bonds used to value pension liabilities, which has fallen by over 1%.
Employer contributions increases
LCP’s analysis indicates that employers have contributed around €1bn in 2011-12 to their DB plans. In its annual report and accounts 2011, the Pensions Board estimates that 70% of DB schemes are in deficit on the statutory funding standard basis. Therefore employers will come under pressure to inject substantially more funds into their pension schemes (or reduce benefits) to meet shortfalls and also to meet the new 2016 reserving requirements – this could add 10-15% to the liabilities of a ‘typical’ DB pension scheme.
If sponsors cannot bear substantial additional costs, it is likely that there will be further changes and closures to DB pension schemes over the coming years.
Impact of accounting on profits
The accounting standard IAS19, under which many large private companies report, is changing from 2013. Currently, companies estimate the amount that they expect to earn on their assets at the start of the year by making assumptions about the returns of individual asset classes and then calculating the overall expected return using the asset allocation of the scheme. This expected return is then credited to profit. Offsetting this is the amount by which liabilities will increase over the year.
This cost is calculated by reference to the yield available on high-quality corporate bonds (the discount rate), which is typically lower than the assumed rate of return on assets. For reporting periods commencing in 2013, under IAS19 companies will be obliged to calculate the return on assets using the discount rate (ie, the same rate used for liabilities).
Therefore the amount credited to profit will be reduced for the majority of schemes.
Based on the disclosures analysed in the 2012 LCP Accounting survey, the vast majority of companies will report lower profits under the new standard. LCP’s analysis indicates that this change could have reduced the cumulative profits of the companies analysed by around €100m.
Legislation on the use of sovereign annuities and sovereign bonds by pensions schemes has been introduced. Sovereign annuities are annuities where the policyholder rather than the insurer takes on the risk that the bonds backing the annuity default and are therefore cheaper than a conventional annuity. The hope was that they would provide some relief to schemes facing funding difficulties.
However, there are some important limitations:
• Schemes can only use the relief where they have formally passed a resolution stating that they intend to purchase sovereign annuities in the event of wind up;
• The implications of buying sovereign annuities must be set out in writing to all members (and relevant parties such as trade unions);
• Where sovereign bonds are held, the level of relief available will vary depending on the specific bonds held.
These restrictions mean that this option may be suitable only to a small number of pension schemes or those in the worst financial state, with few other options.
New directive on pensions
Many readers may be aware of the new Institutions for Occupational Retirement Provision (IORP) directive, which is currently under consultation in Brussels.
The objective of this directive in its current form is to achieve pension provision that is safe, sustainable and attainable. The indications are that this is likely to be achieved by imposing a Solvency II-type insurance regime on pension schemes. In other words, pension schemes will be required to hold reserves in addition to the existing requirements.
Recent research in the UK by Oxford Economics has indicated that the introduction of this Directive could cost UK firms €440m in additional funding demands and reduce GDP by 2.5% over the next 15 years.
While recent changes to legislation in Ireland have already paved part of the way to this type of regime, it is likely that there will still be a number of significant impacts on pension schemes if this is introduced. Implications could include an acceleration of scheme wind ups, benefit restructures, buy-outs, higher costs and potentially higher holdings of bonds to alleviate reserve requirements.
Equities large proportion of assets
Irish pension schemes have traditionally held a high weighting in equities. Adopting a policy of holding a high proportion of equities in a pension scheme means that the scheme is exposed to equity market movements (which can be volatile). For example, in 2010 and 2011, LCP reported that the average equity holding by DB pension schemes analysed in the LCP Accounting Briefings was in the region of 58%-59%.
Now, with the current emphasis on risk reduction, there is evidence of schemes beginning to take steps to reduce their equity holdings. For example, DCC, Elan Corporation and Glanbia held approximately 15% less equities at the end of the 2011 financial year compared to the 2010 financial year. The average equity holding now stands at 52%.
What next for DB pension schemes?
The government has finally provided long-awaited clarity surrounding pension regulation. However, many companies and trustees now face the difficult task of trying to manage their schemes in a continuing challenging environment. Some of them will have to introduce significant changes to their pension arrangements, such as increased contributions, benefit reductions and other measures in a very short period of time (1 July 2013 for most) or consider the possibility of scheme wind up.
The position of companies and trustees is therefore likely to diverge in many cases and both parties will need appropriate specialist advice.
Conor Daly is a partner and Fergus Collis is a consultant at LCP Ireland. The 2012 LCP
Ireland Pensions Accounting Briefing is available at www.lcpireland.com