Accounting for deficits

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As UK pension funds continue to battle with worrying deficit levels, there is likely to be more bad news before things get better, finds Richard Lowe

A raft of surveys on the current health of the top corporate pension funds has been published this summer, all combining to paint a discomforting picture, with the inference that things are likely to get worse before 2009 comes to a close.

The Pension Protection Fund (PPF) revealed in July that the aggregate deficit of some 7,400 DB schemes increased by £20bn (€23.4bn) in one month, from the end of May to the end of June this year, but this led to an aggregate deficit that was still smaller than the £242bn peak reported in March 2009. However, in August Aon Consulting released its latest figures for the 200 largest privately sponsored DB schemes in the UK, and found that despite recent rallies in the equity markets the deficit still remained at an ungainly £73bn, swelling momentarily during the beginning of July to £90bn.

Since then, Lane Clark & Peacock (LCP) has estimated that the aggregate pension deficit of FTSE 100 companies is closer to £96bn, as the true impact of the market downturn has begun to hit home. The actuarial consultancy firm’s heady figure is more than double last year’s equivalent (£41bn) and is the largest since the firm began its annual survey 15 years ago.

UK pension funds have been cushioned for some time from the real impact of the recent market downturn by low bond yields. Somewhat paradoxically, notes Bob Scott, partner at LCP, pension scheme deficits have actually improved during the worse of the crisis, thanks to the behaviour of the AA-rated corporate bond yields against which liabilities are discounted under IAS19, only to degenerate significantly once equity markets have begun to rally. But what might look like a paradox on paper should actually be seen as the consequence of an international accounting procedure that fails to reflect the true health of pension schemes in such situations.

This will inevitably lead to debates about how fit for purpose the current IAS19 accounting standard is. Proposed changes to IAS19 may well spell more bad news for scheme sponsors, since they are likely to increase the volatility of company profits by making it mandatory to include pensions-related losses and gains on company income statements. But as Scott points out, accounting standards will never be a “one-size-fits-all solution”.

Perhaps a more immediate concern is how pension scheme sponsors will respond to the inevitable bad news regarding their scheme deficits. There is a very real danger that the recent cushioning effect of bond yields has led to some companies being ill-prepared for developmentp47s ahead.

“Some employers will get a nasty shock this year if they haven’t prepared themselves for the fact that it is probably going to look worse than it has in recent years,” says Sarah Abraham, actuary and consultant at Aon.

Scott shares a similarly pessimistic outlook for FTSE100 pension reporting. “Companies reporting this year may have some fairly uncomfortable news to show,” he says.

However, some UK pension schemes have actually fared relatively well during the current crisis, although they are very much in the minority, at least where the FTSE 100 is concerned. The average return achieved by FTSE 100 schemes for 2008 was in negative double figures, but the pension funds of three companies - Standard Life, Rolls-Royce, Friends Provident and Schroders - all reported positive performance, while Schroders’ pension scheme significantly outperformed the average, albeit reporting a nominally negative return. Rolls-Royce, the only non-financial FTSE 100 sponsor to post positive pension fund returns in 2008, underwent a timely de-risking programme in 2007.

It would seem it is no coincidence that all four pension funds disclosed to LCP that they had hedged their liabilities to some degree against interest rate and inflationary risks. “This really goes to show that de-risking strategies really have paid dividends during difficult economic times,” says Catherine Drummond, a co-author of the LCP report.

LCP expects a further bout of de-risking activity in the near future, including longevity hedging now that relevant products are available in the market, with Babcock International being one pension fund that has made use of the strategy. Longevity hedges allow companies to lock in to a mortality assumption, effectively ensuring against the risk of their members living longer than expected. This will have become increasingly attractive now that life expectancy is outpacing previously held assumptions.

In fact, according to a separate pan-European report by LCP, UK companies are ahead of their continental counterparts (with the exception of French firms) in revising their longevity assumptions. “This seemingly upward eternal trend on life expectancy is really making companies and trustees sit up and think about the potential very material risk they are bearing,” says Drummond.

Scott adds that the next 12 months will be a challenging period for both employers and trustees, especially since deficits this time next year could be anywhere in the region of £20bn to £100bn, depending on how global economies and markets fare during that time.

“There are a large number of funding valuations this year and trustees are going to have tough negotiations with companies over the approach to valuations,” Scott says. These tough negotiations, of course, could provide the necessary pressure to tip some employers into taking measures like closing DB schemes to existing members, something being considered by a number of companies, such as Lloyds Banking Group. “The prognosis for the future of DB schemes is not good,” he admits.

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