DB Pensions: Deficits are still a problem
Mick O’Byrne looks at the accounting deficits of Irish defined benefit pension schemes
Deficits in the defined benefit (DB) pension schemes of Ireland’s largest private and public sector companies surged by more than 160% over the first three quarters of 2016, according to the LCP 2016 Pensions Accounting Briefing. LCP estimates that the combined accounting deficit of the companies analysed increased from €2º.6bn at 31 December 2015 to €6.8bn by 30 September 2016.
Pension scheme liabilities increased because of falls in bond yields. There is little doubt that the aftermath of the UK Brexit referendum also had a negative impact. That, combined with the expansion of the European Central Bank’s quantitative easing programme, led to growing deficits.
These rises bring challenges both for the companies and scheme members. Rising deficits and liabilities can put company balance sheets under pressure and may influence dividend policy. Financial services companies may be required to hold higher regulatory capital.
However, the unexpected result of the US presidential election has also had an impact on pension scheme deficits. Bond yields in the US and Europe rose in the immediate aftermath and this has offset some of the deficit increases.
The LCP report covered 15 of the largest companies (by market capitalisation) on the Irish Stock Exchange and other exchanges that have Irish DB pension arrangements. It also covered 11 semi-state/state-controlled companies with DB pension schemes that have published pension accounting information for the financial year 2015.
Reported funding levels
The accounting standards look at the pension scheme assets and funded liabilities at the accounting date. Of the 26 companies analysed, only one reported sufficient assets to meet its funded liabilities.
The average funding level increased from 83% in 2014 to 88% in 2015. Figure 1 shows how funding levels changed over the year for the companies analysed.
This improvement – or liability reduction – was due to the rise in yields on high quality corporate bonds (used to place a value on the accounting liabilities) over 2015.
Deficits grew during 2016
The report also considers the movement of pension scheme balance sheet positions during 2016.
On the asset side, global equity markets fell at the start of 2016. However, they recovered and, in spite of volatility in the aftermath of the Brexit referendum, global equities, as measured by the FTSE World index, were up by approximately 3% in the year to the end of September.
On the liability side, high-quality corporate bond yields as at the end of September 2016 were about 1.20% pa lower, on average, than at the end of 2015, which is a significant fall. These lower yields mean that IAS19 liability values increased during 2016 (as pension scheme liabilities are calculated by reference to these yields for accounting purposes).
LCP estimates that the aggregate pension deficit for the companies analysed stood at €6.8bn as at 30 September 2016 (€2.6bn at 31 December 2015).
As figure 2 illustrates, there can be volatility in the deficit as equity values and bond yields fluctuate. Indeed, when deficits hit their high late last July, it is estimated that the aggregate pension deficit was €7.2bn.
How have companies reacted?
Many companies carried out pension liability management exercises over 2016. In some cases, the accrued benefits for existing members were cut while in others the scheme was closed to future accrual.
There were also a number of transfer value exercises where members were offered transfer values – in some cases with enhancements to the standard transfer value – to another pension arrangement in exchange for the benefits accrued.
Trends in asset allocation
The average level of exposure to equities fell from 46% in 2014 to 43% in 2015 (figure 3). The average allocation to bonds fell slightly from 37% to 36% and the allocation to other asset classes increased from 17% to 21%.
The majority of companies disclosed an allocation to property assets. The average allocation was 6% in 2015 (5% in 2014). Most of the companies analysed also held cash assets – the average allocation was 5% in 2015 (4% in 2014). Four companies disclosed an allocation to liability-driven investment and three companies disclosed investments in hedge funds.
There is evidence that a number of trustee boards are continuing to review their investments and implement de-risking strategies or alter the mix of their return seeking portfolios. LCP expects this to continue as many schemes review their asset strategies as part of their funding proposals.
Liabilities and contributions
Figure 4 shows pension accounting liabilities relative to market capitalisations. The total pension liability, expressed as a proportion of market capitalisation, fell over the year (from 27% in 2014 to 22% in 2015).
The companies analysed paid contributions, totalling €1.16bn, to their pension schemes in 2015. It is clear that DB pension schemes remain a sizeable cost.
The analysis shows that the majority paid contributions in excess of the cost of benefit accrual under IAS19 as attempts are made to reduce past service deficits. On average, companies paid contributions of 2.3 times (compared with just over 2.2 times in 2014) the cost of benefit accrual on the accounting basis.
The discount rate
The discount rate is the key assumption used to value pension liabilities. Under IAS19 and FRS17, this assumption is based on the yields available on long-dated high quality (typically AA-rated) corporate bonds in the liability currency at valuation date. The yields on high quality corporate bonds, and hence the discount rate, will fluctuate from day to day with market conditions.
Figure 5 shows companies reporting with December 2015 year-ends, showing an increase in the discount rates disclosed compared with 2014.
The majority of companies disclosed a discount rate in the range 2.5-2.7% pa.
The mean discount rate at 31 December 2015 was 2.5% pa – an increase from the average discount rate of 2.1% pa as of 31 December 2014, reflecting the commensurate rise observed in corporate bond yields over 2015.
Mick O’Byrne is an actuary at LCP Ireland. The 2016 LCP Ireland Pensions Accounting Briefing is available to download at www.lcpireland.com