Uncertainty becomes ever more uncertain
| by Richard Willsher 30 Jun 2008 Topic: Pensions |
|
From among a blizzard of statistics and actuarial calculations one clear truth emerges: no one knows for sure how to deal with the challenges that defined benefit pension schemes pose to their corporate sponsors, reports Richard WillsherAfter a period of calm, the turmoil in the capital markets and the credit crunch since late last year have engendered an early warning lament from corporates and their advisers. They fear that another era of pension fund deficits is about bite into corporate results. First, the good news. Research produced by actuaries Lane Clark & Peacock LLP (1) estimates that, using IAS pension accounting standard IAS 19, 'the UK pension schemes of FTSE100 companies had a net surplus of £12bn as at mid-July 2007. This,' they say, 'is a record improvement from a £36bn deficit' a year earlier. Higher bond yields served to reduce the liabilities in pension schemes. At the same time, higher returns on assets, particularly on equities from a long-enduring bull run, boosted real returns on funds invested. Meanwhile, accounting for these assets by marking them to market at high index levels made them look richer than ever. However, Lane Clark & Peacock's analysis contained some warnings. They pointed out that applying the latest mortality assumptions for their pension scheme members could mar the picture. Every extra year of life expectancy not taken into account by corporates could add £12bn to the pension liabilities of FTSE100 companies. Secondly, the study, published in August last year, referred to 'significant investment risk' stemming principally from the likely fall in the value of equities. On average, 57% of total assets of FTSE100 UK pension schemes was then held in equities. Liability risksThis bad news has, to a large extent, come to pass, and worse. First, the rate at which life expectancy in general is lengthening has forced the UK Pensions Regulator to produce a consultation document (2). This recommends that pension scheme trustees allow for a baseline level of life expectancy for scheme members based on available evidence to date. Secondly, they should make an additional level of allowance based on potential further increase in pension scheme members' life spans. It seems likely that, following the end of the consultation period this month, businesses will need to implement these new assumptions. While longer life expectancy increases the liabilities of pension schemes, the way in which liabilities are accounted for may do so too. Recent proposals put forward by the Accounting Standards Board (ASB) (3) suggest that the rate at which future liabilities are present-valued or discounted should be based not upon future estimated investment returns, such as on AA-rated corporate bonds, for example - a common measure in use at present - but on a so-called risk-free measure. This means using the yield on the highest rated instruments, such as AAA-rated UK Government bonds. This, suggests the ASB, would reflect 'the time value of money only' rather than an assumed level of yield. The results of this, as consultants Watson Wyatt explain, could be significant. '…it has been suggested that these ASB proposals could add around £100bn to reported liabilities,' says their senior consultant Nicola van Dyk, who goes on to distinguish which of the two liability risks is the greater. '…it is speculation as to whether they will be implemented and when. The longevity changes are, by contrast, concrete and in the here and now, and reflect an expectation of increased real cost of benefits due to members living longer, rather than a change in the approach to measurement.' Asset risksThe risks associated to the liabilities of defined benefit pension schemes would be very much easier to control if it wasn't for the uncertainties associated with the asset side of pension fund balance sheets. The events of the last few months have, however, doused any hopes of good times continuing. 'With asset prices falling steadily for the last six months, investors are re-focusing their attention to the long-standing theme of corporate pension deficits,' states a 17 March research document published by US investment bank Morgan Stanley (4). 'Since the start of this year alone, the 10% drop in the FTSE All-Share [and larger declines in overseas markets] and declining property values have added around £40bn to the FTSE350 pension fund deficit.' With several markets suffering falls simultaneously, pensions are returning to greater awareness of risk as against chasing high yields. Research from Bank of New York Mellon Asset Servicing (5) points out, for example, that across the board pension fund holdings in UK bonds and index linked instruments 'now exceed holdings of UK equities for the first time ever'. FD's concernsWhile concerns about the liabilities and assets of pension schemes are the primary worry of scheme trustees, they are also a constant source of anguish for finance directors. The extent to which a business catches a cold when its pension scheme sneezes can easily be imagined by looking at the scale of the pension schemes of some of the UK's leading companies. Lane Clark & Peacock's research shows that even after the relatively benign period ending 1 January 2007, the pension scheme liabilities of British Airways stood at £14.3bn, exceeding its market capitalisation of around £4bn three-and-a-half times. Similar calculations for BT Group show pension liabilities double market cap and BAE Systems one-and-a-quarter times. A worsening on both the liability and asset sides at their pension scheme can wreak further havoc for companies such as these. But for businesses of any scale - and BA, BT and BAE are extreme examples - a defined benefit pension scheme is a huge risk and a significant drag on the business. First, there is risk of uncertainty of how much the business must allow to further bolster its pension scheme. This can be treated financially in the same way as the debt, among the liabilities of the business. At the same time, in any corporate activity involving a bid or an issue of stock for example, the pension scheme will come in for close scrutiny. Meanwhile, shareholders too will be concerned at the drag on business performance. In addition, they should be aware that they are taking risk, not only on the business itself but also on the ability of the trustees to manage its pension plan. So if, for example, 50% of a scheme's liabilities are in equities, shareholders may have significant exposure to equity investment performance that they wouldn't necessarily wish to buy into when investing a company's shares. The crux of the matter is the difficulty of predicting the future. Or, as The Pensions Regulator puts it, the '…actuarial calculation of a prudent reserve to hold in a pension scheme against the pension promises employers make to their employees.' More firms are closing their schemes to new members and considering selling them to one of the increasing number of pension scheme buy-out firms now in the marketplace. Meanwhile, however, in a drum-tight employment market, the human resource advantage in retaining key staff by providing a defined benefit pension scheme should not be overlooked. Greater, more prescriptive regulation might tip this delicate balance. The increasing costs connected with pension scheme longevity risk and liability discount method alone might be enough to persuade more businesses to simply decide that enough is enough, and that the financial and compliance costs are just too high. And who would blame them? It is virtually impossible for businesses to peer decades into the future and predict the reserves necessary to meet those 'pension promises'. It makes more sense not to make those promises in the first place.
References | |