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Pensions under pressure

Pension funds are being artificially supported by unusually high corporate bond yields and may turn out to have much bigger liabilities than is being revealed. Deficits are likely to get even wider as equity markets recover. One pension consultant claims that pension deficits among FTSE companies are being underestimated by some £160bn.

Final-salary commitments pose a huge problem for companies as funding puts pressure on margins at a time when some of the UK’s biggest companies are reporting drop-offs in profits and earnings. Cost-cutting measures are the focus of companies at the moment as they foresee difficult times ahead but firms will also to have to consider pension liabilities which could be much worse than anyone is predicting.

Galls in the underlying assets of pension funds are likely to have been steep, considering market activities over the past two months alone. However, asset falls are only a part of the equation that determines the value of final-salary schemes and whether or not a company’s scheme is in surplus or deficit. The UK Accounting Standards Body’s FRS17 accounting rule requires that pension liabilities be stated in terms of the total funding requirement divided by the yield rate from AA-rated corporate bonds. Amid the financial turmoil of world markets, fixed interest has suffered heavily, causing corporate bond yields to rise dramatically. As yield rates have surged on the back of default fears, the liabilities of final-salary schemes have fallen accordingly.

Illustrating the impact that bond yields have on pension deficit and surplus levels, a recent report from actuaries Lane Clark & Peacock shows that the funding position for FTSE 100 companies on March 31, 2008 would show a deficit of £66bn. This is if liabilities were not discounted using the bond yield level at that time. Once the liabilities are discounted to the yield levels, that deficit turns into a £14bn surplus.

“In other words, changes in credit spreads since July 2007 had flattered FTSE 100 IAS19 deficits as at March 31, 2008 to the value of some £80bn,” the report says.

That situation today could be even more dramatic considering the current level of bond yields alongside the steep asset falls. M&G bond manager Jim Leaviss notes that spreads on corporate debt over Government bonds are wider than during the Great Depression.

Chris Hurry, a partner and actuary at Hymans Robertson, says: “Stripping out the hopefully temporary impact of the financial crisis on AA corporate bond prices, recent reports highlighting accounting surpluses understate the pension liabilities by as much as £160bn across the whole FTSE 350.”

Hargreaves Lansdown head of pensions research Tom McPhail says: “Final-salary schemes are already sitting on substantial capital losses through the equity market downturn but in valuation terms this has been offset by increases in bond yields, which lower their future liabilities.”

He says if bond yields fall back before equity markets recover substantially, then deficits could widen further, even as the public expects them to improve.

Some managers expect that is a likely scenario, considering how unrealistically high yields have moved in recent weeks. The average yield for AA-rated UK bonds was 7.95 per cent as of November 5, according to the IBoxx Sterling index. This is a level that has typically been reserved for the sub-investment-grade level of the debt market, not AA-rated paper.

Pushing up the yields is market pricing amid an Armageddon level of bad news. Default rates at the investment-grade level are being estimated in the double digits. Levels reported by the FT at the beginning of October were nine times the historical average.

In a study of default rates from 1920 until 1996, Moody’s reported that its one-year corporate issuer default rate peaked at 9.2 per cent in July 1932 at the height of the Great Depression. Mid-1929 to December 1939 was the heaviest default activity in the 77-year period examined by Moody’s. The severity of the depression meant default rates did not fall back dramatically but came down from 9.2 per cent to an average of 3.7 per cent for the next eight years after the 1939 peak.

Today, it is expected that as normality returns to markets and sentiment eases, bond yields will come down but how dramatically remains to be seen. Once they start to fall, pension liabilities will start to climb. If the rate at which yields fall is faster than growth in the underlying equity assets, deficits will remain even as markets improve.

Standard Life Investments head of global strategy Andrew Milligan estimates that on the assumption of a 20-year duration for the aggregate UK scheme, changing the real discount rate (bond yields) by 1 per cent could increase the liability by 20 per cent.

He says: “Situations where such bond yields fall back, with or without further falls in equity markets, would then lead to a sizeable deterioration in pension balances.”

Trustees will be forced to push companies for greater contributions to meet their liabilities at a time when cost-cutting is the focus of most. Pressure is already being felt on dividends from many FTSE companies, so this is likely going to add to the burdens being felt.

Hymans Robertson head of corporate consulting Clive Fortes says: “Shareholders should be under no illusion that pension figures reported in company accounts are as manageable as they might seem. The financial crisis, the near 40 per cent fall in equity values over the past year and rising inflation expectations will have severely damaged the finances of UK pension schemes. While trustees might not immediately reassess the level of contributions needed to restore their funding positions, additional cash will eventually be needed.”

Milligan says difficult discussions can be expected in some firms about injecting cash into schemes.

The implications of bond yield moves to pensions are wide. Not only could final-salary members be hit but the impact of funding these schemes could further dampen equity prices.

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