Markets may move, deficits may rise, but companies still have options.

31 August 2016

By Brian Peters

The Bank of England's decision to buy £70 billion of gilts and corporate debt to improve liquidity in troubled economic conditions has led to further falls in corporate bonds since 30 June 2016 and these are now below 2.5%. For pension schemes, this also means an automatic increase in liabilities under the IAS 19R accounting standard and the prospect of needing to pump more cash into the scheme. However, in the face of what may seem like insurmountable external forces, schemes still retain options to control their own destiny using technology to monitor and scenario plan.

The optimists amongst you will say that falling rates of interest and rising accounting deficits are largely inconsequential; the expected cash flows the pension scheme will pay out have not changed and there is no need to pay more cash as a theoretically rising pension deficit is just "funny money".

Unfortunately this argument is false.

Lower bond yields means lower investment returns. As a result, more cash needs to be paid in to the pension scheme to make up the difference. History tells us that this is true. Twenty years ago, expected returns on pension scheme investments were anticipated at 9% a year on an on-going basis. If these returns had been achieved, companies would have needed to fund only 25p for every £1 of pension promised, with the rest being met in investment returns. Ten years ago, expected investment returns had fallen from 9% to 5% due to the falls in bond yields. The 25p had become 50p so required contributions to pension schemes had doubled. Today investment returns could be as low as 2.5%. In this world, companies would have to cash fund 70p out of every £1 of pension promised - nearly triple the cost anticipated 20 years ago. 

Put another the way, when defined benefit pension schemes were set up, companies typically thought the cost of their pension scheme would be 15-20% of pensionable salary. In reality, the cost was well over 50% and now companies have to face the question of how they make up this difference.

It is important to keep in mind, however, that the emergence of accounting deficits is a symptom of this issue, rather than the problem itself; for companies, the important question is when do these pension deficits need to be funded.

Funding reviews are conducted on a three year cycle. Lucky companies with a review not due for over 18 months may be able to ride out the storm knowing the deficit will not turn into a need for real cash in the short to medium term. The less fortunate are those about to start a funding review where the demand for cash may be more pressing.

For companies worried about this issue, there is some good news. The Pensions Regulator is discouraging trustees from making a knee jerk reaction to the bad news, and companies still retain some options in their tool box to manage rising deficits without necessarily needing increase contributions immediately. This includes extending deficit recovery periods, reducing prudence in the funding contributions or using asset-backed contributions to defer cash.

What recent events do reinforce, however, is the need to be prepared for every eventuality. Technology such as Skyval has a clear role to play here. Allowing sponsors to accurately monitor the position of their scheme, to scenario plan, and to assess the right course of action, technology may be the best option available to schemes trying to take control in a fast changing world.

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