Defined benefit (DB) pension funds have, in recent years, both destroyed tens of billions of pounds of shareholder value and caused significant concerns for UK companies and scheme members alike. Indeed, over the past decade FTSE-350 companies have paid an estimated £175bn in mandatory deficit contributions, amounting to nigh on 40% of the average scheme asset value over the period. Yet attempts to plug pension black holes have effectively been in vain – company pension deficits have improved only slightly, if at all, over this period. High-profile cases in the telecoms and airline industries have shed further light on the true size of UK pension risk, yet these are far from isolated cases. The problem is the same across the board.
Yet most companies continue to understate the true economic risk that they are running. Shareholders, equity analysts and ratings agencies have all so far failed to provide treasurers of companies with large pension obligations with any real incentive to face up to the potential impact that fluctuating interest rates, inflation or longevity could have on their schemes’ funding levels. This must change. Pension risk not only affects a company’s short-term profits and cashflow, and hence strategic flexibility, it also stifles merger and acquisition (M&A) activity and, left unchecked, has the potential to threaten a company’s long-term financial viability.
More and more DB schemes in the UK have closed to new members and future accrual over the past few years, with companies increasingly looking to the ‘end-game’. As security of benefits is essential to schemes and their members, this is expected to result in an increasing move to insurance buyout. However, the undervaluation of pension risk is a significant barrier to schemes transacting on a buyout since the price an insurer will charge will certainly reflect these risks.
Schemes must therefore face up to the risks they are running and take steps to manage them, rather than sitting back and watching their funding gap grow bigger the next time interest rates or inflation move against them or the equity markets take a hit.
A Closer Look at the ‘Accounting Illusion’
Understanding the true economic impact of pension risk involves an assessment of three key elements: the size of the pension liability (and how this fares versus the assets); the cash that the company might have to pay out; and the risks the company is exposed to as a result of the scheme.
One source of information is companies’ financial reporting and disclosure. However, these will rarely account for all three of the elements listed. Of course it is worth noting that if accounting introduces known distortions, or if there are obvious omissions, it may be possible to correct for these. Yet more often than not, accounting disclosures are taken at face value – leaving many sponsoring companies of DB schemes with an undervaluation of their pension risk that pervades through all levels of the corporate hierarchy.
So how exactly do pension schemes measure the risk that they are running and, crucially, what is the most accurate approach? Essentially, there are three standard methods of valuation: IAS19, funding and solvency:
- IAS19 valuation:
Most companies disclose their accounting liability and resultant surplus or deficit relative to assets in their financial statements, with the methodology and disclosure governed by IAS19 accounting rules. Under this system, pension schemes discount future payments at the prevailing rate of interest on high quality corporate bonds; the higher the yield, the lower the current value of a pension fund’s liabilities. However, from a risk perspective, arguably this number is somewhat irrelevant being independent of the investment strategy and the assets held by the scheme. As such it bears very little resemblance to the true economic liability.
- Funding valuation:
An implicit limitation of IAS19 can be found in most companies’ funding plans (if fully disclosed). Funding plans often have the company promising to make a series of contributions over succeeding years that would quickly repair the accounting deficit, shaped by IAS19 liabilities, and then some. The ‘and then some’ results from the funding plan being based on a more pessimistic valuation of the liability, which is run by an actuary every three years. Some schemes report this liability; most do not.
While this funding valuation takes into account a scheme’s investment strategy to some degree, it still fails to accurately assess, and take account of, many of the economic risks the scheme is running as a result of its investment strategy and longevity. The rationale here is that the company covenant is providing security to cover that risk, although the security provided at a company level is in most cases implicit and therefore undisclosed.
- Solvency valuation:
The last approach is the solvency valuation. This is calculated triennially at the same time as the funding valuation and predicts the cost an insurer would charge to settle the liability. This is a market-consistent approach, taking into account the cost of locking down most of the risk and the cost of holding reserves against any risk that remains. Figure 1 below shows that the solvency valuation can be as much as 145% of the value of IAS19, with a large part of this difference made up by a more prudent assessment of the interest rate, inflation and longevity risks that the scheme is exposed to. In short, it is the most accurate way to assess the risk brought about by a scheme’s assets and its investment portfolio. Yet it is almost never reported.
Figure 1: Example of Moving Between the IAS 19 and Solvency Valuation.
Source: PensionsFirst Capital.
The Influence of the Equity Story
So why do companies tend not to disclose their solvency valuations? First and foremost, for many it’s a scary number given the current value of their funds. So, with lack of pressure from external stakeholders, there is little incentive to do so.
This pressure is unlikely to be exerted by shareholders of sponsoring companies or equity analysts. These parties tend to be equity focused; that is to say they tend to believe in the growth potential of equities or they would not invest in them. Yet, this has a number of consequences; namely that they often have a generally more positive view on the future of the economy and a higher risk tolerance. But, crucially, from a pensions perspective, it means that there is a tendency to believe that real rates will not remain either low or negative for long – a view that is contrary to the current market interest rate and inflation curves.
Elsewhere, while rating agencies may recognise limitations in accounting valuations of pension liabilities they need a consistent reference point for measuring pension risk. Without the tools to measure risk accurately themselves, and varying levels of disclosure between companies, they revert to accounting numbers.
A Barrier to Action
By continuing to undervalue the potential impact that interest rates and inflation could have on their assets and liabilities, some sponsoring companies are effectively running an enormous short on rates. And this bet, to our knowledge, is neither supported by analysis, nor is it implicitly or explicitly mandated nor, crucially, is it in the interest of shareholders and scheme members.
Given that there is a liquid market for rates and inflation, it is questionable why some pension schemes continue to ignore it. Certainly, they would not ignore the share price of a company or the quoted price of a bond when calculating their value, which makes the current approach inconsistent.
But more than simply being inconsistent, the status quo could also be extremely damaging to companies that sponsor these schemes. Failure to recognise the true nature and scale of the liability has created a sense of inertia, with schemes less inclined to accept the logic of starting down a path of de-risking. Even for those that do recognise the benefits of de-risking as a long-term strategy, most will hesitate to transact in the short-term, instead waiting for a change in interest rates to kick in.
History proves that running bets on interest rates, inflation and longevity simply hasn’t worked for pension schemes and that is unlikely to change. Indeed, interest rates have been at record lows for four years, with little indication this situation will change in the foreseeable future, meaning there may be no better time than now to prepare to remove pension liabilities from the balance sheet. And for many, a full buyout, which involves the transfer of all pension liabilities to an insurance company, offers the most complete solution.
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