Eroding the pension base
As reforms shift pension plans from pay-as-you-go to funded schemes, benchmarks such as funding levels become increasingly relevant. Yet they create a new level of uncertainty
Michael Heim
Employer packages including occupational pensions play an increasingly important role in attracting new hires. To avoid being forced to inject additional funding, company pension schemes need to be well funded with equities, bonds and insurance solutions balancing pension obligations.
Yet the devil is in the detail. According to financial reporting standards as spelled out by the International Accounting Standards, the actuarial interest rate used to value pension obligations is closely linked to capital market developments. Being based on the current yield of corporate bonds with good credit ratings, the rate is to reflect the liabilities’ fair value. In reality, however, the actuarial rate can inflate obligations over the course of one year: The lower the interest rate, the higher the pension obligations. And vice versa.
INTO THE HISTORY BOOK
This occurs against a background of prohibitive investing conditions such as low yields and increasing regulation, as PROJECT M #19 discusses in great detail. In, institutional investors’ demand for good quality investments added to rising corporate bond prices. This pushed their yields, the mathematical basis for the IFRS rate, down. Consequently, the interest rate used to value pension obligations dropped from around 5.5% to approximately 3.4% over the course of.
Pension obligations of many companies listed in the German stock index DAX climbed by more than 20% by the end of, according to German Pension Finance Watch , a report by Towers Watson. While this was offset by strong investment results averaging more than 10% at the time, the low IFRS rate ultimately lead to low funding rates, namely around 61% for the DAX companies – compared with average funding of approximately 65% at the end of. In late, funding had returned to levels thanks to investment results of approximately 5% and a 0.1 percentage point increase in the IFRS actuarial interest rate.
Corporate pension plans in the US and Japan saw their funding levels drop to 91% and 90% in mid-2013. Plans in the Netherlands and the UK saw their levels at 111% and 97% respectively in early, according to the Pension Protection Fund’s Purple Book .
Additionally, new IFRS accounting regulations became applicable in January, aiming to make obligations more transparent. Consequently, changes in valuation have to be immediately and fully recognized outside of profit and loss book keeping. Pension obligations have to be recorded as the difference between assets and liabilities.
WHAT’S AHEAD?
In the first nine months of, the IFRS rate again dropped from approximately 3.5% for a balanced pension portfolio (in terms of the number of employees and pensioners) to roughly 2.5% at the end of Q3.
Mathematically, a rate drop from 3% to 2% leads to a more pronounced increase in pension obligations than a drop from 5% to 4%. Consequently, liabilities at many companies are at risk of rising, and investment results are by and large unlikely to compensate for this. Additionally, valuation changes could put pressure on equity. In light of this, funding rates are likely to drop further.
The good news is, however, that with pension funds’ decades long investment horizon companies can compensate for fluctuations over the long term. A detailed risk management strategy can help make timely adjustments.
For further reading, download the study What is the biggest risk for company pensions?
