What to expect in your Christmas stocking (… a balance sheet deficit, that is)

Richard Smith

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With 31 December being the most common date for corporates to have their year-end, Finance Directors will soon be turning their minds to their annual accounts. After a number of years of falling yields and growing deficits, they might be hoping for a Christmas present of an easing of the pensions problem, particularly if they have read recent headlines around improving pension scheme funding levels

Whilst there is still some time before the year-end, and (as the US election has recently reminded us) anything can happen, we will aim to give sponsoring employers advance warning (unfortunately this wording is chosen deliberately) of what they can expect come the year-end.

Discount Rates

FRS 102 and IAS 19 require the discount rate to be based on yields of high quality (usually taken to mean ‘AA-rated’) corporate bonds, taking into account the shape of the liabilities.

As can be seen in the graph below, despite the recent up-tick, the yields on corporate bonds have fallen significantly since 31 December 2015.

corporate bonds graph

As yields have decreased over the year, liabilities will be greater and as such, balance sheet positions will have worsened. Sponsoring employers of schemes which are open to future accrual will also see a substantial hit to their P&L.

In recent weeks, yields have started to bounce back, and while this will not make up on the ground lost over the period, if this continues in the run up to 31 December 2016, it will have the effect of offsetting some of the increases to scheme liabilities witnessed over the year.

Price Inflation

Unfortunately, the discount rate is only part of the story. The inflation assumption is important, as this generally defines future benefit increases.

Again, there is a range of values that this assumption can take depending on the scheme’s circumstances. The chart below shows how the Bank of England expects the Retail Prices Index (RPI) to evolve over future time periods:

BoE implied inflation spot curve

BoE implied inflation spot curve

We can see that the market’s expectation of inflation since 31 December 2015 has increased at all durations. Consequently, any inflation-linked liabilities will have increased in value of the year. Unfortunately, this comes on top of the increase in liabilities resulting from falls in discount rates.

Asset Returns

2016 has been a strong year so far for most asset classes. Many schemes’ assets will therefore have increased materially. However, for most schemes these gains will be more than offset by increased balance sheet liabilities.

Consequently, even where the sponsor has been paying large contributions over the year, the likelihood is that 2016 will herald ever-worsening balance sheet deficits. Some companies will be able to deal with this; others might find constraints in their ability to pay dividends, and we may even see some technical insolvencies affecting companies’ ability to trade.

Can I influence the accounting disclosures?

The pension deficit is based on a set of assumptions, and the responsibility for setting these lies with the Directors. There is therefore a degree of flexibility and varying the assumptions may have a significant impact on the overall deficit. It is certainly worth exploring potential areas of flexibility with your actuary as this could have a material impact on your disclosures. Once the Directors receive advice from an actuary, the assumptions will be need to be agreed by the Company’s auditors.

However, tweaks to assumptions will only go so far, and ultimately – as with scheme funding – if you paint an overly-optimistic picture this year, it may come back to bite you in the future. Changing assumptions does not change the ultimate cost of the promised benefits.

So what can I do about this?

There are essentially three levers a sponsoring employer can pull to manage deficits that have already built up in their scheme:

  1. Contributions: there may be a more optimal contribution pattern than the one currently adopted. The level and timing of contributions could give the company more influence and flexibility over the investment strategy and risk taken by the scheme.
  2. Investments: many pension schemes are running investment strategies that are taking too much (or too little) risk, and therefore pension schemes may be leaving potential investment return on the table. Although setting investment strategy is a trustee decision, I believe that employers can reap significant value by contributing proactively in this area.
  3. Liability management exercises: if set up correctly, these can result in a win-win for the Company and pension scheme members, with risk being removed from the balance sheet in an efficient manner and members receiving their benefits in a more flexible and appropriate form.

In conclusion, sponsoring employers can expect to see a deterioration of their pensions accounting figures compared to those at last year-end. Some companies may be able to take this on the chin, but others will want to be more proactive. Some timely planning could help the Christmas turkey go down a little easier.

Richard Smith

Post by Richard Smith

Experienced pensions actuary and expert in accounting for pension costs, liability management exercises, dealing with the pensions issues arising from M&A activity and scheme funding.

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