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.

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.