The calendar year end pension accounting season approaches as do the Chrismas and New Year festivities, but there is unlikely to be much cheer amongst finance directors with the former.
Improving world stock market returns over the year will have helped the asset side of the pension balance sheet, particularly for those pension schemes with a meaningful equity exposure albeit it has been a bit of a volatile ride. This may have given some finance direction a false sense of optimism. For example over the year to date the FTSE 100 has increased about 17%.
However this good news is likely to be more than offset by a very significant reduction in bond yields since the 2008 year end. Pension disclosures require liabilities to be discounted using AA corporate bond yields of appropriate duration of the liabilities. One common measure of this is the Markit 15 year iBoxx Corporates AA 15 year + index and over the course of 2009 this has fallen from around 6.7% p.a. to about 5.5% p.a. The impact that this will have on individual pension schemes depends mainly on the age profile of the membership. It will also depend on the extent of any margin that was deducted from the rate used at the previous year end to allow for the effect of the “credit crunch”. For a young scheme with a typical benefit structure and average weighted age of say 45 this will increase the liability value, other things being equal, by about 30%. For a more mature scheme, say with average age 55 the increase is of the order of 20%. Of course there are other factors at play e.g. changes in the inflation and longevity assumptions. This assumes a discount rate of around 6.5% p.a. was adopted at 31 December 2008.
AA corporate bond yields at 31 December 2008 factored in a much higher risk of default than applies today and this resulted in what may be viewed as an artificial reduction in the liability valuations. However, at the time it was a welcome offset to sick asset valuations.
To help to offset the impact of an increase in the year end deficit, finance directors should review if the other asssumptions are derived on a best estimates basis. It is often the case that many of the other assumptions match those used by the pension scheme trustees for funding purposes and these are likely to include margins for prudence i.e. it could be argued that they are not best estimates. This may include for example the allowance made for salary increases or future longevity improvements. This may be an area worth investigating as a possible way of mitigating some of the increase in the year end deficit.
Spence & Partners have extensive experience in advising corporates on pension accounting computations and disclosures and we are gearing up for a very busy end December/early January!