2016 has seen two UK market shocks, first the EU Referendum vote on 23 June followed by the Bank of England’s Base Rate and Quantitative Easing announcement on 4 August, which have been followed by particularly steep falls in available yield (increases in price). From a high of over 7% in late 2008, and a pre-EU referendum level of 3%, AA rated corporate bond yields fell below 2% in late August, though had largely recovered through to the end of November.
Importantly, the majority of pension liabilities are inflation linked, making real AA-rated yields a key parameter. The yields referenced above, when adjusted for market-implied future RPI inflation, show that real yields have fallen from over 4% in 2008 to around 0% pre referendum and -1% around the end of August before some recovery. Most pension schemes don’t fully hedge these movements in real AA yields, only the underlying risk free rates. So whilst asset returns have been strong over 2016, they will not have kept up with the liability measure for the large majority of UK pension schemes. Readers should expect reported IAS19 pension deficits to have increased significantly since the referendum. For example, a scheme with liabilities of 100 and assets of 95 at 23 June, a deficit of 5, could now have liabilities of 114 and assets of 101, a deficit of 13 (to end November 2016). Turn this example into a large plc with multi-billion pension liabilities and the issue is clear. So what are the potential implications of these elevated pension deficits?
- One listed company has recently confirmed that it will not pay a final dividend due to IAS19 pension movements wiping out its distributable reserves.
- We anticipate that others will have pressure on credit rating, which affects the cost of funding the business, although these corporates should currently be benefitting from prevailing low borrowing costs. Bizarrely, if there are too few AA rated companies issuing debt in Sterling, IAS19 would then require the use of a government bond yield to discount liabilities (our example scheme deficit above would more than double!) – surely a death spiral for pension schemes, dividends and credit ratings unless the IASB reconsidered its rules at this stage.
- Banking or loan covenants may be breached as key financial ratios deteriorate (net assets, shareholder equity and retained earnings are all affected by the IAS19 deficit position).
- Forecast charges to operating profit (the “service cost”) for pension schemes still open to accrual will have increased significantly, partly due to the gearing effect of balance of cost schemes and partly due to this being an unhedged cost. Clients should obtain updated forecasts for planning purposes, and perhaps consider for how much longer they can afford to provide defined benefits to the current workforce.
- The above is even before the impact arising from triennial valuation cycles is considered, i.e. pressure on cash funding and covenant assessments.
And what can be done about it in the short term? Mitigating actions fall into three camps:
- Reducing the pension deficit measure: A market price is a market price, and IAS19 does not allow any other measure for discount rates. However, refining discount rate methodologies, revisiting the fine detail of the actuarial assumptions (prudence margins carried across from funding valuations for example) and ensuring that relevant items of actuarial experience are allowed for, are all measures that could be considered. There may be audit and/or disclosure implications of course, and changes in any of these areas need to be objectively justified.
- Increasing distributable reserves: Distributable reserves available for dividend payments could be increased by realising existing reserves within the group structure or for example via capital reductions – these are technical exercises that require careful planning to understand the potential knock-on impacts on a business and its stakeholders. Those companies that optimised their pension deficit allocation to their group entities on transition to new UK GAAP will be at an advantage here.
- Reducing risk: Some companies will take the view that they are running too much balance sheet risk, perhaps belatedly. However, reducing risk when it is difficult or expensive to hedge (e.g. credit spread volatility), and when the traditional negative correlation between equity and bond values seems to have been temporarily suspended, may be harder to achieve in reality than via Monte Carlo simulation.
Expect further pensions related pressure through December reporting seasons if current yield conditions persist.