Premier Foods eats away at deficit by more than £570m

Persistently low interest rates have put pressure on funding levels by inflating deficits, but some schemes have managed to make strong progress in improving their positions through various forms of derisking including hedging.

Premier Foods reported in May that the deficit had fallen to £211.8m between December 2013 and April this year, which was attributed to “a widening of credit spreads between government gilts and corporate bonds; the impact on assets of the scheme’s hedging strategy; a reduction in inflation rate assumptions; and improved investment performance”.

In its latest results released last week, the company announced that the figure had fallen even further, to £32.8m as at October 3, which it said was because of “changes in assumptions used for evaluating the liabilities of the schemes”.

Source: Premier Foods

Discount rate effect

The discount rate rose to 3.7 per cent from 3.3 per cent, partly offset by a higher inflation rate assumption of 3.1 per cent, up from 3 per cent previously.

Accounting standards mandate that discount rates are based on AA-rated corporate bond yields, which had “quite a large shift” between April and October according to Lynda Whitney, partner at consultancy Aon Hewitt.

A corporate bond discount rate used for IAS 19 could have increased 0.4 per cent in this period just due to the market conditions, she said.

“There was an increase in credit spreads, meaning that liabilities used for company accounting would fall by more than liabilities that are shown in funding valuations that are based on gilts,” she explained.

Whitney warned changes to the IAS 19 deficit often had little effect on the scheme, as cash contributions were driven by the actuarial valuation.

The scheme’s existing deficit cash contribution regime is fixed until 2019 and will not be affected by the change.

DB hedging strategies

Alan Collins, head of trustee advisory services at consultancy Spence & Partners, said the scheme’s hedging most likely took the form of leveraging up exposure to long-term interest rates.

He said: “These leveraged strategies have performed very well, which would match your funding on a buyout level but outperform on corporate bond levels.”

As-yet-unreleased research from consultancy PwC shows two differing camps emerging with regards to how schemes should approach hedging, said Paul Kitson, partner at the company.

“Funds are on average about 50 per cent hedged,” he said, but explained few of the schemes surveyed were actually hedged at close to this figure. They tended to be grouped around a 20-30 per cent or a 70-80 per cent hedge.

He said it can be difficult to judge when the moment is right for setting up a hedging arrangement: “When we think about hedging, typically we’re talking about either interest rate or inflation hedging. The challenge is timing.”