Recent pension deficit reductions are unlikely to be sustainable

Consultancy Barnett Waddingham’s annual survey found that by December 2015, FTSE 100 companies’ overall pension deficit had decreased by £15bn, stimulated by low salary assumptions and a discount-rate increase of 0.2 per cent from 2014, to 3.8 per cent, based on higher corporate bond yields.

However, industry experts have said that the deficit is now rising again, and not only are the reduction drivers unsustainable but they can pose problems of their own.

Lower asset values don’t mean that liability values are also lower; it is the disconnect between these two that is the concern

Melanie Cusack, PTL

Liability-management exercises are needed

Martin Hooper, associate at Barnett Waddingham and co-author of the report, emphasised the correlation between longevity and deficit levels.

“The sustainability of deficit reduction depends on longevity assumptions – larger schemes have been investigating ways to hedge this risk using more sophisticated tools such as longevity swaps,” he said.

The survey also found that higher discount rates had increased funding levels under IAS 19. He said that while IAS 19 and IFRIC 14 had posed minor obstacles for companies and schemes, “a bigger problem could be increased deficits from 2017 valuations”.

Hooper said the best that companies can do to reduce pension deficits is to increase contributions and consider liability-management exercises. “Introducing more flexibility for members at retirement can produce welcome results on both sides,” he advised.

Only deficit management is realistic

Melanie Cusack, client manager at professional trustee company PTL, pointed out that “lower asset values don’t mean that liability values are also lower; it is the disconnect between these two that is the concern”.

In terms of investments, she advised that “assets and liabilities correlating is what matters”, and advocated implementing liability-driven investments to balance risk-management and growth.

Cusack acknowledged that, for trustees, “it is a continued challenge to explain the difference between the numbers on IAS 19 and in triennial valuations… but the challenge is not insurmountable”.

Cusack stressed that “reducing the pension deficit is difficult to do in a low-return environment… aim to manage it instead”, she added. “A good dialogue with the employer also helps.” 

One number among many

Vassos Vassou, an independent trustee at Dalriada Trustees, emphasised that any single deficit measure is an approximation. He said IAS 19 is only a single measure of a deficit, and that it is more important to have a “strong and viable employer supporting the scheme”.

He added that trustees tend to “look at the circumstances of the scheme and the sponsoring employer” and less at corporate bonds yields when calculating a discount rate.

Vassou pointed out that despite appearing more stable in the short term, bonds usually generate lower returns than equities, so investing in them may mean companies will have to “put more money in to make up for lower future asset returns”.

Vassou cautioned schemes against taking a recent downward trend in life expectancy for granted. “It could be foolish” for a scheme to change strategy based on very recent data, he said. “The [Pensions] Regulator would also ask to know your reasoning.”

Overall, Vassou advised schemes to manage their deficits by “looking at the bigger picture to ensure funding, employer covenant and the investment strategy are managed in a consistent way”.

Trade-offs are unavoidable

Simon Robinson, principal consultant at Aon Hewitt, said: “There was a [deficit] improvement on 2014; but the situation has now gotten worse." Discount rates have dropped, pushing up liability valuations.

If the 2015 deficit reduction was primarily down to discount rates, he said, it is worth noting that “they are also driven by long-term views of whether interest rates are likely to rise, which have reversed dramatically”.

He said of the retail and the consumer price indices that, “over the long term, both indices will move the same way; they will have similar long-term projections”, so this should not be a major concern for schemes.

With regard to IAS 19, Robinson said: “There is an element of shooting the messenger”.

He said that the measure “is not causing the problems, but reporting them”, and standardising companies’ and trustees’ valuations should be prioritised.

Robinson advised that “investment in riskier assets” could also help reduce schemes’ deficits, but the trade-off would be “volatility in the short-term… you might have a few very bad years”.