Pensions are interesting and topical things, especially the accounting for them.
For instance, we see lots of headlines surrounding pension deficits. In fact, we were told earlier this week that the collective deficit of the 200 largest privately-sponsored pension schemes in the UK soared by a further £16bn in February to end the month at £45bn, the biggest deficit in a year.
Bad times, yes. But the truth could be worse.
These are accounting deficits - and the way you account for them will lead to different sizes of deficit.
UBS’s Dennis Jullens puts it succinctly in the bank’s latest edition of its (fascinating) valuation and accounting footnotes:
Falling pension assets in 2008 were offset at many European companies by lower pension liabilities on the back of higher corporate bond yields. This has left funding ratios more or less unchanged between 2007 and 2008…
Under current accounting rules, companies calculate their pensions liabilities using a discount rate based on high-quality corporate bond yields (usually AA). Those have had a decent 2008, moving, as they do, inversely to bond prices, so that yields have risen from circa 5.75 per cent to about 6.7 percent on average. That’s helped offset the fall in asset values caused by the collapse of equities (the size of that offset will vary from scheme to scheme of course, depending on the composition of the portfolios).
So while the asset sides of pension schemes have fallen, this has been mitigated by a simultaneous rise in corporate yields, pushing down liabilities.
Under current rules, then, many pension schemes are actually very well-funded. But there are other ways of calculating the value of pensions liabilities. For instance, against government bonds or corporate bond yields of non-financial companies, which would generally be lower.
For instance, the Dutch Central Bank uses the term structure of interest rates in order to calculate pension liabilities. That’s a more onerous number, being currently lower than corporate yields (see the chart of the difference below). In general, it leads to funny things such as Dutch postal group TNT’s experience.
TNT posted a pension funding figure of 97 per cent at the end of 2008 in current accounting terms (assets fell 14 per cent, but were offset by a 12 per cent fall in liabilities). By the Dutch Central Bank’s calculations, however, the company’s funding ratio fell to 93 per cent — below minimum requirements and necessitating the preparation of a pension ‘recovery plan’.
In other words, much like banks’ balance sheets, the value of companies’ pension liabilities will largely depend on what type of accounting and benchmarks are used. To put things in perspective, the head of pensions at KPMG estimates that an increase of 1.7 per cent in the AA-corporate bond yield will depreciate a pension scheme’s liabilities by as much as 40 per cent. Happy times for pension trustees.
The key for European pension deficits (in terms of headline numbers) going forward, then, will be the performance of corporate yields. If those were to suddenly drop without a concurrent recovery in equities, you could expect a boom in pension deficits — in current accounting terms. Likewise, any change in the accounting rules could also yield a sudden reversal in companies’ fortunes.
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Related links:
Measure for measure – three ways to measure pension deficits – Financial Director
Aspects of accounting for pension costs (1998 discussion paper) – Accounting Standards Boards