December 2011 was not a good year end for corporations with defined benefit (DB) liabilities. The story was broadly the same around the world, but it had a different effect depending on your location. The headlines were compelling: “US pension deficits widen for second straight year,” and “Confidence in UK debt inflates pension deficits by nearly a third in 2011.” The second headline could have been even worse, but the year actually ended well above the worst point in September and the measurement used was accounting numbers (based on corporate debt) rather than local funding regulations (based on sovereign debt yields).

For a multinational wanting to manage its DB costs – even if these are now nearly a legacy issue – it is time to take stock, try to understand the effects of the 2011 crisis and plan for the future.

Year-end position

In the US, the aggregate deficit in plans sponsored by S&P 1500 companies reached US$484 billion at 31 December 2011. This equates to a funded ratio of 75%, a drop of 6% in the funded status over the year. It was not as though assets had done badly over the whole of 2011 − US equities were actually up 1% and total assets rose from US$1.37 trillion to US$1.45 trillion. By the end of the year it was clear the problem was not on the asset side. The key issue is the measure of liabilities. For accounting numbers, this is driven by the yield on high-quality corporate bonds, which dropped by over 1% per annum over the year, driving up the capitalized value of the liabilities from US$1.68 trillion to US$1.93 trillion.

The situation in the US is not unique. Funding positions have worsened even after significant sponsor contributions. The UK is, perhaps, an example of the eye of the storm. It is affected by the reassessment of eurozone growth, but it was also regarded as a “safe haven” when it came to the attractiveness of its sovereign debt. Translating that into the year-end accounting position and taking into account the FTSE350 companies, the total comparable assets of their sponsored plans rose in value from £463 billion to £478 billion over the year – but at the same time, the liabilities grew from £527 billion to £562 billion. Thus, the deficit widened as assets increased. And if liabilities had been assessed using UK funding requirements (“technical provisions”), the effect would have been much more dramatic. The chart below demonstrates the effect in the UK over 2011.

The calculations are approximate and intended to give a broad indication of the trend in the funding level over time. The assets are updated in line with market indices. The IAS 19 liabilities are updated with corporate bond yields and the implied market rate of inflation. The Technical Provisions have been re-based at 31 March 2007, 2008 and 2009 so they have the same relative strength to IAS19 liabilities as illustrated by the funding positions in "The Purple Book". The liabilities are then updated with gilt yields and the implied market rate of inflation.

Comparing the UK to the eurozone, at the start of 2011 the corporate bond yield in use to value liabilities was around 1% per annum above that in the euro area, but by the end of 2011 there was more or less no differential. A couple of tentative conclusions:

• Funding problems are now being driven by bond and debt issues – that is, they are about security, not just about maximizing returns at the cost of risk and volatility.
• The euro crisis has opened up large and varying differentials in yields (and changes in ratings, credit default swaps, etc.) on sovereign debt from different countries and on the debt of different corporates in the region.

For many pension plans, the choice and design of bond mandates and managers are becoming much more important.

The story of 2011

Mid-2011 was a key turning point for long-term investors. It was another step on the path to realization of the nature of the crisis facing developed economies. The first step occurred over the three prior years, when the banking crisis swept the markets. Collective government action kept the banks alive and created banking life support.

One problem remaining is how to encourage economic growth when the banks cannot really help. Up to the middle of 2011, there had been a hope that governments would be able to support their banks enough to create a bounce back in growth. However, the hope that this might be enough for growth in the eurozone was dashed in 2011.

The other key problem with taking on someone else’s debt is that this tests your own creditworthiness. Thus, the focus moved from banks onto sovereign debt. The euro area did not fare well under this test as the market did not have the flexibility of exchange rate movements to take out some of the strain of economic uncertainty.

These pressures came to a head in the middle of 2011. The consequences for pension fund investors have been profound. The flight to quality has challenged the concept of valuing liabilities on a risk-free rate. For euro-denominated liabilities, this is clearly not the yield on Greek or Spanish government debt, even if you happen to reside there or are invested in those instruments! For UK funds, the perception of the country as a local safe haven also increased DB deficits through significant reductions in yields. Across this whole area, the effect of quantitative easing in the UK and the long-term refinancing operations in Europe have acted to reduce yields on sovereign debt. At the same time, in all countries, but particularly in those with trade across the eurozone, there was a realization that the outlook for growth should be lowered, which had a detrimental effect on equities.

This is no minor blip. Looking back a decade, longer-term investors are now seriously considering the level of the equity risk premium when in so many markets returns from equity-type investments have stood still while returns from investment in long-dated bonds has soared (assuming, of course, that you were invested in a bond still regarded as secure).

The next chapter

For many years we have applied risk reduction techniques by looking at the variability of deficits coming from variation in growth asset prices, interest rate movements, inflation or longevity. These have been driven by market movements through a time of overall growth with long-term interest rates reducing and inflation coming under control. But across the world, the drivers of inflation and, indeed, economic growth are shifting, and at low long-term yields the capital effects of such moves on very long-term pension liabilities are magnified.

In the short to medium term, there is also a key significance for sovereign debt that puts politics back into the markets as a driver of change. While the first quarter of 2012 does look very positive, there could still be jitters in the bond or equity markets.

So where now for DB assets and liabilities? What will happen to commodity-driven inflation? Will a country exit the eurozone? At what level will growth return? And where? The simple answer is that we don’t know. We can, however, plan from what we do know and find the right tools to analyze what matters to our particular problem – providing for the sponsored pension liabilities and reducing future volatility.

Suggested Actions

The first step is to reconsider the tools and framework being used to monitor the situation. Aggregating and tracking the net deficit for accounting purposes is a first step most corporations will be familiar with. Risk assessment would be the next step – again, probably already analyzed and consolidated in most multinationals.

Another vital step is to consider the stakeholders and decision makers in your key countries. Changing policy direction or having the power to act quickly means preparing the ground carefully with the governance in each jurisdiction. This might be as simple as sharing monitoring information with a committee, or as complex as agreeing on a decision framework for a joint working group with a fiduciary body.

If times are changing, a good way of testing out risk assessment methods is to consider scenario analysis and to apply it to your specific liabilities and where they are situated. Scenarios might simply be set around a current consensus of low bond yields and sluggish growth, a return to higher growth, a depression or a eurozone breakup. The aim would be not to establish what is most likely to happen – although you may have views – but to understand the effect of these global scenarios on your own situation. This is worthwhile for accounting, funding and benefit planning. In addition,

For your accounting numbers:

• Understand the new volatility and the possible range of assumptions
• Test out effect of liabilities if one of your businesses was in a country that exited the euro

For funding DB plans:

• Understand the timing of when current low yields might affect the cash requirements for funding
• Consider communication with fiduciaries and employees to explore their understanding of your own covenant, cash funding and the opportunity to reduce risk

For benefit planning:

• Look at DC design solutions
• Consider the issues from the point of view of different members: the retiree, the starter and the longer-serving employee

Deciding to do nothing because the ideas you planned about derisking and change of benefits now don’t seem to work may not be the best option.