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- US S&P 1500 experiences largest ever aggregate pension deficit of $506 billion
- Balance sheet effects on companies with DB schemes inflated by falling bond yields
- Global pension scheme deficits ‘proving stubbornly hard to eradicate’
New Mercer research shows that accounting measures of the liabilities of defined benefit (DB) schemes in most developed economies have seen marked increases in liabilities due to declining corporate bond yields. Combined with equity market performance experienced over 2010, this is likely to result in larger deficits at company year ends.
Equity values in most countries with developed financial markets have been volatile throughout 2010, although in many cases returns over the past 12 months have been positive. However, according to Mercer, companies with significant defined benefit occupational pension schemes preparing their financial statements under current market conditions would still report larger pension scheme deficits than those 12 months ago.
This has been caused by falls in corporate bond yields, which affect the value placed on pension scheme liabilities for accounting purposes. In some markets, bond yields have fallen by over a quarter. In the US, for example, since the end of June 2008 AA corporate bond yields had fallen from 6.97% to just under 5% at the end of August 2010. Mercer’s latest analysis of the S&P 1500, showed the impact: corporate America has just experienced its largest ever aggregate pension deficit.
“A 50 basis points fall in discount rates roughly results in a 10% increase in liabilities for a pension scheme,” said Frank Oldham, Mercer’s global head of Pension Risk Consulting. “As a result, measures of pension scheme liabilities have increased faster than the value of the assets held across numerous markets. The result is even larger deficits on company balance sheets.”
The problem isn’t always immediately evident, says Mercer. Pension schemes in different countries have different benefit structures and the market consistent valuation approach adopted by most accounting standards means that company balance sheets can be affected by both local and global market sentiment in different ways. However, research by Mercer consultants shows that scheme deficits in most local markets are likely to have increased to record levels.
Frank Oldham commented, “Our experience is that regional differences will affect the liabilities recorded – for example, in the UK the liabilities are predominately inflation linked. Since the fall in corporate bond yields partly reflects market expectations that future inflation will be lower, the accounting measure of pension scheme liabilities has not changed as dramatically as it has in other countries that do not have index linking. However, despite such local differences, pension scheme deficits measured on an accounting basis are proving stubbornly hard to eradicate around the world.”
In the US, there remains concern over the level of AA corporate bond yields, which have been steadily declining in 2010, reaching 4.94% (for a mature plan) as of the end of August 2010, the lowest yield in a decade. Both US and international accounting standards require pension plan liabilities to be valued using AA corporate bond yields, and these lower yields translate into higher plan liabilities as the latest Mercer research has shown.
In both the US and the UK, nominal corporate bond yields declined in the second half of 2009 and have continued to fall throughout 2010. In the UK, benefits are inflation linked so liabilities have been more stable over the year, but they still sit at historically high levels. According to Mercer’s latest data, the aggregate FTSE350 IAS19 pension deficit stood at about £85bn at 30 June 2010, the same level as the previous quarter. £15 billion was added to liabilities due to falling bond yields.
Canada’s economy was less infected by the crisis in financial markets, but Canadian companies are also experiencing record deficits. The story in Canada is more nuanced with poor investment performance, hobbled by flat markets in the first half of 2010, combined with declining AA corporate bond yields driving up liabilities. As a result, pension scheme deficits overall are expected to more than double, from about Canadian $20 bn to just under Canadian $50 bn.
German accounting rules currently differ from those adopted in most other countries, permitting companies to average bond yields over seven years, so the impact can appear more muted. Even so, unless market conditions improve, liabilities reported at the end of the year are expected to reach their highest levels yet. According to Mercer, the €220 billion liabilities of the 30 DAX companies could increase by €33 billion upon each 1% decrease in the discount rate. Ultimately, further effects will emerge as accounting standards are harmonised internationally.
In the Netherlands, pension accounting liabilities are based on AA corporate bond yields drawn from the wider European Monetary Union (EMU) market, where there has been a significant fall. The total IAS19 deficit of the pension schemes of the 48 companies included in the AEX and AMX had, at 31 August 2010, increased to €59 billion from €24 billion in December 2009. As in other countries, some pension funds in the Netherlands have been matching their assets to their liabilities in order to manage the risk in this area.
Like the Netherlands, pension accounting liabilities in Ireland are based on bond yields drawn from the wider EMU market, where yields have fallen to around 4.5%, down from 6% at the beginning of 2010. As at 31 December 2009, ISEQ companies had accumulated assets of around €13.4bn and liabilities of around €17.8bn giving a cumulative pension deficit of €4.4bn. Mercer estimates that as at 31 August 2010, these companies would have assets of the order of €14bn and combined defined benefit obligations of €21.9bn, giving a deficit of €7.9bn.
According to Mick Moloney, the leader of Mercer’s Financial Strategy Group, “To manage the effects on company balance sheets created by local differences between subsidiaries’ pension schemes, multi-national companies will need to introduce risk management strategies that reflect local differences. They need to be proportionate to the relative importance of the pension plan on the company's financial and reporting position.”
“The trend is for companies to implement investment strategies that result in higher correlation between how assets and liabilities behave, hedging more of the funded status risk. This trend will only accelerate given the current market conditions. Companies with mature plans will be seeking to implement specific strategies to dynamically reduce pension plan financial risk over time as the plan’s funded status improves.”
Notes to Editor
A basis point is a unit of measure used to describe the percentage change in the value or rate of a financial instrument. One basis point is equivalent to 0.01% (1/100th of a percent) or 0.0001 in decimal form. In most cases, it refers to changes in interest rates or bond yields. For example, there is a 50 basis points (0.50%) difference between 3.5% and 4.0%.
Mercer is a leading global provider of consulting, outsourcing and investment services. Mercer works with clients to solve their most complex benefit and human capital issues, designing and helping manage health, retirement and other benefits. It is a leader in benefit outsourcing. Mercer’s investment services include investment consulting and multi-manager investment management. Mercer’s 18,000 employees are based in more than 40 countries. The company is a wholly owned subsidiary of Marsh & McLennan Companies, Inc., which lists its stock (ticker symbol: MMC) on the New York, Chicago and London stock exchanges.