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Home > Blogs > Anthony Harrington > European pensions see deficits rise despite record contributions

European pensions see deficits rise despite record contributions

Pension management | European pensions see deficits rise despite record contributions Anthony Harrington

The pain associated with running a defined benefit (DB) pension scheme could not be more graphically illustrated than it is in the latest survey of European Pension Funds 2010 by actuaries Lane, Clark & Peacock. This is the third year that LCP has carried out its Europe-wide review and the picture just keeps getting worse. But as LCP points out, 2010 has been something of a shocker anyway for DB pension schemes.

“Over the past 12 months the global pensions environment has suffered a series of heavy blows. The fallout from the credit crisis and subsequent economic challenges have left many pension schemes with weaker funding positions and increased liabilities. Falling bond yields have wiped out the combined effect of record high cash contributions from corporate sponsors and positive equity returns. It is no exaggeration to say that the corporate risks of a material DB pension scheme deficit have never been greater…”

Falling bond yields have been disastrous for schemes. This is ironic since corporate bonds were the success story of 2009 for many schemes, returning well over 8% and in some cases well over 10% or even 15%. In the aftermath of the crash, with investors worrying about possible defaults, non-investment grade company debt was traded at significant discounts, sometimes as high as 50% of face value. So buying and holding these bonds to maturity gave schemes the chance of getting both a high risk premium coupon (interest payment) and very substantial capital growth.

However, now we are in an era of low returns, corporate bonds are much in demand as investors chase after better yields than the near zero real yield available from supposedly risk free assets such as UK 10 year government bonds. This means that there are very few significant discounts in corporate bonds to be found, with most near investment grade bonds trading at 100%, so capital growth is out of the question. It also means that the interest corporates have to pay to attract investors has come down, since demand for corporate debt is stronger than ever.

Not only does this hit what is currently the most successful asset class for schemes, it also has a dramatic impact on the calculation of scheme deficits. As LCP notes, a 1% reduction in corporate bond yields doubles the average pension’s accounting deficit. This means that across the 100 largest multinationals corporate pensions have seen their fund liabilities balloon out by a total of 140 billion euros through 2010. This is a larger sum, LCP points out, than the Irish bailout!

"Over the three years to 31 December 2009 the FTSE Global 100 companies ploughed 90 billion euros into their schemes yet saw deficits climb by a similar amount to reach a staggering 150 billion euros."

This rate of attrition is worse than running to stand still. It is draining companies of much needed cash which they would much rather have invested in revenue earning projects and acquisitions. The deficit LCP has highlighted amounts to almost exactly 10% of the profits recorded by the FTSE Global 100 over that same three year period (1,580 billion euros).

On the plus side for companies who haven’t completely bailed out of equities, many fund managers are now of the opinion that equities are likely to do well over the next 10 years, having done nothing at all for the last 10. However, even if that happens and scheme sponsors and, more importantly, scheme trustees – since it is the trustees who have responsibility for the scheme’s investment strategy – stay invested in equities, and therefore reap the rewards of an upturn in the equity markets, their problems are unlikely to diminish. Longevity keeps marching onwards and calculations by HR consultants Hewitt Associates point to scheme liabilities increasing by 3% to 4% for every additional year that scheme members survive beyond the scheme’s benchmark mortality date (FTSE 100 companies currently assume 60 year old males will have an 86 year expected span).

This explains the current interest by some trustee boards and scheme sponsors in longevity swaps, the aim of which is to hedge longevity risk out of scheme calculations. In some ways though, this simply creates another dilemma for trustees, namely how much is it sensible to spend on removing one level of risk after another from schemes, without going direct to a full insurance buyout of the whole scheme (an impossibly expensive option for many)?

Further reading on pension management and liabilities:

Tags: banking , FTSE 100 , Pensions , pensions deficits , scheme sponsors , trustees
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