Published in Professional Pensions, 24 April 2008: In the middle of 2007, things looked rosy for UK pension schemes – albeit briefly. They had benefited from the perfect combination of strong stock market gains and increased long term interest rates. Unfortunately, subsequent events have meant that the remainder of 2008 is likely to be a difficult time for trustees who have the unenviable task of managing the finances of their pension scheme.
The credit crisis has had the perverse impact of making pension schemes look healthier in company accounts. In broad terms, this is because lending money to companies is now considered more risky and so companies have to pay higher interest for the privilege. These higher interest rates (“corporate bond yields”) mean that in company accounts, less money needs to be set aside as a reserve to meet the cost of future promised pensions. This means that the Finance Directors of companies with recent year ends will be quite happy with how their pension schemes look in their accounts — the positive impact of the higher corporate bond yields will have more than offset the stock market falls during 2008.
Good news you might say. But the problem is that, unless company expectations have been managed, there will now be a significant gulf in the way the company views the financial health of the pension scheme compared to the trustees. Trustees typically use Government bond yields in their assessment of their pension scheme’s financial health. Government bond yields have not been directly affected by the credit crisis because the market assumes that the Government will always pay back your money. This means that when trustees are looking at their pension scheme valuations, they haven’t got anything to offset the stock market falls during 2008 – unlike the valuations in company accounts where the credit crisis is perversely having a positive effect. Worse still, recent mortality surveys and announcements from the Pensions Regulator, will mean that trustees are likely to need to allow for the fact that their scheme’s members will live longer than previously expected. Trustees will therefore have a much more gloomy view of the financial health of their pension scheme.
These issues are likely to heighten the sensitivity of discussions between companies and trustees during their negotiations to agree the future level of company contributions. This will particularly be the case for pension schemes with a 31 March 2008 valuation date and company financial year end. Market conditions on that date were such that the gulf between how companies and trustees view the financial health of their pension scheme will be particularly wide.
To exaggerate this issue yet further, the new international accounting rules (which apply for company year ends from 31 December 2008 onwards) are likely to mean that regardless of the favourable effect from corporate bond yields, the company’s actual cash contribution rate will impact on the company’s accounts. This prospect will mean that companies need to take an even keener interest in funding negotiations with trustees — mindful of the fact that the outcome of the valuation will affect not only the company’s cashflow but also its balance sheet.
By way of background, the new international accounting rules only have a significant impact in cases where the trustees’ funding assumptions are more prudent than the company’s pension accounting assumptions. When the new rules were announced in mid-2007, this would have only been the case for a small proportion of companies. However, the credit crisis impact discussed in this article means that the vast majority of FTSE350 companies will now be affected by the new accounting standards if current market conditions persist. Conflicts of interest in this area need to be carefully managed and this is an area likely to receive ever increasing attention in 2008 and beyond. The Pension Regulator’s new guidance in this area will mean that many trustee bodies will need to put in place formal conflicts of interest policies during 2008.
The pensions industry tentatively awaits the results of the Pension Regulator’s consultation on mortality. Whatever the exact outcome, it seems clear that trustees’ valuation discussions will be increasingly dominated by mortality assumptions and that these assumptions will have to be made more prudent. The irony is that the stress of having to deal with the impact of improved mortality is likely to shorten the live expectancy for those involved in the pensions industry!
James Mullins