Since 31 March 2014 yields on AA rated corporate bonds (which are used to set discount rates for pensions accounting disclosures under IAS19 and FRS17) have fallen by around 1.4%. The current levels of yields are the lowest experienced since UK companies have been required to account under IAS19/FRS17.
Whilst most asset classes have seen positive returns on assets over the same period they are unlikely to have kept up with the growth in liabilities.
Impact on balance sheet
If bond yields remain at this level, employers with financial year ends of 31 March 2015 are likely to see increases in their accounting liabilities of between 20% and 30% as a result of the fall in bond yields alone.
The impact will vary according to the specific circumstances of the scheme, including the duration of the scheme’s liabilities. Schemes with large exposures to UK equities and benefits which are not linked to inflation are likely to have fared the worst.
Companies with 31 March 2015 year ends should start preparing for the possibility of a significantly increased accounting deficit. We also expect that companies will want to pay closer attention to the derivation of assumptions to mitigate an increase in deficit.
Read more on this in our latest Current Issues in Pensions Financial Reporting.
Impact on profit & loss account
Employers who currently account for their pension schemes under FRS17 will be required to adopt the new FRS102 for accounting periods beginning on or after 1 January 2015.
Under FRS102 the ‘expected return on assets’ will cease to be used, and the finance cost will be replaced by a ‘net interest’ entry, calculated using the discount rate applying at the start of the period.
For many schemes, the discount rate is likely to be much lower than the current expected return on the scheme’s assets. With bond yields at their current level, the impact of adopting FRS102 will be keenly felt by employers.
The fall in bond yields will not only affect accounting liabilities. Gilt yields have fallen as well and many schemes’ funding liabilities are linked to these. Employers approaching 2015 valuations will be facing an increase in the deficit and will need to consider what options are available to them ahead of any negotiations with trustees.
Employers should also seek to understand any action the trustees of their scheme may be considering, for example in connection with transfer values for members or reviewing investment strategy.
While it may come as cold comfort for employers, at least schemes will not see a large increase in their Pension Protection Fund (PPF) levies this year as a result of the fall in bond yields. The PPF levy is calculated using average values for market conditions over a five year period. This smoothing will mitigate the effect of the recent fall in gilt yields to some extent.