Don’t look back in anger

Rowan Harris contributed to the writing of this blog post

When employers make additional contributions to pension schemes, they might expect to see deficits fall.  Unfortunately the markets are not always kind.  2014 was such a year.

Treading water

We have this week published our latest survey on accounting for pension costs by FTSE100 companies.  The survey shows that despite employers making significant contributions over 2014, many schemes have made little progress towards reducing deficits.  In fact the overall deficit for the companies in the survey increased by nearly £5bn.  The mean funding level for companies in the survey (89%) remained the same as at the end of 2013.

Bond yields, which are used to set discount rates for valuing the pension cashflows, plummeted by around 1% over 2014.  This one factor was more than enough to offset gains from contributions, asset returns and falling inflation expectations.  However, employers should not dwell on this, but instead plan for what is to come.

Front crawl

The Pensions Regulator has warned that employers may face increased contributions at forthcoming funding valuations.  Employers may wish to start budgeting now, perhaps by obtaining an estimate of the scheme’s funding position in advance of the valuation date, or by considering what the accounting deficit may look like at the end of 2015.

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The survey also shows a slightly wider spread of discount rate assumptions in 2014 than in 2013.  Companies have been moving away from using an index yield in favour of an approach which better reflects the scheme’s liabilities, such as their longer duration.  Any company which is still using an index yield should be aware that this may be overstating their liabilities.

Indeed, some employers may benefit from paying closer attention to their chosen assumptions.  While many aspects of the framework are prescribed there is some flexibility.  Longevity assumptions, for example, where the assumption used for the scheme’s funding valuation may not be appropriate for fair value accounting.

In many cases in our survey, particularly where the scheme has significant holdings of gilts, bonds or other liability hedging strategies are in place, the damage to the balance sheet will have been tempered by strong performance on the asset side.

Employers who were not so lucky may wish to review their scheme’s investment strategy.  While this is typically the responsibility of a scheme’s trustees, it is very important for the sponsoring employer to understand pension scheme investment issues so it can influence the strategy to meet its objectives for the scheme.  After all, the company will ultimately have to bear the risks taken within the scheme’s investments.