Going from Bad to Worse

Andrew Kitchen

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Having witnessed strong returns on assets over 2014, many scheme sponsors could be looking forward, optimistically, to reporting improved balance sheet funding positions in 2015.

However, assets are only one part of the picture.

With Greek politics leading to fears of Euro-zone instability and quantitative easing in Europe resulting in record low bond yields, as well as low oil prices; employers could be forgiven for being unclear as to the net effect on their balance sheet reserve.

To help provide some clarity, let us consider how changes in market conditions over the period from 31 March 2014 have impacted Example Pension Scheme (“EPS”), a defined benefits scheme with half of its benefits fully linked to inflation and an average liability duration of 20 years.

Market effect on Scheme Liabilities
The key financial assumptions affecting a scheme’s liabilities are the discount rate and future rate of inflation.

Discount Rate
Pensions accounting standards generally require discount rates to be based on yields of high quality (usually taken to mean ‘AA-rated’) corporate bonds, taking into account the average term of the scheme’s liabilities. The chart below illustrates the change in iBoxx Sterling Corporate Bond Over 15 Year yield index over the period 31 Mar 2014 to 31 Jan 2015.


We can see that annualised yields have dramatically reduced, by 1.5%, from 4.3% to 2.8% over the period to 31 Jan 2015. This reduction in discount rate assumption will directly increase schemes’ liabilities. For our example scheme, this reduction in yields has resulted in a disconcerting 34% increase in liabilities.

The Bank of England’s market-implied inflation spot rate reflects market expectations over a range of terms. Adjustments may be applied to remove the effect of such external influences as supply and demand. However, by reviewing changes to the raw spot rates, at the average term of a scheme’s liabilities, we gain insight into how inflation assumptions may be expected to change over a given period.

The chart below shows how the Bank of England’s implied inflation (RPI) spot curve has changed over the period 31 Mar 2014 to 31 Jan 2015.


We can see there has been a significant change in market projections of inflation, over all periods, since 31 March 2014. For our example scheme, with a 20 year average duration, we see from Chart 2 a reduction of around 0.6% over the period to 31 Jan 2015.

For EPS, all else being equal, this change will have reduced liabilities by around 5% – a welcome offsetting factor from the plummeting bond yields.

Market Effect on Scheme Assets
The chart below outlines the effect of market movements on the assets held by our example scheme, over the period to 31 Jan 2015.


We have assumed EPS has the following broad asset allocation: 60% UK equities, 20% UK corporate bonds, 10% index-linked gilts and 10% fixed-interest gilts.
Equities: FTSE All Share Total Return index.
Corporate Bonds: iBoxx £ Corporates AA 15+ Total Return index
Index-linked Gilts: iBoxx UK Gilt Inflation-Linked Total Return index (Nominal).
Fixed-interest Gilts: iBoxx £ Gilts 15+ Total Return index.


Each scheme’s investment strategy will differ, depending on a variety of factors. Nevertheless, using the chart above as a guide, we can see many schemes’ assets will have grown strongly over the period to 31 Jan 2015, with returns of around 13% for our example scheme.

This has largely been driven by an increase in bond prices and so, where exposure to bonds is higher than assumed for EPS (i.e. greater than 40% of total assets), average returns may be higher still.

Net Effect on Balance Sheet Position
Our example scheme has seen its 29% increase in liabilities far outstrip a more modest 13% increase in assets over the period to 31 Jan 2015, resulting in a 16% deterioration in its balance sheet position. To put this into context, for a £50M scheme this would translate into a worsening of the sponsor’s balance sheet of £8M.

The actual effect on balance sheet positions will be heavily dependent on schemes’ particular circumstances, but the impact on EPS may serve as a rough guide for employers on what to expect come 31 March 2015.

Taking Action
With the expectation of a significant hit to corporate balance sheets, employers will want to carefully consider what actions they can take – particularly with the introduction of FRS102 just around the corner.  For more information on FRS102, please see our FRS102 Guide and Calculator.

Employers should certainly review the assumptions used in their accounting disclosures. Small adjustments in assumptions can have surprisingly material impacts on liabilities and thus deficits. Scheme actuaries frequently use assumptions similar to those adopted in funding valuations, which tend to include significant margins for prudence – an approach inconsistent with the ‘best estimate’ basis envisaged by accounting standards.

Many employers will have given some thought to these assumptions in the past. It may now be worthwhile revisiting this analysis, given the likely increased materiality of these figures.

Employers with liabilities in multi-employer schemes, such as the Local Government Pension Scheme (LGPS), may not have undertaken such an analysis before, however they should now be considering the case for bespoke assumptions.


With such a large drop in bond yields over 2014, without action, an increase in liabilities is almost guaranteed. However, while we would not recommend adopting Tesco’s recent accounting practices, the adage “Every Little Helps” surely remains true.