In recent years, managing pension liability risk has increasingly featured on the agendas of CFOs.
Recently, the importance attached to pension liabilities and their proper funding has changed dramatically; the issue has evolved from a purely actuarial approach to company pensions, to a serious corporate finance problem. New European regulations and accounting standards, such as those discussed or already introduced under Solvency II, Basel III or IAS 19, first changed the general conditions and, with them, the angle from which to view the issue of company pensions. The current low interest environment in the wake of financial repression is adding explosive potential to the issue, and is elevating funding strategies and the management of pension asset risk to key corporate governance disciplines – and thus to part of a CFO’s day-to-day business. The magnitude of the impact on financial results is forcing companies to take action. Targeted actions that add value require high levels of transparency with respect to how the pension side interacts with a company’s financial success factors. An individual company solution could be founded on an integrated Asset Liability Management (ALM) study, enhanced with intelligent approaches to risk management.
1st challenge: low discount rate
When performing IFRS valuations of defined benefit pension liabilities, the rate used to discount future benefits to the relevant valuation date constitutes the key economic assumption. The discount rate is closely linked to capital market trends, and aligned to the current yield of corporate bonds with good credit ratings. In recent months, the prices of these corporate bonds have soared, not least thanks to the high demand for capital investments offering as much security as possible. In turn, yields are declining, and with them the discount rate.
“The following rule of thumb applies when assessing the impact of the discount rate on the level of pension liability: depending on the group of beneficiaries, reducing the discount rate by one percentage point can raise the pension liability by between 10 and 20 %.”
Even though the nominal amount of a pension commitment remains unchanged, implications arise in respect of the actuarial valuation of the pension liability: the amount of the pension liability rises if the discount rate falls, and it falls if the discount rate rises. Since the end of 2011, the discount rate for balanced groups of beneficiaries has dropped from around 5.5 % to about 3.6 %. Chart 01 shows the impact on the valuation of pension liabilities.
Applying IFRS accounting can result in much higher fluctuations in pension liabilities in line with the discount rate than would be the case if analysed, for example, under HGB-BilMoG1. The following rule of thumb applies when assessing the impact of the discount rate on the level of pension liability: depending on the group of beneficiaries, reducing the discount rate by one percentage point can raise the pension liability by between 10 and 20 %.
This example demonstrates the enormous extent to which capital market trends can influence the pension liabilities that have to be reported in the corporate balance sheet. Companies have absolutely no means of controlling these trends, which can substantially impact the overall net assets and relevant key indicators of a company. The funded status of pension liabilities, and its influence on the level of a company’s debt, are clear examples of this.
2nd challenge: low funded status
The funded status, i.e. the ratio of pension assets to pension liabilities, of pension plans operated by DAX companies declined significantly last year. By year on year comparison, pension liabilities posted a strong increase of more than 20 %, and even the very good investment earnings (of more than 10 % on average) generated by the plan assets were unable to compensate. The funded status of pension schemes operated by DAX companies dropped to about 58 % on average in 2012. By comparison, the funded status at international level is generally much higher. The average for the UK’s FTSE 350 share index was about 78 % in 2011, and even rose to 87 % at the end of Q3 2012 (Chart 02).
For companies, reductions in funded status do not incur any direct negative consequences in terms of liquidity, since neither national nor international accounting standards legally stipulate that the pension assets must be topped up. They can, however, definitely incur negative financial consequences, which might include downgrading of the credit rating.
Funding of pension liabilities from the perspective of analysts and rating agencies
In recent years, analysts and rating agencies have demonstrated steadily increasing interest in the management of pension risks. Both the status quo and trends in pension liabilities and assets, as well as the ensuing implications in terms of funded status, are increasingly being taken into consideration. These analyses can generally be positively influenced by companies adopting individual approaches and strategies to dealing with pension risks (such as ALM – Asset Liability Management, or LDI – Liability Driven Investment).
“The current low interest environment is shifting focus in annual financial statements to both pension liabilities and pension assets, and posing entirely new challenges for CFOs.”
Generally speaking, most analysts and rating agencies classify nonfunded pension liabilities as debts – with the ensuing possible impacts on an upgrade or downgrade of the company, as shown in Chart 03.
Accordingly, non-funded pension liabilities can have quite different effects on the value and competitive strength of a company, which frequently only become obvious at second glance. In the case of older companies with “generous” pension schemes in particular, this balance sheet item often exceeds the entire market value of the company and can (over the medium term, at least) impose quite considerable constraints on the company’s room to manoeuvre. As such, pension liabilities that are currently underfunded expose companies to a potentially serious risk of future imbalances in their statements of net assets.
Possible solution: development of a suitable investment strategy for pension liabilities
The current low interest environment is shifting focus in annual financial statements to both pension liabilities and pension assets, and posing entirely new challenges for CFOs. In light of these developments, ever more companies are converting their pension commitments from defined benefits to defined contributions. This conversion will, however, only show effect over the medium term, not least because of the long-term horizon of company schemes for company retirement pensions.
In the current scenario, there is therefore an increasing need for intelligent capital investment and risk management solutions that can help, for example, to maintain the funded status of the pension schemes at a largely stable level, even in “difficult markets”. The aforementioned long-term horizon of company retirement pensions is a key characteristic in this respect: decades can pass between making a pension commitment and actually paying the benefits. This provides investors of pension assets with the chance to balance out fluctuations in the funded status over the long term, and to adjust and manage the pension assets in line with the current situation on capital markets. Intelligent investment solutions with a long-term horizon are crucial if this is to succeed even in times of extreme conditions in capital markets, such as during periods of financial repression.
ALM study could be the first step towards identifying a solution
An integrated ALM study could be the first step towards identifying a solution, as it creates the transparency needed to ensure that the decision-making process is as target-oriented as possible. A standard simulation framework is used to play out totally different capital market scenarios, to analyse and spotlight both the resulting impact on pension liabilities and the corresponding development of various strategic asset allocations and risk management approaches. The ALM study also explicitly takes account of a company’s individual risk preference, and assessment of the capital markets.
The outcome should enable a company’s capital investment committee to reach an objective decision in respect of which investment concept is best suited to producing which results in terms of funded status and other key corporate results over the coming years. A direct assessment of the possible investment alternatives should be possible, along with a quantitative evaluation of the financial impacts. Based on various financial results, an ALM study should therefore provide an objective basis for decisions relating to future investment, risk and funding policies for pension liabilities (Chart 04).
The table uses some key financial results that can be derived from an ALM study to illustrate how targeted investment, risk and funding policies can be derived from an objective basis. In particular, the possible investment alternatives can be directly assessed to produce a quantitative evaluation of the financial impacts.
The results that are optimised in the course of the ALM study frequently demonstrate that the initial situation of an individual company can produce quite different investment portfolios. Differences arise for example from the type of pension scheme and the underlying risk factors, from the current funding status, the respective contribution policy, or the capacity to shoulder investment losses. In view of the numerous different circumstances of each individual company, a standardised investment solution is not going to produce optimal results. Optimised portfolios therefore differ in terms of both composition of a so-called “liability-matching portfolio”, and the scope and structure of the “growth portfolio”.
A liability-matching portfolio tries to replicate the risk characteristics of the liabilities to the greatest possible extent, by aligning the investments accordingly in respect of duration, credit risks of corporate bonds, and inflation sensitivity and, by doing so, to ensure that investments and pension liabilities are largely synchronised. A growth portfolio strives for the optimal composition, for example of global equity market investments and alternative asset classes, to enable medium-term generation of additional earnings from anticipated risk premiums.
Benefits of an ALM study and how to implement it
Companies can benefit from an ALM study in monetary terms, but they also gain a better decision-making basis, and improved transparency in respect of fiduciary actions:
- Reduction of top-ups that are otherwise necessary to fund the pension liabilities
- Cost-efficient implementation of an optimised investment structure
- Improved control of the funding risk
- Improved accuracy in estimating the effects of funding activities on balance sheet accounting
Practical implementation requires professional asset management, including the necessary infrastructure for cost-efficient and smooth implementation in daily business. Such pension asset management does not usually constitute the core competencies of a company. In the interests of ensuring as efficient a division of labour as possible, outsourcing individual components of the investment, monitoring and reporting functions to an experienced asset management partner or fiduciary manager may prove to make sound business sense.
 HGB: German Commercial Code
BilMoG: Bilanzrechtsmodernisierungsgesetz = German Accounting Law