Consulting Actuaries

Is defined benefit funding on the mend?

Royal London Consulting Actuaries

5 August 2013

Equities have shown double digit performance so far in 2013 and both corporate bond and gilt yields are on the rise. We take a look into whether this means the finances of defined benefit (DB) schemes are improving.

In summary

  • For any DB pension scheme with a significant holding in equities, the deficit to be recognised in the company accounts is likely to have fallen over 2013.
  • However, for trustees and employers undertaking triennial funding valuations, the current funding levels are likely to be worse than 3 years ago despite the recent improvements in market conditions.

Corporate bond and gilt yields are on the rise, but so is inflation

The chart below shows the yield on an AA Corporate Bond index and a Gilt index since January 2010, together with the 15 year spot rate for price inflation.

Graph illustrating the yield on an AA Corporate Bond index and a Gilt index since January 2010
Sources: Barclays Capital, FTSE International and Bank of England

Since the start of 2013

The yields on AA Corporate Bonds and Gilts are on the rise, and are now higher than they were at the start of 2013. In isolation this is generally good news for the finances of DB pension schemes. Rising Corporate Bond and Gilt yields typically result in a fall in the value of DB pension scheme liabilities. However this good news may be more than offset by the rising expectations of future price inflation.

Over the last 3 years

Although yields on AA Corporate Bonds and Gilts are now on the rise, they are still lower than they were 3 years ago. Future inflation expectations are also marginally higher than were 3 years ago. For trustees and employers who have just commenced, or who are about to commence, a triennial funding valuation this is generally bad news.

Equities have performed well in 2013... so far

The total returns on the major asset classes over 2013 to date are shown below. The overall returns over 2010, 2011 and 2012 are also shown for those interested in the historic performance over a longer period.

Total return over 3 years 2010 - 2012

Total return over 2013 to 31 July 2013

UK Equities

+ 24.2%

+ 15.9%

Overseas Equities

+ 24.2%

+ 12.1%

Fixed Interest Gilts

+ 27.2%

- 2.3%

Index-Linked Gilts

+ 31.4%

+ 1.2%

Corporate Bonds

+ 41.8%

- 1.2%

Property

+ 19.8%

+ 2.9%

Since the start of 2013

Equities have performed well over 2013 so far; but overall investment performance for a particular DB scheme will crucially depend on the exposure to the different asset classes.

Over the last 3 years

Investment performance has generally been good over the period 2010-2012. However, the good performance of Gilts, Index-Linked Gilts and Corporate Bonds over 2010-12 is a double edged sword.

Lower Gilt and Corporate Bond yields typically result in a higher value being placed on DB scheme liabilities, potentially overwhelming good asset performance.

Have DB pension costs in company accounts fallen since the start of 2013?

Probably.

The cost of a DB pension scheme booked in a company's accounts is heavily dependent on the yield available on long dated AA Corporate Bonds. The yield on AA Corporate Bonds is on the rise, and is now higher than it was at the start of 2013 (by 0.2% p.a.) .

In isolation this is good news for UK companies, but this may be more than offset by rising expectations of future price inflation (now 0.4% p.a. higher than at the start of 2013).

Overall, given the performance of equity markets, for any DB pension scheme with a significant proportion of asset held in equities, the deficit to be recognised in the company accounts is likely to have fallen over 2013, so far.

DB scheme funding worse than 3 years ago, but with an improving trend

For DB pension schemes with a July 2013 triennial funding valuation, the funding position is likely to be worse than 3 years ago (by potentially 5-10%); with the impact on the liabilities of falling Gilt yields potentially being partially offset by the strong performance of equities. April 2013 valuations are likely to have fared even worse, with funding levels falling by potentially 10-15%; these valuations pre-date the recent rise in Gilt and Corporate Bond yields.

Trustees and employers with funding valuations in progress may wish to consider what allowance, if any, to make for post valuation date events in their funding negotiations. They should also consider making greater use of the flexibilities available in setting contribution rates.

Find out more

If you would like to obtain more detailed funding information on your DB pension scheme, or if you have any questions, please contact us.

Notes

In deriving the above illustrative figures, we have assumed that the duration of the DB pension scheme's liabilities is 20 years and 75% of both pension increases in deferment and in payment are linked to price inflation. The assets are assumed to be invested broadly 60% equities (equally split between UK and overseas) 40% bonds (equally split between fixed interest Gilts, index linked Gilts and Corporate Bonds).

For the assets, we have measured UK equity performance by reference to the FTSE All Share Index, overseas equity performance by reference to the FTSE Global All Cap ex UK Index, Gilt performance by reference to the FTSE Over 15 Year Index, index-linked Gilt performance by reference to the FTSE Over 5 Year Index and property performance by reference to Scottish Life's property fund.

No allowance is made for any contributions paid by companies to address a funding deficit.

The impact of the change in financial conditions over the 3 years to April or July 2013 (or over 2013) for a specific scheme will depend on the scheme's membership profile, benefit structure and investment strategy. The impact for a specific scheme may be higher or lower than the effect described in this article.

Circumstances may have changed since this article was written. It should not be taken as actuarial or legal advice.