Someone asked:
Is someone here able to provide definitive guidance on if/how pension scheme deficits have been reducing since the rise in interest rates? Many stocks have been, and still are, encumbered by the size of their pension scheme deficits. The large amounts that De La Rue (LON:DLAR) have to pay into their pension scheme yearly was the main reason I never bought any shares.
I increasingly read that pension scheme deficits have been reducing and even surpluses being achieved as a result of interest rate rises. Is that correct and, if so, why? I can understand that being the case if pension scheme funds were being held in cash but that will not be the case.
Clearly, if pension scheme deficits are now universally reducing, it will become a more attractive proposition to invest in companies, the share price of which had been held back by the size of their pension scheme deficits.
Ok here goes:
Pension Deficits
It is important to understand that the term ‘pension deficit’ refers to two very different numbers, thus causing much confusion.
Firstly, there is the pension deficit that appears in the company balance sheet. This is calculated annually by the company and is of limited use. It is not a figure that is used to calculate the level of deficit contributions needed to be paid. It is little more than a bit of accountancy window dressing.
Secondly, there is the more important tri-annual actuarial review conducted by the pension trustees and actuaries which culminates in a negotiation (and often heated disagreement) with the sponsoring company as to the level of any future annual deficit payments that may be deemed necessary.
Therefore you may well have a pension surplus appearing in the year end balance sheet but in actual fact the company are still tied to paying an agreed annual level of deficit contributions under the latest tri-annual review.
It is the commitment to pay annual deficit contributions that is the crucial number to focus on as it is soley this that affects current and future cash flows.
Pension Liabilities
When companies offer their employees a pension plan, they promise to pay them a certain amount of money when they retire. This amount of money is known as the pension scheme liabilities. To calculate the amount of money they need to set aside to cover these future payments, companies use a method called discounting.
Discounting takes into account things like inflation and interest rates, and it helps companies figure out how much money they need to put aside today to be able to pay out their employees’ pensions in the future. If interest rates go up, the amount of money the company needs to put aside today goes down. This is because they can earn more interest on the money they set aside. So, when interest rates go up, the company’s pension fund has less of a deficit, which means it’s in a better financial position.
Let’s take an example. In terms of pension liabilities, i.e. what the company pension must pay out to its pensioners , simplistically if as an example, say an employee has a pension that pays £10,000 per annum for say another 5 years. Then you might expect that the company records a liability of £50,000. However the pension valuation rules allow the company to reduce the liability by a discount rate (the government bonds risk free rate). There is an inherent assumption that the company can invest money to meet the pension liability in govt bonds. So for example if the govt bond rate is 2% then if a company has to pay the pensioner £10,000 next year it could invest £9,800 in govt bonds for a year, receive £200 in interest and pay the £10,000. If govt bond rates move to say 4% then it could invest £9,600 today in order to pay the £10,000. So the company liability recorded falls if rates rise – also as you can imagine if we took our 5 year example out to the full 5 years the impact of compounding has an even more material effect on the liability. In the example the £10,000 due in 5 years at 2% would be recorded as a liability of £9,057. But at 4% it would be only £8,219.
Clearly there are a lot more moving parts in pensions – eg inflation clauses, the impact on interest rates on pension assets etc. but hope this helps answer your specific question.
Pension scheme liabilities refer to the amount of money that a pension fund owes to its members in the future. To calculate this amount, the pension fund uses a discount rate which is based on long-term interest rates and bond yields. If the interest rates increase, the discount rate used to calculate the amount owed also increases. As a result, the amount owed (known as the net present value or NPV) decreases, which reduces the pension fund’s deficit.
