Pension Risks in a Low-Interest Environment
As pension obligations look set to rise, companies will have to increase their pension contributions.
Pension obligations have reached an all-time high for a number of companies in many countries, with the main reason for the poor shape of corporate pensions being the significant decline in interest rates since 2008. As of the end of 2015, a number of companies had a pension deficit higher than the reported book value of their equity. In a handful of cases, the pension deficit even exceeded the market capitalization.
Interest rates around the world are very low due to central bank measures. In the euro zone, interest rates are expected to stay lower for a longer period than in the US, which suggests that the pension obligations for companies from the euro zone and the UK will be more affected by low interest rates than for comparable US companies.
How are low rates affecting pensions?
The pension obligation of a company is determined by two factors:
- Estimated future benefits.
- The discount rate used to discount future payments based on the current value. The lower the interest, the higher the value of future obligations is, because more money has to be set aside now in order to meet future obligations.
International Accounting Standard Nineteen stipulates how high the discount rate has to be. Specifically, the discount rate should be determined by reference to market yields on high-quality corporate bonds with maturity and currency similar to that of the firm's future pension payments. This results in the sensitivity of pension obligations to interest rates.
Pension plans are also sensitive to interest rates – not only defined-benefit plans (the employer guarantees a certain level of benefits), but also defined-contribution plans (the benefits depend on what is paid in):
- Reinvestment risk: For defined-benefit pension plans, the duration (average capital commitment period) of the pension obligations is generally longer than the duration of the assets. In a low-interest environment, this leads to reinvestment risk, because the coupon and the principal from maturing debt instruments must be reinvested in lower-interest bonds, which therefore generate lower yields.
- Offset only in part: For defined-benefit pension plans, the impact of low interest rates is greatest if the future pension benefits are fixed, or guaranteed. For pension plans with benefits tied to salaries or inflation, low interest rates are partially offset by downward adjustments in wages and the inflation-linked indexation of benefits.
Negative Impact on Equities and Bonds
Declining yields require companies to lower their discount rate, which increases their pension obligations. This can lead to a funding deficit if the increase in the pension assets cannot keep pace. At the same time, low yields can adversely affect the expected returns on the pension assets.
The volatility of the funding ratio (pension assets minus pension liabilities) creates a risk for equity investors. The pension deficit could result in higher pension contributions in the future, thus negatively impacting profitability and cash flows. Furthermore, it can jeopardize the sustainability of dividend payouts and adversely affect stock valuation.
For fixed income investors, rising pension deficits may adversely affect leverage and future cash flows. In order to eliminate pension deficits, companies may issue bonds to raise cash. In this case, they benefit from the low financing costs. Although bond investors are likely to view this strategy as negative, replacing volatile pension deficits with fixed obligations is ideal for some companies. For high-rated companies, it is economically beneficial to borrow today to immediately fund pension deficits and accelerate tax benefits from deductible pension contributions.
British Companies with the Highest Discount Rates
Based on our reporting universe, US companies saw the largest absolute percentage increase in pension plan shortfalls from 2013–2015 (25 percent), followed by Switzerland (20 percent), Germany (10 percent), and France (9 percent). Interestingly, companies in the UK registered a decline in underfunded status by 26 percent. This can be explained by the fact that UK companies have been pioneers in pension reforms by hedging or locking their underfunding risks.
But the UK still has the highest average discount rate of 3.7 percent among all the major European countries. We believe that shortfalls will increase again once these companies re-adjust their discount rates toward the end of the year.