PENSION SCHEMES FACE INCREASING RISK OF INSOLVENCY  

Despite current market volatility, using standard accounting measures, defined benefit pension scheme funding levels have not been hit as hard as drastic stock market falls might suggest, according to the Mercer Pension Update report.  The report also highlighted the increased threat of counterparty risk and corporate insolvency as fall out from the economic crisis, and called for greater diligence by trustees and companies.  

According to the report, when measured using methods consistent with the accounting standard IAS19, the aggregate FTSE350 pension scheme surplus was £1 billion as at 30 September 2008. Taking market movements up to 10 October into account, Mercer estimates that despite asset falls of £39 billion, decreasing liabilities have left this £1 billion surplus virtually unchanged.  In comparison, there were deficits of £14 billion at 31 December 2007 and £47 billion at 30 June 2008.

The report noted that there remains an investment bias towards return-seeking assets so exposure to equity market volatility still accounts for a substantial portion of total risk. The headline equity proportion was estimated at 47 percent for FTSE350 companies. However, 25% of FTSE350 companies continue to hold over 60% of their pension scheme assets in equities. With September showing the largest one month fall in UK equities for 10 years and a general 21% decline in UK equities over the past 18 months, equity price movements will have a significant impact on some schemes.   

Deborah Cooper, principal in Mercer’s retirement business, SAID: “While undoubtedly distressing, snapshot calculations of asset and liability values can paint a misleading picture to members of defined benefit schemes, where the employer is obliged to support the scheme. Defined benefit scheme assets are held to cover long-term liabilities that also fluctuate with market movements. It is therefore important to look at both asset and liability values, and the employer’s covenant, when considering the impact of market volatility on pension scheme funding levels.   

“Schemes have reduced their exposure to volatile ‘return-seeking’ assets in recent years, with a marked increase in bond holdings, but often for good reasons they remain considerably exposed to equity markets. Recent equity market falls have been offset – on an accounting basis – by falls in liability values, so company balance sheet liabilities will not have increased by as much as was perhaps expected. However this will not always be the case. Those schemes most exposed to equity markets continue to present the highest risk to their sponsoring employer – especially with the uncertainty in global financial markets.” 

As at 30 September 2008 the aggregate funding level of the FTSE350 was 100%. By contrast, the funding levels at 31 December 2007 and 30 June 2008 were 97% and 90%. Between 31 December 2007 and 30 September 2008 the funding level varied between 86% and 106%.

The current economic climate poses a significant risk to trustees and plan sponsors. With an increasing focus on risk management and use of complex investment strategies, often involving the use of derivative instruments, trustees and sponsoring employers can become exposed to a wider range of covenant risk, albeit not originating from the sponsoring employer.

Cooper concluded: “This counterparty risk originates from schemes’ reliance on the ability of external entities to meet their obligations and relates to positions in investments such as swap contracts. The demise of some of the world’s largest banks shows that, while risk can be mitigated and transferred, eliminating it altogether is nearly impossible.

“Trustees must diligently measure and monitor the credit risk of sponsoring employers as well as any counterparties the scheme relies on. Sponsoring employers should also be concerned, since they are likely to be exposed to any shortfalls created by the collapse of external counterparties.” 

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