Treasury Today Country Profiles in association with Citi

Defined benefit schemes get clearer look at volatility

Pension analysis company, PensionsFirst, this week released its first monthly report on the total valuation of the UK’s largest defined benefit (DB) scheme deficits and the focus on volatility and risk in those schemes.

In the first release, the firm cites potential monthly deficit increases of as much as £25 billion, and a possible yearly increase of as much as £100 billion in UK corporate defined benefit pension schemes.

The company is using a specifically designed Value-at-Risk (VaR) model to evaluate risk within defined benefit schemes, and noted that current deficits run at about £43 billion – with £407 billion in DB liabilities on £364 billion of DB assets.

To put it in perspective, report author Matthew Bale, Director at PensionsFirst, explained that a £100 billion deficit increase – which has a 5% chance of occurring under the VaR model used by PensionsFirst – would require FTSE 100 companies to increase cash contributions to their schemes by about £10 billion each year to make up the shortfall. This would, naturally, have huge P&L implications, Bale noted.

Furthermore, that £100 billion deficit increase could be realised through just a 20% decrease in equities, which would increase the deficit by £34.2 billion, and a 1% increase in long term inflation, which would add £60.8 billion to the deficit, noted the report. This is a key concern for UK corporates and other DB scheme stakeholders, as the unhedged liabilities could lead to big market-directional risk exposures.

The goal of the monthly report is not just to highlight the current deficit but also to delve deeper into critical risk areas within UK DB schemes by drilling down into specific risk areas, such as equity, interest rate, and inflation risk. The report said: “Most companies are ill-equipped to manage the high levels of financial market volatility embedded in their pensions schemes and shareholders typically have little information on the risks to which they are consequently exposed.”

The report will provide forward-looking analysis to put some perspective on “the likelihood and magnitude of future deterioration or improvements in the FTSE 100 pension schemes’ funding position,” PensionsFirst noted.

TT Insight

Six years after accounting regulations changed to require more transparency into pension deficits, companies are still often flying blind or relying on outside consultants to tell them what the risks are in their DB portfolios and how to mitigate them.

There are many factors that could affect potential liabilities. Companies would be advised to take a closer look at where the risks lie in their own portfolios and ensure that they are managing and mitigating those risks as best they can.

By having a clear picture of risks, companies can more proactively offload those risks in a way that is simply not possible without deep analysis.