How DB Deficits Became a Major Problem
Following a combination of economic, demographic and regulatory changes, defined benefit (DB) pension schemes now represent obligations for sponsoring employers and the implications can even threaten a company’s short-term survival.
Economic
Both absolute and real interest rates have fallen significantly. As a rough rule of thumb, a drop of 1% per annum in real interest rates currently adds around 25% to liabilities. In addition, equities have not provided returns to keep pace with growth in bond derived liability values.
Longevity
Improvements in health and medical advancements over the last 20 years have been dramatic. The outcome, a longer living population, has typically added 20%or more to scheme liabilities. The mortality assumptions currently being adopted by the industry project forward further improvements in longevity.
Regulatory
Actual increases in the cost of providing DB pensions come from lower investment yields and longer payment terms. Regulations have served to enhance the degree of conservation and the timing of the funding of the deficit. In particular: -
- Since 2004, if a DB scheme is to be wound up it generates a debt in a solvent employer equal to the shortfall in assets needed to secure immediate and deferred annuities. This is prohibitively expensive so is not a practical option.
- FRS17 and now IAS19 disclosures give a relatively consistent public illustration of funding on a basis based in corporate bond yields, which are much more conservative than historic funding assumptions.
- The Pensions Act 2004 gives the Pensions Regulator (tPR) considerable power to accelerate deficit amortisation periods, calculated on more conservative basis than before. A more aggressive approach to funding is taken where an employer’s covenant (link to glossary) is weaker.
The weaker employer, while struggling to meet the deficit funding requirement, is further burdened by the risk based Pension Protection Fund (PPF – link to glossary) levy and the need to seek Clearance for corporate activity.
Click here to see an example of a typical scheme
