Employer Action Code: Monitor

Turbulence in financial markets is a fact of modern life, especially over the past few years. For those who follow pension accounting, the effects can be jarring. The liabilities and benefits expense of pension plans (as well as other postemployment benefit plans), as measured under global accounting rules, are a direct function of the discount rate, which, in turn, is driven by movements in corporate bond yields. As the yields fall, so does the discount rate, driving up the present value of pension benefits; increases in corporate bond yields, leading to increases in the discount rate, have the opposite effect.

During 2012, the yield on corporate bonds has been falling in a way reminiscent of 2010 (see our Global News Brief of September 2010, which reported on a similar phenomenon that year). This means that companies should expect significant increases in pension plan liabilities in 2012, with a consequent effect on the 2013 benefits expense, even if no changes have been made in the plans themselves. The decreases in bond yields have been most pronounced in the Eurozone.

Towers Watson reports on movements in financial markets in our Global Pension Finance Watch (GPFW), published in the weeks following the end of each calendar quarter (see our latest GPFW, which covers the first two quarters of 2012).

Interest Rate Environment

The following chart shows the changes in three commonly followed indices in the Eurozone, the U.K. and the U.S.

Index

iBoxx Euro Corporates
10-yr+ AA

iBoxx Sterling Corporates
15-yr+ AA

Merrill Lynch High-Quality
10-yr+

Market

Eurozone

U.K.

U.S.

December 31, 2011

4.60%

4.68%

4.51%

June 30, 2012

3.38%

4.25%

4.18%

July 21, 2012

2.94%

3.89%

3.77%

August 31, 2012

2.82%

3.90%

3.85%

These are the indices we follow in the GPFW. There are several points to note:

  • Decreases in Eurozone bond yields year to date have been greater than those in the U.K. or the U.S. by about 1%.
  • The decrease in yields during July was significant in all three markets, but that was not the case in August. In fact, in the U.K. and the U.S., yields actually recovered during August.
  • Inflation expectations often decrease as bond yields decrease, which in some instances, particularly in the U.K. where benefits are often inflation-linked, may mitigate the effects of decreases in discount rates on the benefits expense and liabilities.

Towers Watson tracks a wide universe of AA-rated bonds in its various RATE:Link portfolios. RATE:Link methodology then takes into account the duration of liabilities under a plan to develop a discount rate. In the GPFW, we develop benchmark plans for each market and used RATE:Link to derive benchmark discount rates. Here is what happened to the benchmark discount rates during 2012 (it must be pointed out that the results for a specific plan could be quite different):

Benchmark discount rate using RATE:Link

Market

Eurozone

U.K.

U.S.

December 31, 2011

5.49%

4.96%

4.51%

August 31, 2012

3.53%

4.58%

3.73%

There have been decreases in all three markets, but the tumble in discount rates in the Eurozone has been much more precipitous than in the U.K. or the U.S. While it is often not clear to economists and other experts why these apparent anomalies occur, one current theory is that, with the turmoil in the Eurozone during the past year, there has been a significant “flight to quality” in that market. Indices that track lower-quality corporate bonds have not fallen as much as the high-quality indices we look at in the GPFW.

Investment Returns

It is possible that increases in liabilities due to changes in the benchmark discount rate might be offset by increases in assets due to investment gains. Generally, investment returns under pension funds globally were favorable during the first quarter of 2012 and mediocre during the second quarter. Anecdotal evidence suggests that investment returns in the Eurozone during the third quarter may be poor, while those in other markets may be better and possibly even robust (e.g., the U.S. stock market, which has been soaring the past few months). Plans that emphasize fixed-income investments are likely to experience positive returns when bond rates fall, while those that emphasize equities can go either way. Unfunded plans will, of course, have no opportunity for investment gains.

Implications for Plan Sponsors

While the liabilities and costs under pension plans are not marked to market each month, they are recalculated at the end of each fiscal year, and in some circumstances more often (e.g., quarterly or semiannually). As accounting rules change, the trend is definitely toward marking to market. Smoothing techniques built into the accounting rules that reduce volatility may mute the effect of these changes for those companies that still have smoothing options available and have chosen to use them; however, the number of companies in this position is decreasing with the introduction of changes to the IAS 19 standard.

Employers should be planning now for the effects these changes will have, such as:

  • Size of pension deficits recognized on their balance sheets
  • Higher expenses under plans versus amount currently reflected in budgets
  • Depending on local funding requirements, higher minimum required contributions
  • Impact on loan covenants with banks
  • Other ramifications, depending on the jurisdiction in which a plan operates

Some employers might decide that the wide swings in discount rates during 2012 could dictate the need for new valuations or new sensitivity calculations ahead of schedule for some plans, since roll-forward approaches using prior sensitivities are less reliable when the assumptions change significantly. Because individual employers’ circumstances vary considerably, it is dangerous to generalize about the impact of the drop in corporate bond yields on pension and other employee benefits accounting. It could be very significant for some employers and relatively insignificant for others.

We suggest contacting your Towers Watson global benefits accounting consultant to discuss ways to analyze these changes in the financial markets, and the effects they might have on the liabilities and costs of your pension and other employee benefit plans. Otherwise, your top management may be in for some surprises at year-end.