UK companies that have their review of pension valuations this year will need to raise their contribution or inject new assets to avoid shortfalls, given that retirement funds have been hit by falling equities and may be further hurt by quantitative easing.
British companies are estimated to have a combined deficit of 218.7 billion pounds ($326.3 billion) under the defined benefit scheme as of end-February, according to the Pension Protection Fund. Pension experts said about a quarter of UK companies will have their triennial valuation this year, when the economic crisis has already put a strain on their finances.
With stock markets down sharply from their previous review three years ago, retirement funds with a big equities allocation would have a big hole to fill. UK schemes have a much higher allocation to equities compared with their European peers. However, those which have a large gilt and corporate bond allocation may also face chunkier liabilities as the Bank of England (BoE) launched quantitative easing to reflate the recession-hit economy, possibly sending bond yields lower.
Under UK accounting rules, pension schemes have to calculate their liabilities using a discount rate based on AA-rated corporate bond yields. A higher bond yield results in lower liabilities, and hence lower deficits.
"When companies are going to do their triennial review in the next three to six months, there is an increased risk of higher contributions compared to the last review, which was done in 2006, 2007 when equity markets were still strong and the pension deficits were much smaller than they are today," said Dennis Jullens, head of valuation and accounting research in Europe at UBS.
"It is really a question of the timing of the triennial review whether the current increase in deficit is going to immediately cause additional cash contributions." Oil major Royal Dutch Shell said last month it had an $8.3 billion gap in its pension fund at the end of 2008 and would need to increase contributions. It expected to put $5-6 billion into the funds, on top of normal annual contributions of $1-2 billion.
British engineer Smiths Group reported in late March that its pension deficit widened to 464 million pounds at the end of January from 11 million pounds six months earlier, largely caused by the fall in equity values. It also said the BoEs quantitative easing has caused discount rates to fall which would have increased pension fund liabilities since the period end, and that the triennial review would cause future contributions to rise.
"In the short term quantitative easing is not going to help. If it leads to lower discount rate, thats a potential threat," said Robert Parkes, UK equity strategist at HSBC. Parkes, however, said quantitative easing would likely result in long-term inflation, which would push bond yields higher. Others also said it was too early to tell whether the BoE action would have a long-term implication for pension funding.
"Thinking about it from a corporate perspective, it might be that deficit might have gone up on a funding basis because of quantitative easing," said Rash Bhabra, head of corporate consulting at Watson Wyatt, said. "But clearly there is wider step going on from a corporate perspective. The effect of quantitative easing is to reduce the cost of borrowing and make credit more available. Then in the greater scheme of things, it may be a good thing."
Among the FTSE 100 companies that may face a higher pension bill after their review are BT Group, which Morgan Stanley estimated needs a minimum 500 million pound per annum top-up, and retailer Marks & Spencer. The aggregate deficit of the FTSE 100 pension schemes has almost doubled to 245 billion pounds in the year to the end of March on an "economic" basis - measuring pension liabilities against the interest rate swap curve as opposed to against AA-rated corporate bonds, consultant Redington said.
Bhabra said it was a fine balance for trustees to squeeze as much money out from companies to improve their pension funding position but not put the firms into financial difficulties. However, there were alternative options for trustees to look at to get additional securities for members benefits, said Andrew Evans, a partner at PricewaterhouseCoopers.
"What is going to happen is that companies and trustees are going to look at a whole range of different options, not just how much funding is going to be paid into the scheme but also something that is called contingent assets," he said. Those options include putting money into an escrow account, having a charge over certain properties or taking a certain percentage of the proceeds if a company is selling an asset. Nevertheless, high inflation, a possible by-product of quantitative easing, would still be bad for pension funds if bond yields cannot go higher than consumer prices.