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FTSE 350 profits could shrink by GBP2bn in 2017 due to pension costs

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The annual accounting cost of building up new defined benefit (DB) pensions for the UK’s largest 350 listed companies has increased by over GBP2 billion since the start of 2016, according to Mercer’s Pensions Risk Survey.

This has been driven by record lows in high-quality corporate bond yields, which are used to measure the pension costs reported in company accounts. The lower the interest rate yield used, all else being equal, the bigger the reported pension cost. 
 
In August, AA corporate bond yields as measured by the markit iBoxx >15 year index fell to a record low of 1.89 per cent per annum, compared with 3.68 per cent per annum at the end of 2015.
 
Falling bond yields partly reflects investors’ outlook for economic and productivity growth, which in turn will influence the timing of changes in central bank interest rates and their likely long-term level. The EU referendum and the Bank of England’s expansion of quantitative easing in August 2016 have contributed to the low bond yields.
 
Warren Singer (pictured), Mercer’s UK head of pension accounting, says: “Our analysis of current low bond yields shows that new DB pension savings now typically have an accounting cost about four times higher than the cost of defined contribution (DC) retirement savings. The impact of over GBP2 billion on profits is material compared with pre-tax profits of FTSE 350 companies of GBP84 billion in 2015.
 
“Brexit has introduced considerable uncertainty on how profit will be impacted by DB pension plans after 2017. To help companies understand this, we have developed some scenarios to illustrate a range of possible Brexit outcomes and how they would affect pension costs over the medium term.
 
“The key question is whether you expect 30 years of stagnation in the UK, as implied by the UK bond market. We have seen in Japan this scenario is possible but the Governor of the Bank of England has stated that UK bond yields are distorted by an investor community as a whole that is taking out insurance for extreme risk events. He believes there will be adjustment and growth without question. However, if employers believe in a low growth world, they may find it unsustainable to allow employees to continue building up new DB pension savings.”
 
Alan Baker, partner and head of DB risk in Mercer’s retirement business, adds: “Whatever your long term view of bond yields, many employers will want to stop the current bleeding caused by spiralling DB pension costs and for schemes that are still open to contributions this may well involve closing the scheme and moving to less expensive DC saving plans, yet DC plans are not immune, as the same economic conditions could cut the benefits paid out, causing problems for both employees and employers.
 
“DB plan trustees should be reviewing whether the employer covenant continues to support the level of pension risk being taken, including the risks associated with the continued provision of DB pensions. This requires scheme specific strategic thinking rather than following the herd. In some cases where the covenant supports investment risk, the ultimate cost of providing DB pensions may be lower than currently suggested by the high quality corporate bond yields that must be used for financial reporting of pension costs. In other cases where the employer covenant is stressed, the trustees and employer may need to work together to reduce the pension risk exposure. In all cases schemes should be actively reviewing their plans rather than waiting to see.”

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