Most FTSE350 companies under-price inflation in their pension accounting
Key findings of Hymans Robertson’s “FTSE 350 Accounting Assumptions Survey”:
Discount rates:
• The range of discount rates was significantly wider in 2011 than in 2010, and skewed towards higher discount rates, reducing reported pension liabilities.
• In 2010, 92% of companies used a discount rate within 10 bps of the AA over 15 year yield, whereas this fell to 68% in 2011, with the remaining 32% of companies using a discount rate of 20 bps or more higher than AA over 15 year yield of 4.7% pa.
• Long-dated corporate bond yields fell 70bps over the year, meaning lower discount rates were used this year.
• Given the upward sloping yield curve and the wide dispersion of yields on AA stocks, it is perhaps surprising that there wasn’t greater dispersion of discount rates adopted by companies.
CPI inflation assumptions:
• 58% of companies disclosed a CPI linked increase on some pension increases in 2011, compared to 49% in 2010, reflecting the trend that more schemes now have certainty on their RPI/CPI position.
• On average, companies adopted a CPI assumption of 2.1% pa, 100 bps lower than the average RPI assumption.
• The assumed wedge between RPI and CPI of 100 bps is greater than the 70 bps disclosed in 2010, and reflects further analysis emerging in 2011 of greater technical differences between the two inflation measures than had previously been evident.
• However, the increase in the wedge may be a temporary feature as the Consumer Prices Advisory Committee is now consulting on a change to the way CPI is calculated, which would reduce this wedge.
RPI inflation assumptions:
• RPI inflation assumptions continue to vary across the FTSE 350, skewed towards a lower assumption than that implied directly by the UK gilt market.
• 43% of companies adopted an RPI inflation assumption lower than the 15+ year market implied inflation of 3.1% pa.
• 36% of companies used an RPI assumption of 3.1% pa, but as many pension schemes are longer in duration than 15+ year gilts, these companies arguably under-priced inflation.
Hymans Robertson, the UK’s leading independent experts in pensions and benefits, has published its “FTSE 350 Accounting Assumptions Survey”, analysing the key assumptions adopted by the FTSE 350 for their defined benefit pensions disclosures in 2011.
The report underlines that companies used a wider range of discount rates than in 2010, reflecting both the steepness of the yield curve and the wide range of credit spreads amongst AA stocks.
Most companies continue to under-price inflation in their pension accounting, implying that investors need to keep scrutinising pension risks inherent in company accounts.
The majority of companies now have CPI exposure in their pension schemes, and they typically assumed a much larger wedge between future RPI and CPI than in 2010.
Clive Fortes, Partner and Head of Corporate Consulting at Hymans Robertson, comments:
“We continue to see companies use the flexibility in IAS19 to formulate their own judgements on discount rates and long term inflation.
“Whilst the dispersion of AA yields continues, and the upward sloping yield curve remains, it is likely that there will continue to be a dispersion in the discount rates used for IAS19.
“Since AA bonds make up such a mixed bag, the market perception of what AA really means varies greatly, leading to a wider range of discount rates. In fact, it is perhaps surprising that there isn’t a wider range of discount rates being adopted given the dispersion in AA yields.
“There is considerably more dispersion in the assumptions adopted for inflation with a significant number of FTSE 350 companies using an inflation assumption below that implied by bond markets. Investors and analysts will therefore need to carry out more rigorous analysis of pension risks when scrutinizing company accounts.
“Companies continue to be optimistic about long term future returns on equities notwithstanding falling bond yields and continuing concerns over the Eurozone. However, from 2013 companies will no longer be permitted to take advance credit for investment returns in assessing their profits. As a result, we expect that investors and analysts will strip out any allowance for equity returns in assessing companies’ 2012 accounts.”
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