Lyncombe

Pension Deficits

Pension deficits arise in relation to funded pension schemes when there is a difference between the values of a pension schemes promised pension payments (pension liabilities) and the pension assets needed to fund these pension promises

Defined Benefit Pensions

A defined benefit (DB) pension is a promise by a pension provider to provide a certain pension payment at retirement. In the case of occupational DB schemes the pension provider or sponsor is usually the employer, who promises to pay the employee a pension on retirement, and can be thought of as deferred pay. The DB pension payment will depend on the salary earned by the employee while working (the accrual rate) and the number of years of service. The pension promise by the employer represents a liability for the firm which will need to be honoured at some point in the future. Defined benefit schemes are usually funded by contributions from both the employer and employee and represent the assets of the pension scheme. In a funded pension scheme the pension assets match the pension liabilities. If the pension funds are greater than the liabilities, the pension scheme is referred to as being over-funded; if the pension liabilities are greater than the assets, the scheme is under-funded and there is a pension deficit. The pension deficit is the difference between the value of the pension fund assets and the value of the pension liabilities.

Definitions

There are a number of different definitions of a pension deficit because any definition will depend upon how the values of the pension assets and the pension liabilities are calculated. It is fairly easy to estimate the value of pension assets, from the market value of the fund’s assets. Although as pension funds are long-term investors they tend to invest part of their portfolio in illiquid assets that might be difficult to value. More fundamentally it is the valuation of the pension liabilities that are inherently difficult to measure, because these pension payments will not occur for many years in the future, and the present value of these liabilities will depend on various modelling assumptions.

There are three conceptually different ways of estimating the value of pension liabilities, which in turn will mean three different measures of pension deficits. In addition each of these methods may have a range of underlying assumptions that can be varied with implications for the values of liabilities and deficits. The three methods are:

• A funding valuation or actuarial calculation which uses actuarial methods to compute the value of the liabilities;
• An accounting valuation that uses accounting principles to value the liabilities; and
• Buy-out valuation that uses a market-based approach by estimating how much a third party would pay to take over the pension liabilities.

The actuarial valuation establishes the value of a scheme’s assets and the required funding needed to ensure that the assets are able to pay the promised pensions as they fall due. The promised pensions are referred to as the ‘technical provisions’ or ‘funding target’, and will depend on assumptions made about mortality rates, investment returns (depending on the scheme’s asset allocation), inflation projections, and also on the strength of the pension-promise (employer covenant). The accounting valuation applies the relevant accounting standards (International Accounting Standard, IAS 19 or FRS17 in the UK) to value the pension liability and is the number companies use when reporting their annual accounts. IAS19 requires the use of the yield on long-term government bonds or AA corporate bonds as the discount rate to value liabilities, irrespective of the funds asset allocation, and these parameters will increase the value of the liabilities. On the other hand, some of the assumptions in the IA19 calculation can be set by the employer (such as longevity), and may result in a more optimistic value of the pension liabilities. The buy-out valuation assesses the cost of selling the pension liabilities of the scheme to an insurance company; so that the insurance company then takes over responsibility for paying out the promised benefits to the scheme members.

Pension Funding Requirements in US and UK

In US the calculation of pension contribution are based on both SEC (Securities and Exchange Commission) and IRS (Internal Revenue Service) form 5500 filings. Langbein and Wolk (2000) provide a detailed guideline on pension and employee benefits in the US. Generally speaking, firms with underfunded pension schemes are required to make contributions equal to the new benefits accrued during the previous year plus a fraction of the funding shortfall whilst firms with overfunded plans do not have to make contributions but the extent to which a scheme can be overfunded is limited by maximum deductibility laws to prevent firms from deliberately increasing pension plan surplus by reducing employee benefits.

Under the US pension law, firms with defined benefit pension plans are required to make contributions according to either minimum funding contribution (MFC) or the deficit reduction contribution (DRC) rule, whichever is larger. The former was first introduced in 1974 by the Employee Retirement Income Security Act (ERISA) which established the minimum funding standards for most voluntary pension and health plans in the private industry. According to MFC, firms must make annual contributions equal to the cost of benefits earned during the year (‘normal cost’) and any unfunded shortfalls in the plan (which may be amortised) in order to maintain a "funding standard account". The DRC is the contribution established to reduce the shortfall of the plan until the funding status reaches some threshold level, in which the plan assets are between 80% and 90% of the current liabilities of the plan (i.e. 80% to 90% funded).

Funding requirement in US were changed though the Pension Protection Act (PPA) which came into effect in 2008. The new PPA rules apply differently to single- and multi-employer plans. The funding requirement for single-employer plan is simply that a plan must stay fully funded (i.e. plan assets equal or exceed its liabilities). If a plan is fully funded, the minimum required contribution is the cost of benefits earned during the year. The contribution will also include the amount necessary to amortize the deficit over seven years if a plan is not fully funded and stricter rules will apply to severely underfunded plans or plans in ‘at-risk status’. For multi-employer pension plans, most of the pre-PPA funding rules will apply but the amortization period for benefit improvements will be shortened.

The British system of funding for DB pension plans is similar but was established later than its US counterpart, and only after the debacle of the Maxwell scandal of 1991. As a part of the Pensions Act 1995, the Minimum Funding Requirement (MFR) was introduced from April 1997 and applied to most private-sector defined benefit pension schemes. The MFR specified its own methods for calculating the funding status of defined benefit schemes and operated in a similar way to the DRC mentioned above. For a scheme which had a funding level less than 90% the sponsor had to make up the shortfall below 90% within three years whereas for schemes between 90% and 100% funded the shortfall had to be paid off over a period not to exceed ten years. The detailed methods and assumptions for minimum funding valuation were specified in Guidance Note 27 issued by the Institute of Actuaries and the Faculty of Actuaries and a summary can be found in Davis (2000). The Pensions Act 1995 also enforced a limit for scheme overfunding, where schemes more than 105% funded were required to reduce the surplus by benefit improvement or contribution decrease.

However the MFR was heavily criticised by Myners (2001). First in a number of cases, the level of assets required by the MFR proved insufficient to provide the benefits promised by the scheme. Second, it increased the regulatory costs for sponsoring firms without delivering the level of security as expected. Third, it made firms focus on meeting the requirements of the MFR, rather than on developing an appropriate funding strategy for meeting their specific pension commitments, which hampers firms from making appropriate investment decision. The Pensions Act 2004 replaced the MFR with a new scheme-specific ‘statutory funding objective’ (SFO), allowing more flexibly to individual schemes' circumstances whilst at the same time protecting members' benefits. Pension scheme trustees have the discretion to decide on an appropriate strategy for funding their pension commitments and making up any funding deficits, given advice from the actuary. Further, pension fund trustees are allowed the flexibility to choose the optimal funding plans that are ‘appropriate having regard to the nature and circumstances of the scheme’ (Pensions Act 2004, Section 226 Point 3), whether it is a short-term funding shortfall caused by cash flow difficulties or temporary decrease in asset values, or relates to its long-term pension obligations. In addition, the Pensions Act 2004, created two new regulatory institutions: the Pensions Regulator and the Pension Protection Fund. The Pensions Regulatory backs up the responsibilities of the trustees and is required to approve the schedule of contributions in the recovery plan, and has the power to review these contributions. The Pension Protection Fund was established to pay compensation to pension scheme members of defined benefit pension schemes whose sponsoring employer has become insolvent, and where there are insufficient assets in the pension scheme to cover the promised pension payments. However, Pension Protection Fund levels of compensation are capped in two respects: they only pay 90 per cent of the promised pension, and up to a maximum annual pension of £35,000 (Pensions in payment when the employer goes bankrupt will generally be honoured in full). The valuation of the PPF liabilities of a pension scheme is called an s179 valuation, and is also the valuation method used to assess the value of pension deficits of the PPF7800 Index.

Research

Since the introduction of FRS17 in 2001 and IAS19 in 2005, companies have had to report the value of their pension liabilities on their balance sheets. There are regular reports from HR consultants such as Lane Clarke and Peacock, Mercer, KPMG and Hymans Robertson on the funding status of company pension schemes. The UK’s Pension Protection Fund publish a monthly update on the funding status of the 6,000 eligible DB pension schemes that it regulates, as well as an annual “Purple Book”.

Academic research has examined the impact of pension deficits on corporate behaviour. Rauh (2006) examines the relationship between pension contributions and investments, to test the idea that in a financial constraints setting, required pension contributions will have an effect on investments. He warns that a negative relationship between investments and pension contributions should not necessarily be interpreted as evidence for financial constraints, since this correlation could also imply limited investment opportunities with firms making voluntary pension contributions instead. He suggests that to identify the effect of required pension contributions on investments one needs to condition on pension funding status, since in when funding status is negative, US pension regulations require companies to make mandatory pension contributions. Rauh notes that funding status might be correlated with investment opportunities, since if a firm has funding problems this could be because asset values are low due to low investment returns. He argues that the function relating funding status to investment opportunities is different from the function relating funding status to pension contributions, and therefore it is possible to identify the effect of contributions on investment. He uses an unbalanced panel of 1,522 Compustat firms that reported DB pension assets and made an IRS 5500 filing between 1990 and 1998. He finds that pension sponsors decrease spending on capital expenditures in response to a reduction in internal resources caused by required pension contributions. The point estimate of 0.60–0.70 is high and implies that a $1 increase in mandatory pension contributions reduces capital expenditures by $0.6-0.7. The response emerges most strongly in samples of firms that appear more constrained or more dependent on external finance,

Liu and Tonks (2012) assess the effect of pension deficits on company dividend and investment policies. Using a panel of all UK FTSE350 companies between 2001 and 2007 with DB pension schemes, they establish a strong negative relationship between the firm’s dividend payments and its mandatory pension contributions even after controlling for the endogeneity of pension funding status on dividends and investments. They find that the effect of pension contributions on investment is weaker than in Rauh (2006), implying that in the UK the response of balance sheet adjustments to financial pressures takes place through dividends rather than real investments. They also assess whether the funding requirements under the Pensions Act 2004 had any effect on firms’ expenditure decisions, and found that the dividend and investment sensitivities to pension contributions were more pronounced in and after 2005, indicating that these regulations had a significant effect on corporate expenditures.