Mercer: Pension Liabilities May Be Overstated By GBP40bn

by Robin Pilgrim, LawAndTax-News.com, London

23 November 2009

FTSE 350 companies may be collectively overstating or understating their pension liabilities by as much as GBP40bn, according to new analysis by Mercer. Most analysis suggests that the outlook for long-term inflation is overstated and Mercer would concur that some downward adjustment is often appropriate; however, such adjustment is subjective and is likely to vary by company.

According to data analyzed by Mercer, at March 31, the long-term price inflation assumptions of the FTSE 350 varied by 0.8% from 2.6% to 3.4% a year. The discrepancies are caused by the current uncertainty in the price inflation assumption underlying the calculation of pension scheme liabilities. The effect of the price inflation assumption, alongside uncertainty in other assumptions, illustrates the difficulties in determining whether share price valuations effectively reflect the impact of pension liabilities.

“Either extreme could be right but most companies’ inflation assumptions are currently somewhere in the middle,” commented Warren Singer, principal at Mercer. “However, there is no economist consensus on the changing nature of UK inflation over the next five years, let alone for the decades over which pension benefits are paid, so the difficulty is obvious.”

UK pension benefits are closely linked to price inflation over many years into the future – more so than is the case in other countries. UK pension liabilities commonly allow for price inflation based on the yields on nominal and inflation linked bonds issued by the UK government.

According to Singer, “The traditional method used in the UK reflects the price of hedging against inflation risk as measured by government bond or swap markets – this is influenced by supply, demand and investor preferences and fears. Over the long term, though, it has been a less than perfect measure. Most analysis suggests that it overstates the outlook for long-term inflation and Mercer would concur that some downward adjustment is often appropriate – however, such adjustment is subjective and is likely to vary by company.”

“In 1999 the government bond market implied that price inflation would average about 2.2% per year over the 10 years starting from the end of January 1999, compared to about 3.4% per year over the 10 years starting from the end of July 1999. In fact, actual price inflation has averaged about 2.6% per year over both 10-year periods,” continued Singer.

Mercer’s analysis suggests that, whilst this level of volatility will be due partly to the market trying to settle on a price for long-term inflation expectations, it is likely to be exacerbated by other market influences that have little to do with inflation. Looking forward, Mercer believes that the difference between the market price for long-term inflation and the underlying inflation expectations will depend on the time period being considered and will vary from month to month.

The International Accounting Standards Board (IASB) is expected to consult in the next few months as part of an updating of the accounting standard for pensions. According to Singer, the IASB is likely to require additional disclosures to highlight to investors the impact on pension liabilities of material risks such as the uncertain UK inflation assumption.

Mercer recommends that, as companies prepare for their calendar year end accounting disclosures, they reconsider the inflation assumption used for their pension liabilities – in particular, whether inflation is being estimated over a time period that is suitable for their plan liabilities. “They may also wish to consider other evidence available from the Bank of England and economists in determining whether their inflation assumption should differ from a traditional market-based measure,” concluded Singer.

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