BREAKINGVIEWS-Pension discount-rate relief is easy to overstate
(The author is a Reuters Breakingviews columnist. The opinions expressed are his own.)
By Robert Cole
LONDON, July 4 (Reuters Breakingviews) - Not everyone is fretting about rising bond yields. While bondholders don’t like lower capital values and borrowers worry about higher costs, sponsors of defined-benefit (DB) pension plans are generally very happy, even if the plans have big bond portfolios. They can thank the accountants.
Why? Standard practice is to translate the expected sum of future pension payments into a current value by totting them up and then applying a discount factor to capture the present value of future cash. The discount rate applied is usually the prevailing bond yield.
Higher yields reduce this present value. Over the last year, the yield on 10-year U.S. Treasuries has risen from 1.5 to 2.4 percent. That reduces the sum needed to fund a $1,000 liability due in ten years from $862 to $781.
Given that worldwide defined-pension-plan assets are estimated at $16 trillion, the implication for liabilities is enormous. Analysts at Goldman Sachs calculate that, if yields move as they expect, UK pension liabilities could decline from 1.3 trillion pounds to 1 trillion pounds by the end of 2016. For some pension schemes that were struggling with massive deficits, it may be the difference between reported disaster and actuarially endorsed equilibrium.
The choice of bond yield as the discount rate is not entirely illogical. But the relationship between yields, inflation and investment returns is complex, especially when bonds are under the influence of financially repressive monetary policy.
The current government-bond rate may actually be too low. Some blend of equity and fixed-income returns might better reflect pension funds' asset-allocation positions. On the other hand, the sponsors’ current relief cannot change the reality that defined-benefit pensions are an open-ended commitment of uncertain size. The accounting adjustment does not justify complacency about funding or riskier investment strategies.
The future lasts a long time, so assumptions are likely to be changed many times between now and then. The funding picture remains uncertain and fraught.
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- The yield on 10-year U.S. Treasury bonds, which hovered around 1.5 percent in June and July last year, has recently risen to 2.5 percent. The yield on 10-year UK government bonds, which sat at 1.6 percent on May 6, 2013, has climbed to 2.4 percent.
- A report published on July 2 by Goldman Sachs, the investment bank, stated: “Falling bond yields have weighed on pension fund and insurance company solvency over recent years, and rising bond yields are therefore a clear positive as their liabilities are discounted more”.
- The Towers Watson Global Pension Assets Study for 2013 valued the worldwide total invested in retirement schemes at $29.7 trillion. About 17 trillion is in U.S. schemes, with another 3.7 trillion in Japan and 2.7 trillion in the UK. The same study indicated that 55 percent of the worldwide total is held for defined-benefit schemes and 45 percent for defined-contribution plans.
- Towers Watson study link.reuters.com/zyk49t
- For previous columns by the author, Reuters customers can click on [COLE/]
(Editing by Edward Hadas and Sarah Bailey)
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