UK pensions still exposed to volatile equities

Many UK pension schemes still face pension deficit volatility as a result of mismatches between assets and liabilities, according to a report by Mercer Human Resource Consulting.

Mercer's FTSE 350 Pension Scheme Survey claims that, for the most exposed 5% of the FTSE 350, the median impact of a one-in-20-year adverse event – for example, a major collapse in equity markets combined with low interest rates – could reduce their market capitalisation by at least 12%.

“This number is not surprising; UK pension schemes tend to be very risky entities with large asset/liability mismatches,” said Serkan Bektas, head of European pension solutions structuring at Barclays Capital in London. “When you look at an overall portfolio of a pension scheme, these types of events can reduce their funding levels very substantially.”

Mercer’s report states that, as at June 30, the average pension scheme for FTSE 350 companies has 59% invested in equities, down from 60% at the end of the first quarter. This exposure could leave funding positions of these pension schemes vulnerable to movements in equity markets. The fall in equity markets over the past two months could harm those pension funds with large equity portfolios, said Bektas.

“Recent movements in the stock market valuations led to declines in asset values while declining real interest rates pushed liability present values up. The combination of these two factors will adversely impact the funding positions of most UK pension schemes,” said Bektas.

The report found that overall pension scheme funding levels for FTSE 350 companies on an IAS19 basis improved from 93% as of March 31 to 98% at the end of the second quarter. This translates to a deficit of £9 billion versus a deficit of £35 billion at the end of the first quarter. Mercer attributed this improvement to positive equity returns and falling bond yields over the three-month period.

On a buyout basis – that is, the cost of converting a large pension scheme into an insurance company capable of meeting insolvency standards – Mercer estimates the aggregate deficit of FTSE 350 companies to be £120 billion as of June 30, down from £230 billion at the end of the first quarter.

This decline is attributed to a number of new entrants to the bulk-purchase annuity market, which has put downward pressure on bulk-annuity prices. Mercer estimates that increased competition has reduced the liability buyout premium above IAS19 levels from a historical 40% to around 25%.

Meanwhile, pension schemes are using more conservative mortality assumptions, reducing exposure to longevity risk. However, some participants say these assumptions still fall far short of reality.

“The pension schemes and actuarial profession have generally been strengthening their mortality assumptions, but they are still some way short of where they should be,” said Ed Jervis, risk and compliance director at Paternoster, a London-based bulk-annuity buyout insurer.