The debate over how to discount pension scheme liabilities has taken a crucial turn. The National Association of Pension Funds (NAPF) has rejected gilts as a basis for the discount rate, favouring a swap-based rate instead. The UK-based organisation, which represents more than 2,000 workplace pension schemes with €1tr in assets, is concerned that moving to gilts, would further increase pension scheme liabilities.   

Since the 1990s, AA-rated corporate bonds have been used to discount the liabilities of defined benefit pension schemes. In 2000, the Accounting Standards Board (ASB) endorsed this approach. It recently invited the pension fund community to comment on its discussion paper which addresses many issues in the accounting for pensions. A move away from the use of the AA bond rate to discount pension liabilities is one of its more controversial proposals.

The first set of accounting standards was set by the FASB which mandated AA corporate bonds as the discount rate. This presents a number of short-comings.  “AA corporate bonds tend to be dominated by financial institutions,” says Andrew Lennard, Director of Research at ASB, “and so may not be appropriate for many other companies.” In addition, corporate bonds generally have maturities of ten to fifteen years, while pension schemes have longer liabilities.

Defined benefit schemes are likely to see their liabilities increase if a gilt rate is used as the basis for discounting liabilities. Lennard notes that “ASB’s discussion paper proposes the use of a risk free rate, but does not specify whether that would be a gilt rate.”

DB schemes 

The process to adopt a new discount rate may well take more than two years. The ASB is expected to counter with final recommendations based on the answers it has received later this year. As the leading organisation representing defined benefit schemes, the response from the NAPF has been lukewarm at best. “A number of commentators have pointed out that a switch to a risk free rate would encourage the closure of defined benefit schemes,” says Lennard.  “If we continue to argue for a risk free rate, we may have to consider whether it should be a gilt rate or some other rate.  It is too early to say where we will end up on the issue.” 

A switch to a gilt rate would double reported liabilities for young pension schemes, increasing them by 60% and 25% for medium and mature schemes respectively. Young schemes are defined as those with durations of 29 years, while medium and mature with durations of 20 and 12 years.  A move to a gilt rate would increase the estimated liabilities of FTSE 350 schemes by €325bn, according to actuaries Punter Southall.

“There is no intellectual justification for using AA bond yields as the measure to discount pension fund liabilities and note that the credit crunch has shown this measure to be very volatile,” says Matthew Plail, Senior Consultant at Punter Southall. “Accounting for pensions using a risk free rate, such as gilts or swaps, runs counter to the best estimate approach adopted for valuing on-going concerns and will cause a big hit to company balance sheets. A sensible approach is to adopt the basis agreed by the scheme trustees and sponsor as set out in the Statement of Funding Principles. This reflects the circumstances of the scheme and reflects the true cash cost to the business.”

VB