Fitch: Brexit Vote Is Near-Term Negative for UK Pensions
We expect pension deficits to deteriorate further in 2016 as monetary policy changes lead to lower yields on high quality corporate bonds, which are used to determine the discount rate under IFRS. A declining discount rate generally inflates defined benefit schemes' liabilities and assets, but liabilities are more sensitive due to the longer duration of pension payments.
The effect of pension deficits on companies depends on the regulatory regime under which they operate. In funded systems like the UK, companies are required to hold sufficient assets to meet liabilities, with any shortfall being made good over a period agreed between trustees and employers. In the UK, The Pensions Regulator has significantly strengthened the hand of trustees in recent years, meaning increased deficits are likely to result in additional cash outflows into pension schemes.
Our corporate analysis focuses on the cash flow implications of a deficit, rather than adding deficits to our standard debt metrics. This recognises both the variability of deficits over time due to exogenous factors, and the different cash funding implications that deficits have in different jurisdictions.
The stance of The Pensions Regulator will be an important consideration for trustees going into negotiations post-Brexit referendum. To date this has been a long way from the unambiguous message of forbearance many corporates could have hoped for. The regulator has indicated it wants trustees and sponsors to focus on the longer term, but also to assess how the referendum result will affect employer covenants in the event of deteriorating business prospects.
At the same time the government's Work and Pensions committee has launched a broader consultation into defined benefit schemes, including the balance between meeting pension obligations and ensuring the viability of sponsoring employers. The recent pension issues at BHS will be a factor, but we believe this is likely to be reflected in tighter rules on pre-clearing M&A rather than a blanket tightening of funding requirements.
The cash impact on corporates will also be affected by the three-year timetable for most funding reviews. This will limit any immediate impact of widening liabilities but also delay any benefits from future improvements.
In a sample of 25 FTSE 100 companies, we found that pension deficits had declined by around one third in the 2015 financial year. This was mainly due to a 23 basis point increase in the average discount rate used and employer contributions equivalent to around 18% of 2014 deficits. However, a "lower for longer" interest rate environment resulting in additional cash contributions to address increased pension deficits could prove to be a credit negative for UK corporates.
Over the medium to longer term there is a strong chance that UK real interest rates will rise somewhat from current levels as monetary policy eventually normalises. Real 10-year bond yields in the UK are currently below the real growth rate of the economy, a pattern that contrasts with that seen from the early 1980s until the global financial crisis.