Corporate bond yields have risen over the past 12 months, significantly reducing companies’ reported pension liabilities and accounting deficits, possibly even turning the latter into surpluses.
For a typical 1 billion fund this could add as much as 200m to the company’s balance sheet value.
Between 31 December 2006 and 31 December 2007, high-quality corporate bond yields rose from approximately 5.1% pa to about 5.8% pa, whilst long-dated gilt yields have held steady at 4.5% pa. This means the margin between gilt yields and bond yields has more than doubled from about 0.6% pa to about 1.3% pa – largely as a result of the global credit crunch.
“If the 0.7% pa increase in bond yields is translated into a 0.7% pa increase in the discount rate, companies may see the defined-benefit (DB) liabilities reported on their balance sheets reduced by as much as 20%, depending on the age profile of the membership. This would create a substantial one-off gain, all other things being equal, conceivably as much as 200m for a company with a 1 billion pension scheme,” says Gary Tansley of Hamish Wilson & Co.
“The problem is that the effects of the credit crunch are likely to be unwound over time, with the credit spread falling back again. As this happens, DB pension schemes’ reported liabilities will increase, giving rise to accounting losses.”
“This makes us question whether it is sensible for companies to increase their discount rates mechanically in line with corporate bond yields. In the context of their wider corporate objectives, finance directors would be well-advised to consider not taking credit for all the short-term gain without understanding the potential for the longer-term pain.”
“Companies that decide to exercise judgement in this way should discuss the scope for so doing with their auditor,” adds Tansley.