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The Actuary The magazine of the Institute & Faculty of Actuaries

FTSE350 firms under-reporting pension deficits by £7bn

Two in three FTSE350 companies are using below market-implied inflation for pension accounting, according to a report from Hymans Robertson. In particular, considerable inconsistencies were found in the inflation and longevity assumptions used by companies to report their pension liabilities under IAS19.

Hymans Robertson’s FTSE 350 Accounting Assumptions Survey found that the government’s change in indexation from RPI to CPI has also introduced the need for a CPI assumption, though there is a wide discrepancy between schemes as they struggle to asset an accurate benchmark in the absence of CPI-linked bonds. Longevity assumptions also varied greatly across the FTSE350. The average assumed inflation adopted by FTSE350 companies was 0.1% below that implied by market yields, reducing reported deficit by £7bn.

Clive Fortes, head of corporate consulting at Hymans Robertson, added: "While two-thirds of FTSE350 companies adopt inflation assumptions below that implied by market yields, this is down from 82% last year. The average difference between assumed inflation and market implied inflation has fallen from 0.2% in 2009 to 0.1% in 2010.

"Our report also found a high degree of variation in CPI assumptions. The switch to CPI indexation has clearly saved companies considerable amounts of money - as much as £25bn across the FTSE350. There is, however, considerable uncertainty about the level of CPI inflation given the lack of appropriate CPI-linked bonds against which to benchmark CPI inflation making this estimate unreliable.

"Notwithstanding the uncertainty over future CPI inflation, based on the extent of the impact of the change to CPI, we estimate that the market demand for CPI-linked bonds by FTSE350 sponsored pension schemes could be approximately half of that for RPI-linked bonds. Although some investment banks are prepared to quote a price for CPI hedging, the market capacity is extremely thin. There is therefore likely to be a strong demand for Government-issued CPI bonds.

Mr Fortes also noted the significant difference in longevity assumptions being used. "What is surprising is the extent of the difference (7 to 8 years) and the apparent underestimate in the rate of future improvement in life expectancy. Current studies suggest increases of two years per decade, yet companies are assuming on average only a one year per decade improvement.

"Given the differences in assumptions, investors cannot simply take at face value reported IAS19 figures but need to analyse them and understand the risks inherent in pension schemes in a more comprehensive way."

Key findings of the survey
RPI assumptions:
>> 65% of FTSE350 companies use below market implied inflation for pension accounting
>> Average assumed inflation adopted by FTSE350 companies is 0.1% below that implied by market yields reducing reported deficit by £7bn
>> Considerable improvement over 2009 where 82% of companies used below market implied inflation with an average assumed inflation rate of 0.2% below that implied by market yields.

CPI assumptions
>> The Government’s change in indexation from RPI to CPI introduces need for a CPI assumption
>> In the absence of any market in CPI bonds, there is a high degree of uncertainty over CPI inflation
>> Wide range of CPI assumptions adopted by FTSE350 companies of between 2.3% and 3.4%
>> Average CPI assumption is 2.8% - 0.7% lower than the average RPI assumption, consistent with historic differences
>> Uncertainty highlights need for CPI-linked bonds.

Longevity assumptions
>> There is a 7-year age difference in assumed life expectancy across the FTSE 350 for pensioners and 8 years for non-pensioners
>> FTSE350 companies allow for life expectancy improvements of one year per decade on average, less than half the rate of improvement indicated by current trends (analysis produced by Club Vita indicates that life expectancy is increasing by at least 2 years per decade).