Defined Benefit pension risk exposes Corporate UK to unhedged financial volatility – and potential deficit increase of £100bn in one year – RiskFirst report reveals.
The combined Defined Benefit (DB) pension deficits of the top-100 UK companies run the risk of an increase of over £25 billion* within one month, according to the new PF Risk ReportTM published today by pension risk specialists RiskFirst. Over a year, this could result in an increase of around £100 billion in the total deficit, potentially taking the deficit to over £140 billion (the current deficit stands at £43.5 billion across the FTSE-100). However, according to the report the real concern for the UK’s largest companies is the fact their exposure to market volatility remains unhedged.
“For several years the media and the pensions industry have focussed on pension deficits, but we believe the real issue is the volatility that sits beneath the headline numbers, and in publishing the PF Risk Report we are seeking to shift the debate to the far more important issue of risk,” says RiskFirst Analytics CEO Benjamin Reid. “This is a serious issue for all stakeholders – including pension scheme members and shareholders – because unhedged pension liabilities can result in significant exposure to market-directional risk.”
The report indicates that many UK companies (not just those in the FTSE-100) are running market exposures similar to hedge funds alongside their core business. However, unlike hedge funds, which are specifically mandated by their investors to take market exposure, most companies are ill-equipped to manage the high levels of financial market volatility embedded in their pensions schemes and shareholders typically have little information on the risks to which they are consequently exposed.
“An increase of £100 billion in DB pension deficits would clearly have a dramatic impact,” comments Matthew Bale, Director at RiskFirst and the key author of the report, “and would result in FTSE-100 companies having to make approximately £10 billion of increased cash contributions into their schemes each year with major P&L implications.”
This stark warning for FTSE-100 companies is detailed in the inaugural PF Risk Report, a new monthly analytical report on UK DB pension risk for FTSE-100 companies published by RiskFirst. Calculated using value-at-risk methodology and publicly-available data, the reports will offer a forward looking view of the pension assets and liabilities held by the UK’s largest companies. Uniquely, the reports will break down the pension risk into key risks including interest rate, inflation and equity risk. They will also reveal the likelihood and magnitude of future deterioration or improvements in the FTSE-100 pension schemes’ funding position.
As an illustration of the sensitivities that could potentially lead to increased deficits on this scale, a 20% decrease in equities would increase the aggregate deficit by £34.2 billion, and a 1% increase in long term inflation, would increase the deficit by £60.8 billion. The two events combined would increase the deficit by almost £100 billion.
“These are not wild predictions, but realistic scenarios,” says Reid, “which is why we believe that simply looking at a pension scheme’s deficit number is inadequate. Instead the analysis needs to go much deeper – looking at the key drivers and the extent to which they could change the deficit. By publishing this report, which is derived from individual scheme analysis, we hope to draw greater attention to volatility and the management of risk”