DB pensions are largely a thing of the past, as employers now prefer defined contribution schemes, where an employer commits only to add a certain amount to employees’ pots each month. This shifts the risk of the underlying asset performance from the employer onto the employee.
However, many companies retain legacy DB pension schemes. In accounting terms, a pension has two component parts; the defined benefit obligation (the present value of what the pension fund expects to pay out) and the pension assets. If the former exceeds the latter, i.e. if the company owes more than it can cover with the pension fund’s assets, then a net pension liability will be reported on the company’s balance sheet.
The issue with these pension liabilities is that they continue to grow beyond original estimates. As employees work for longer, they earn benefits which the company is obliged to provide. If, for example, the pension actuaries forecast an increase in life expectancy, companies will be required to provide an annuity for a longer period of time.
The recent rise in yields has changed this though, as the present value of these liabilities has shrunk. Present values are calculated using a discount rate which is linked to UK base rates. So as interest rates have risen, so the present value of future liabilities has shrunk.
While higher rates are testing many balance sheets and business models, companies with big DB pension scheme deficits may finally breathe a sigh of relief.
