Risk. Management. Reward. Pension Obligations in Times of Financial Repression

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1 Risk. Management. Reward. Obligations in Times of Financial Repression

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3 Obligations in Times of Financial Repression Content 4 Obligations in Times of Financial Repression 4 International accounting rules for pension obligations in times of financial repression 7 obligation funding in times of financial repression 8 Case Study: Impacts of financial repression in practice 10 Possible effects of the funded status of pension obligations from the perspective of analysts and rating agencies 11 Summary Imprint Allianz Global Investors GmbH Bockenheimer Landstr Frankfurt am Main Global Capital Markets & Thematic Research Hans-Jörg Naumer (hjn) Ann-Katrin Petersen (akp) Stefan Scheurer (st) Data origin if not otherwise noted: Thomson Reuters Datastream Allianz Global Investors 3

4 Obligations in Times of Financial Repression Obligations in Times of Financial Repression Institutional investors are currently facing a wide range of pension management risks and challenges: together with the current low interest environment in the wake of financial repression, new European regulatory and accounting standards, such as Solvency II or IAS 19, are changing the previous approaches to risk management by institutional investors as well as their investment behaviour. In times of financial repression, what are the risks and challenges facing investors of pension assets and providers of occupational retirement provision? Michael Heim is a DAV actuary and an IVS-examined actuarial expert for pension schemes at Allianz Global Investors s department. After his studies in business mathematics at Ulm University he started his career with Allianz in He has more than 16 years experience in the field of occupational pension schemes. Dr. Bernhard Holwegler is Head of Allianz Treuhand GmbH and operates for the s division of Allianz Global Investors Europe since April After his banking apprenticeship he studied Economics at the University of Hohenheim, Stuttgart. Following his Ph.D. in Economics at the Chair of Economic Theory, he worked as an Executive Assistant and Consultant from 2002 to 2011 at Towers Watson. 1. International accounting rules for pension obligations in times of financial repression One of the aims of the International Financial Reporting Standards (IFRS) is to ensure that annual and consolidated financial statements are presented in an internationally comparable manner irrespective of national legislation. The use of IFRS by capital marketoriented companies is binding in numerous countries. The past reporting season has shown that the IFRS valuation of defined benefit plans is not only very volatile; it can also impact the 4

5 business result to an extent that should not be underestimated. Fundamentally, these valuations are based on the following parameters: Biometrics Probabilities for the occurrence of biometric risks including death, disability, etc. Dynamics Assumptions about the trend in pension benefits (e. g. for adjusting future ongoing pension payments) Discount rate Discounting future benefits at a rate that is appropriate for the maturity The discount rate is the most important economic parameter. It is used to discount future pension benefits to the respective reporting date for valuation purposes. Risk no. 1: The low discount rate Under international accounting regulations as defined in IFRS, the discount rate for calculating the pension obligation is closely linked to performance on capital markets. The discount rate is generally intended to reflect the current value of money. It is based on the current yield of fixed-interest corporate bonds with good credit ratings on the reporting date for valuation purposes. Such high quality corporate bonds (to use Standard & Poor s terminology) usually mean corporate bonds rated at least AA. This AA rating specification dates back to an SEC (SEC: U.S. Securities and Exchange Commission) announcement made at the beginning of the 1990s. The maturity and currency of bond and pension obligation must also match. If there is a change in the current yield on the relevant corporate bonds, the discount rate to be used as a basis for calculating the pension obligation also changes, due to the reporting date principle. Even though the nominal amount of the payment commitment remains unchanged, implications arise regarding the actuarial valuation of the pension obligation. The amount of the pension obligation in the accounts rises if the discount rate falls, and it falls if the discount rate rises. The prices of good quality corporate bonds have risen sharply, not least due to high demand for investments that many have considered as less risky as possible, especially from institutional investors. This has been accompanied by a fall in the yields on these bonds, which form the basis for calculating the discount rate under IFRS. Since the end of 2011, the discount rate for balanced groups has dropped from about 5.5 % to about 3.6 %. Figure 1 shows the IFRS discount rate trend and the impact of low discount rates on the level of pension obligation. Risk no. 1: The amount of the pension obligation in the accounts rises if the discount rate falls. Figure 1: Development of the IFRS discount rate and its impact on the level of pension obligation as of July 2013 IFRS discount rate for balanced groups Interest rate 5.5 % 5.0 % 4.5 % 4.0 % 3.5 % 3.0 % Percentage change in the level of pension obligation Interest rate 5.5 % 5.0 % 4.5 % 4.0 % 3.5 % 3.0 % Dec 11 Jan 12 Feb 12 Mar 12 Apr 12 May 12 Jun 12 Jul 12 Aug 12 Sep 12 Oct 12 Nov 12 Dec 12 Jan 13 Feb 13 Mar 13 Apr 13 May 13 Jun % 105 % 110 % 115 % 120 % 125 % 130 % 135 % Level of pension obligation 140 % 145 % Source: Towers Watson Source: Own calculations. Allianz Global Investors s, as of July 23 5

6 Obligations in Times of Financial Repression leap in the pension obligation, can no longer be subjected to deferred amortization but must instead be recognized immediately and directly in the statement of changes in equity. The three key changes that IAS 19 rev has imposed on the accounting standard for pension obligations are: Current discussion: Proposed extension of the AA rating specification to include A ratings for purposes of deriving the discount rate was rejected by the IASB Interpretations Committee at the beginning of August. 1 Detailed information about Discount rates low on the reporting date what effect could this have on the international valuation of pension liabilities? can be found here. Risk no. 2: The new IFRS accounting standards apply to financial years beginning on or after 01/01/2013, and will increase the volatility of the figures recognized in the balance sheet. Interpretation of the results The IFRS valuation of pension obligations can fluctuate strongly in line with the discount rate: Depending on the group of beneficiaries, a reduction of one percentage point in the discount rate can increase the pension obligation by 10 % 20 %. As discussed above, data about good quality corporate bonds constitute the basis for deriving the discount rate when accounting for pension obligations under IFRS. As a result of a number of downgrades by the rating agencies, the number of these high quality corporate bonds has continued to fall sharply in recent months. Efforts by various European corporations to extend the term high quality to include A-rated corporate bonds and thus to stabilize the database of suitable corporate bonds, respectively to produce a yield curve that is comparable to previous years, were rejected by the IASB Interpretations Committee (IASB: International Accounting Standards Board) at the beginning of August. 1 Risk no. 2: The new accounting standards under IAS 19 rev New IFRS accounting standards that substantially change and strengthen the accounting implications of low discount rates came into effect for financial years commencing on or after 01 / 01 / Accordingly, remeasurements, e. g. caused by a sudden 1. Abolition of the corridor method Deferred amortization of remeasurements, e. g. under the corridor method, is no longer permissible (according to the wording of the previous IAS 19, remeasurements were frequently designated as actuarial gains and losses). In line with current German Commercial Code (HGB / BilMoG), the liabilities on future IFRS balance sheets must indicate the net liability and / or net assets as the difference between pension obligation and pension assets. The abolition of the corridor method has already forced some well-known companies (including DAX-listed corporations) to report a sudden leap in their pension provision accompanied by a sharp drop in equity in their reports for the first quarter of Impact of the OCI method on equity Future remeasurements must be recognized immediately, completely and directly in equity, or more specifically according to IAS 1.81, in the statement of comprehensive income under OCI (Other Comprehensive Income). The recognition of the remeasurement in equity protects the income statement from excessive volatility. This approach is, in practice, often referred to as OCI or SoRIE method (SoRIE: Statement of Recognized Income and Expense). 3. Change in the return on pensions assets Future income statements must recognize a net interest item representing the interest cost or interest income arising from the net liability or net assets. In the terminology of the previous version of IAS 19, net interest comprises the sum of the interest cost and the expected return on plan assets, while the discount rate used to calculate the benefit obligation is now to be applied to both figures. Accordingly, the (expected) return on pension assets must no longer be determined individually for the company, and the allocation of the pension assets is irrelevant to its determination. 6

7 2. obligation funding in times of financial repression In recent years, numerous companies have successfully and sustainably funded their pension obligations. In this respect, funding means that the pension obligations are backed by offsettable assets as defined in international accounting standards (e. g. IFRS, US-GAAP) or national accounting regulations (HGB incl. German Accounting Law Modernization Act BilMoG). These companies recognize that occupational retirement provision must fulfil several requirements to retain its value: not only the need to be perceived by employees as an attractive employer, but also the need to back up the pension obligation with a funding strategy and to orient management of the investments on that basis. The press has repeatedly focused on the issue of pension obligation funding, not least as a result of the current low interest environment (see Figure 2). Risk no. 3: The low degree of funding 2 The historically low IFRS discount rate at yearend 2012 (year on year, it was as much as 2 percentage points lower) caused the pension obligations in the DAX and MDAX to rise by more than 20 % on average in each case. Funded pension obligations are backed by specific assets (in particular, equities, bonds, insurance-based solutions, etc.) that earned very good returns of more than 10 % on average in The sharp rise in the obligations outweighs the good performance by the pension assets, however, resulting in a considerably lower funded status of only about 58 % for DAX and about 44 % for MDAX company pensions, compared with a funded status of about 66 % (DAX), respectively about 49 % (MDAX) back at the end of By comparison, the funded states of company pensions were generally much higher internationally at the end of A typical US pension plan was funded to about 78 %, while in Switzerland the SMI company pension schemes reported a funded status of about 83 %. The average funded status of a Dutch pension fund was even higher, at around 102 %. The pension schemes of ATX-listed companies in Austria had a funding ratio of about 38 % (see Figure 3). Risk no. 3: Low funded status can exert additional pressure in the current low interest environment. 2 Source: Studies by Towers Watson, incl. announcement dated 21 February 2013 Figure 2: obligation funding in times of financial repression German companies should top up their pension provisions (FAZ, 14/03/2003) burdens are suffocating corporations (FTD, 14/08/2012) burdens are putting pressure on ThyssenKrupp (FTD, 21/03/2003) 10 years down the road, and still topical Dax corporations in the pension trap ThyssenKrupp: Relative to its market value, the steel conglomerate has a massive funding gap of 73 % (FAZ, 22/01/2013) Post: obligations are weighing on the company stock burdened by S&P s downgrading (manager magazin online, 07/02/2003) Dax corporations in the pension trap Volkswagen:... but the pension gap exceeds 20 per cent (FAZ, 22/01/2013) Source: Own Illustration. AllianzGlobal Investors s 7

8 Obligations in Times of Financial Repression 3 This more or less reflects the average funded status of the DAX 30 companies at the end of 2012 (58 %), the change in the discount rate between year-end 2011 and year-end 2012, and the average return earned by the pension assets of the DAX 30 companies in A reduced funded status does not incur any direct consequences for the companies, since neither national nor international accounting standards stipulate that the pension assets must be topped up. Nevertheless, the companies could face negative consequences, e. g. in the context of a reduced funded status or downgrade (see 4. Possible effects of the funded status of pension obligations from the perspective of analysts and rating agencies). and funded status, together with the resulting interdependencies, affect a fictitious company that prepares IFRS accounts. At the beginning of the accounting period, the funded status in this company is 50 %. As the discount rate declines from 5.5 % to 3.5 %, the pension obligations increase by 30 % at the end of the accounting period (see Risk no. 1). During the same period, the pension assets earn a return of 10 %. 3 During the first few months of 2013, the IFRS discount rate increased moderately, which can be interpreted as a sign of interest rate normalization and / or has taken the pressure off company pension schemes (see Figure 1). Irrespective of these developments, however, the trend in pension scheme funded status, especially in the DAX and MDAX, shows how sharply pension obligation valuations can fluctuate in tune with the discount rate, and how large the funding requirement can (still) be, even in major corporations. 3. Case Study: Impacts of financial repression in practice The following case study illustrates how the aforementioned risks in terms of discount rate trend, international accounting regulations From a simplified IFRS perspective, Figure 4 shows the trends and changes over the course of the accounting period, together with the resulting implications in respect of balance sheet recognition / funded status, pension expense and liquidity. 1. Balance sheet recognition / funded status The figure recognized in the balance sheet at the end of the accounting period is the net difference between pension obligation and pension assets (see Risk no. 2). The company is now reporting a pension provision of 775 monetary units, i. e. all other general conditions remaining equal, the sharp increase in the pension obligation has caused the funded status to drop from 50 % to about 40 %, despite high earnings from investments (see Risk no. 3). The decline in funded status is mainly due to the reduced discount rate (see Risk no. 1). Figure 3: Funded states of company pension schemes at year end % 100 % Funded status trends in the DAX 110 % 100 % Funded states by international comparison at end % % 80 % 80 % 70 % 70 % 60 %? 60 % 50 % 50 % 40 % 40 % 30 % Germany 30 % Austria USA Switzerland Netherlands Source: Towers Watson; Past performance is not a reliable indicator of future results. 8

9 2. expense In the income statement portion of the pension expense, the service cost and net interest are both taken into consideration (consisting of the interest cost for the pension obligation and the interest income from plan assets, in each case based on the discount rate for calculating pension obligations). The income statement shows a pension expense in the amount of 52.5 monetary units. The remeasurements at the end of the accounting period are also materially affected by the lower discount rate and the associated increase in the pension obligation. The fictitious company recognizes monetary units directly in equity. In the terminology of IAS 19 rev. 2011, a negative (positive) sign implies an actuarial loss (gain) that can reduce (increase) equity (see Risk no. 2). Figure 4: Impacts on balance sheet recognition / funded status, pension expense and liquidity Start of accouting period End of accounting period 1. Balance sheet recognition 2. expense 3. Liquidity Actual values Expected values Actual values Income statement OCI obligation at the start of the accounting period 1, % Service cost Interest cost (5.5 %) payments Remeasurement obligation at the end of the accounting period 1,030 1,300 1,300 assets at the start of the accounting period % Contributions payments Interest income (5.5 %) Remeasurement assets at the end of the accounting period Funded status 50 % 40 % Source: All numbers represent monetary units. Own Illustration. Allianz Global Investors s 9

10 Obligations in Times of Financial Repression 3. Liquidity The company withdraws payments to beneficiaries entirely from pension assets, and contributes 25 monetary units to the plan assets, both of which impact liquidity. Figure 5 compares the expected and actual situations at the end of the year, and the resulting funded status. 4. Possible effects of the funded status of pension obligations from the perspective of analysts and rating agencies Analysts and rating agencies have become steadily more interested in pension risk management in recent years. Ever closer attention is being paid to both the status quo and the development of pension obligations and pension assets, together with the resulting implications in terms of funded status. Measures and strategies implemented by individual companies to deal with their pension risk (such as ALM Asset Liability Management, LDI Liability Driven Investment) can impact the analysis generally positively. Analysts and rating agencies generally classify unfunded pension obligations as debt with the resulting possible upgrade or downgrade of the company. One key financial indicator that is frequently analyzed compares EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) as a ratio of debt. In the case of the company from our case study, Figure 5: Comparison of expected and actual situation at year end Actual situation at start of year Expected situation at year end Actual situation at year end Balance sheet Balance sheet Balance sheet Assets Equity Borrowings provision 500 Assets Equity Borrowings OCI 0 provision Assets Equity Borrowings provision OCI Funded status 50 % assets obligation Expected funded status 49 % assets obligation Actual funded status 40 % assets obligation 500 1, , ,300 Source: All numbers represent monetary units. Own Illustration. Allianz Global Investors s Figure 6: Example of key financial indicator Debt / EBITDA Example 2.7 Downgrade possible Upgrade possible Adjusted Debt / EBITDA Reported Debt / EBITDA Source: Own Illustration. Allianz Global Investors s The hypothetical performance and simulations shown are for illustrative purposes only and do not represent actual performance; they are not a reliable indicator for future results. 10

11 debt would thus have to be measured at 775 monetary units compared to 500 monetary units the previous year. Analyzing the company as a whole, this key financial indicator can therefore increase and thus deteriorate. Figure 6 illustrates how the key indicator can increase when unfunded pension obligations are counted as debt, and can thus contribute to a possible downgrade. 5. Summary management is facing huge risks and challenges, not just in the wake of the new accounting regulations for pension obligations under IAS 19 rev. 2011, but also under the influence of financial repression (see Figure 7). In light of the very low discount rate and frequently resulting low degree of pension obligation funding, many institutional investors are currently rethinking their risk management and investment behaviour. However, company pension schemes have by their very nature a very long-term investment horizon. Decades may pass between making a pension commitment and actually paying out benefits. This provides companies with the chance to balance out fluctuations in the funded status over the long term. In addition, companies can also adjust and actively manage the pension assets to reflect the current situation on capital markets even in times of financial repression. Against this backdrop, ever more companies are not only modifying their pension commitments (the proportion of defined contribution pension schemes is growing steadily), but are also increasingly relying on intelligent investment concepts, e. g. to help keep the funded status of their pension schemes as stable as possible, even in difficult market conditions. Figure 7: Current pension management risks: low interest environment, IAS 19, etc. How sensitive is my pension obligation to interest rates? Should I consider dynamic funding of the pension obligation? Should I invest in alternative asset classes? How can I best prepare for deflationary and inflationary scenarios? What actuarial risks are my defined benefit plans facing? How will rising interest rates impact my (bond) portfolio? How does longevity risk affect my portfolio? Low interest rates: how can I earn a target yield of 4 % p.a. with reasonable risk exposure? To what extent am I going to be affected by the new accounting rules under IAS 19? Do I need to adjust my strategic asset allocation? Source: Own Illustration.. Allianz Global Investors s 11

12 Obligations in Times of Financial Repression Do you know the other publications of Allianz GI Global Capital Markets & Thematic Research Risk. Management. Reward. Smart Risk investing in times of financial repression Strategic Asset Allocation Managing Risk in a time of Deleveraging Active Management The New Zoology of Investment Risk Management Constant Proportion Portfolio Insurance (CPPI) Portfolio Health Check : Preparing for Financial Repression Financial Repression Shrinking mountains of debt International monetary policy in the era of financial repression: a paradigm shift Financial Repression and Regulation: Paradigm Shift for Insurance Companies & Institutions for Occupational Retirement Provision Silent Deleveraging or debt haircut? that is the question Financial Repression A silent way to reduce debt Financial Repression It is happening already EMU You can find our wide-ranging supply of publications on the euro on our Market Insights section Bonds Duration Risk: Anatomy of modern bond bear markets Emerging Market currencies are likely to appreciate in the coming years High Yield corporate bonds US High-Yield Bond Market Large, Liquid, Attractive Credit Spread Compensation for Default Corporate Bonds Why Asian Bonds? Dividends Dividend Strategies and Troughs in Earnings Revisions Dividend Stocks an attractive addition to a portfolio Dividend strategies in an environment of inflation and deflation High payout ratio = high earnings growth in the future Changing World Renewable Energies Investing against the climate change The green Kondratieff Crises: The Creative Power of Destruction Demography Discount rates low on the reporting dates IFRS Accounting of Obligations Demographic Turning Point (Part 1) Systems in a Demographic Transition (Part 2) Demography as an Investment Opportunity (Part 3) Behavioral Finance Reining in Lack of Investor Discipline: The Ulysses Strategy Overcoming Investor Paralysis: Invest more tomorrow Outsmart yourself! Investors are only human too Two minds at work All our publications, analysis and studies can be found on the following webpage: / AllianzGI_VIEW 12

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14 Allianz Global Investors GmbH Bockenheimer Landstr Frankfurt am Main October 2013