Better pension funding in Europe may not be sustained

European companies' pension plans suffered less damage than their US counterparts' in 2008, Moody's Investors Service said in a Special Comment published Thursday. However, companies on this side of the Atlantic are vulnerable should a future narrowing in credit spreads not be offset by a recovery in asset prices.
The Moody's report compares the performance of the largest pension plans sponsored by non-financial companies in Europe and the US. The study shows that the Europeans suffered a median negative return of 14% on their pension plan investments in 2008, significantly better than the 24% decline calculated by the rating agency for their US counterparts.
Estimated investment returns in Europe ranged from plus 8% at Rolls-Royce to minus 29% at Shell. At the end of 2008, the median funding level — pension assets expressed as a percentage of the funded pension obligation — derived from the companies' financial statements was 93% for the Europeans compared with 79% for the US companies.
"European companies, which generally have a lower exposure to equities than those in the US, benefited from relatively better (or less bad) returns on their pension plan investments, but their outperformance in funding level terms was also due to an increase in the rate used to discount the pension obligation," said Trevor Pijper, a Moody's Vice President and author of the report. The higher discount rates used by the European companies are largely due to a widening in the "spread" of corporate bond yields over "risk-free" government bonds. Using a higher discount rate reduces the size of the pension obligation because the pensions promised to employees are worth less in present value terms. 70% of the European companies included in Moody's study reported a reduction of at least 5% in their aggregate pension obligation as a result of discount rate-induced actuarial gains. Only 15% of the US sample enjoyed a similar benefit.
Moody's adds pension deficits to debt for credit analysis purposes, but the rating agency also pays particular attention to their adverse effect on the cash flow of the sponsoring employer. When BT Group's credit rating was downgraded in March this year, Moody's pointed out that the company's financial flexibility remained constrained by cash outflows needed to fund the deficit in the BT Pension Scheme. The valuation of the scheme undertaken for funding purposes is likely to identify a deficit that is significantly bigger than the discount rate-boosted figure reported in the financial statements.
While European companies are ahead of their US counterparts for now, deterioration in the funded status of their pension plans caused by a narrowing in credit spreads and a lower real discount rate could feature in certain semi-annual reports released over the next few months.