Pension obligations continue to represent significant financial risk for certain banks and will continue to require proactive risk management for many years to come, Standard & Poor’s Ratings Services noted in a report entitled “Defined-Benefit Pension Obligations: Massive Reductions In Deficits For Western European Banks Mask Underlying Risk.”
“Even though favorable market conditions during 2006 have resulted in a reduction in reported deficits under IAS19, we consider such improvements as temporary rather than permanent, and not indicative of a significant decrease in risk,” said Standard & Poor’s credit analyst Eddie Khamoo. “While benefits expected to be paid in the future have increased due to revised assumptions regarding longevity, and salary growth and inflation rates, improvements caused by the increase in the discount rate mask the real increase in expected benefit payments,” he added.
The accounting measure of deficit or surplus is a measure of funding levels that we expect to be very volatile over time, as it depends on the movements of very large asset and obligation values that, when offset, determine the deficit or surplus. Movements in asset and obligation values in turn depend on a variety of factors including bond yields and other market movements, and the application of asset-liability management strategies. Under IAS19, pension plan assets are measured at fair value and plan obligations are measured at the estimated value of benefit payments earned, discounted at the yield on high quality corporate bonds.
“We recognize that, to the extent assets include other than high quality corporate bonds, or there is a significant gap between asset and obligation values (surplus or deficit), asset returns and the discounting of obligations will not be correlated under this measurement approach, resulting in a potentially volatile measure of deficit or surplus that needs to be taken into account when analyzing this information,” said Standard & Poor’s credit analyst Michelle Brennan.
The report is a follow-up study of the defined-benefit pension plans of 45 Western European banks as at the end of the 2006 financial year. Our study is based on the top-50 Western European banks rated by Standard & Poor’s, extended to include certain banks in Portugal and Greece in order to gauge the wider impact of the pension obligations in Western Europe. For more information on the initial study, see “Defined-Benefit Pension Obligations: New Accounting Rules Mean Past Promises Return To Haunt Western European Banks,” published on Nov. 10, 2006.
“We consider that banks can do a lot to assist analysts and financial statement users to discern the financial risks arising from their benefit schemes by providing detailed analysis of their pension plans rather than complying with the minimum disclosures that IAS19 requires,” added Ms. Brennan.
The key additional disclosures that we would strongly encourage are:
— Disclosures of full sensitivity analyses to major assumptions;
— Components of the movements in actuarial gains and losses;
— Mortality assumptions;
— Funding plans for deficits;
— Whether management uses derivatives to hedge major pension risks such as exposure to interest rate movements;
— The extent that such risks are hedged; and
— Whether hedging instruments are held by the pension fund or elsewhere within the sponsoring bank.
“This additional quantitative and qualitative information would significantly help the users to convey the real picture behind these plans and bridge the gap arising from limitations in the accounting measurement of such complex structures,” she said.
