The pension Leviathan, bound to stir

Pensions, as an accounting and possibly a cash issue, are best kept under the carpet. Two things can wake up that monster: lower risk-free rates that kick future obligations higher and collapsing markets. A mighty double-whammy is in progress as it happens.

On the discount rate front (largely determined by ongoing risk-free rates), most corporates have pretended that sub-zero rates would not last (how does one value long-term rates with sub-zero discount rates?), so the best option was to keep a low profile and pray such rates go away. That may not happen post COVID-19, as central banks swamp markets with cheap money.

Before COVID, some regulators (Dutch and UK) were already banging on the table and pressuring sponsors (the funny pension industry nickname given to corporates paying pension defined benefits) to pay up in real money/assets for those never-closing deficits, i.e. pension deficits were no longer some exotic bit of accounting that previously no analyst masters but real cash out at the expense of shareholders.

This is not a funny perspective for companies which have essentially been unable to raise their FCF generation over the last decade (something that regulators obviously spotted and worried about).

Enter COVID and its inordinate capability to destroy every asset class. Pension plans were not exactly above water before COVID struck. As we write, there must be blood all over the wall and the pretence of pension funds to chase unlisted assets (Private Equity, infrastructure) will see them with their pants down when those ‘assets’ knock on the door with the begging bowl as underlying operations are way too geared for comfort. A total wipe-out may be the order of the day in some instances, if only because of the silly gearing. With that in mind, sponsors will be under even more pressure to cough up the cash that they do not have.

Obviously, governments will ask regulators to find a way and offer time to sponsors. Still, there will be, technically at least, more of the sponsors’ assets bound to go to pensioners.

Below is a summary chart of the parallel behaviour of funded obligations (i.e. pension obligations matched by assets in a pension fund somewhere) and plan assets, i.e. the market value of such assets. The gap between the two is c. €200bn (a deficit) to which €175bn in unfunded obligations must be added. We compute a combined pension deficit of €367bn by year end 2019. As a reminder, this is highly concentrated in a handful of “old” industries such as Autos, Steel, Banks, Insurance, Telcos, Utilities.

Funded pension obligations and plan assets: a gap before COVID

Any rough guess for 2020?

Before the COVID impact we were contemplating a €411bn deficit for 2020. Using 2008 as a proxy for the market impact (-18% on plan assets), the loss in value of plan assets would be c. €270bn, so that the deficit would hit €700bn even before an allowance is made for discount rates that look unwilling to help (see chart below). Even dollar-based obligations that enjoyed comparably high US rates may need to be reassessed. A very rough guess is that a 50bp drop in discount rates would expand combined deficits by c. €200bn.

Ever closer to zero do not help sponsors  

There is also the unknown of labour costs. The lower the wage inflation, the better the outlook for shareholders in their capacity as payers of last resort facing unbalanced pension obligations.

One would expect wages to reflect subdued growth. But governments now in control of the real economy as a result of the COVID crisis may decide otherwise. This is another paragraph to be written in the COVID post-mortem.   

More research about Pensions is available : click here