UK pension funds still exposed to volatility

A huge reduction in pension liabilities in the UK's top 100 companies last year is being jeopardised because fund managers have failed to rein in exposure to market volatility, say UK dealers.

Unfunded obligations under UK accounting rule FRS 17 stood at £39.9 billion at the end of last year, according to a report released last month by consultancy firm Watson Wyatt. That reduces by a third the levels reported at the outset of 2006, when deficits stood at a record high of £60.4 billion, and is the largest annual reduction since records began.

Funding levels were buoyed by equity and bond bull markets, helping close the gap between funds' assets and liabilities. Equity investments - still the staple of many funds - performed well over the 12-month period, with the FTSE 100 gaining nearly 15% since January.

At the same time, bond yields were more favourable after a torrid start to 2006, when the 4.25% 2055 gilt hit 3.54% on January 18. Since then, the yield on the 50-year gilt has averaged around 3.9%. That's important for UK pension funds, as they are required to value their liabilities using a discount rate based on corporate bond yields.

But a number of dealers say UK funds haven't learned from previous market downturns, adding that funding levels are still highly sensitive to equity, bond and inflation volatility. "Many funds are still as exposed to these risks as they were a year ago," says Bob Tyley, head of insurance and pensions solutions at Merrill Lynch in London.

Dealers say there has been de-risking at some funds, but it has mainly involved diversification of the investment portfolio, rather than managing the exposure within particular markets through the use of swaps, caps and floors.

Hope had been growing among some dealers that the Pension Protection Fund (PPF), a government-sponsored payer of last resort into which all pension schemes must pay a levy, might vary the amount individual funds have to pay into it according to the risk of their investments. But in a statement last month, the PPF board announced it was "unlikely to be appropriate to introduce an investment risk factor into the risk-based levy at the current time". The announcement precludes a consultation into such a risk-based levy that will conclude at the end of this month.

"I'm not sure that is the right thing to be saying to funds, and certainly isn't the approach some other pension regulators are taking," says Tyley. "The PPF may well be able to prop up a number of failing funds, but a systemic failure would both wipe out many corporates and the assets their schemes are invested in."

Nonetheless, Stephen Yeo, a London-based senior consultant at Watson Wyatt, says this year is set to see further reductions in funding mismatches, noting that shareholder aversion to huge pension deficits will prompt many corporates to throw extra money at the problem.

"There are signs that deficits may be experiencing the first part of a sustained fall," he says. "We estimate that FTSE 100 companies will make deficit contributions of at least £5 billion in 2007, in part to reduce the requirement to pay levies to the Pension Protection Fund."

Gareth Gore.