Pension deficits and the equity market

by George Hatjoullis

The defined benefit pension scheme is being phased out in the private sector but there are still substantial legacy schemes that remain, ultimately, the liability of the corporation. The precise relationship between the corporation and the scheme, as represented by the trustees, varies from jurisdiction to jurisdiction. In the UK, Deloitte’s offer a tidy guide to the issues at this address (

Conceptually the structure of the corporate pension scheme is quite simple. The scheme has existing pensions-in-payment and potential pensions-in-payment arising from current employees. The present value of these contingent liabilities is compared to the current value of assets and the difference is the pension deficit/surplus. The difference is either the liability or asset of the corporation depending upon the ‘covenant’ that exists between the corporation and trustees. The devil is in the detail of how the value of assets and contingent liabilities is calculated.

Assets are typically linked to market values but contingent liabilities are much more difficult to calculate and always incorporate some assumptions. The foundation reference point, however, is normally the relevant government bond yield curve. As yields go down, ceteris paribus, the value of contingent liabilities, and therefore pension deficits, goes up. This deficit is, in principle, a liability of the corporation and thus enters the corporation’s planning and financing decisions. It will also impact the market valuation of the corporation and potentially in a negative way. Logically, the opposite is also true which creates something of a paradox for equity valuations in a rising interest rate environment.

Rising interest rates is normally deemed a negative for equity valuation. The higher rates depress economic activity and thus earnings potential. The higher rates also depress the discounted present value of these potential future earnings. However, other things being equal, they also reduce the present value of contingent pension liabilities and, potentially, pension deficits. Ironically, the bigger the deficit the greater the benefit from rising bond yields. The reduced liability should have a positive effect on valuations, in part offsetting other negative influences. Another somewhat paradoxical effect is that it may improve the finances to such an extent that is allows greater capital expenditure, to the extent that such expenditure was constrained by the balance sheet. The pension effect may be quite significant for some corporations that have large pension legacies and this may materially impact the interest sensitivity of both valuation and predisposition to commit to further investment.

The sensitivity of pension deficits to yield changes in the UK is illustrated in this article from Investment and Pensions Europe (