Pension Accounting Liabilities – A real world perspective

19th November 2014

• Once upon a time….no disclosures!

• Then, basic disclosures with subjective assumptions (e.g. SSAP24)

• Move in the late ’90s towards more stringent assumption setting, particularly discount rate (1998 – IAS19, 2001 -FRS17)

– Discount rates based on yields on high quality (AA) corporate bonds

– Expected return on assets allowed to offset financing charge

A brief history

• IAS19 compulsory for all EU-listed entities from 2005

• More recently, expected return on assets replaced by interest on assets (IAS19 revised 2011, FRS102, possible moves in US GAAP)

A brief history (cont.)

The role of the (pensions) actuary

• Advise on assumptions

– But not the ultimate owner!

• Calculate liabilities and relevant P&L items

– Assess experience

– Explain movements

• Provide report

– Assist in additional disclosure items (assets, risks etc)

• Sit back and relax…

– (until discount rates start to plummet)

Recent trends in discount rates

2014 – cause and effect

• Further significant (perhaps over 100 bps) fall in yields on highly-rated (AA) corporate bonds…

• …leading to significant fall in discount rates used to value pension scheme liabilities…

• …leading generally to further increases in deficits at year end and P&L charges for following year (FY15)

Recent progression of liabilities and costs

Based on a closed scheme of duration 20 and €2m pensions in payment in 2010; no change in any assumption other than discount rate; no benefit changes

Reactions to deficits

• Range of impacts and attitudes:

– “It’s just an accounting number, right?”

– “This is a temporary market aberration, it will revert to normal soon won’t it?”

– “This puts the future of the scheme, some jobs and even the whole operation into doubt”

• Similarly, there is a range of interpretations

– Accept disclosures as presented or adjust for other information?

Who cares?

• Will differ depending on (among other things):

– Financial institutions v non-financial

– Listed v unlisted

– Location of ultimate parent company if part of multi-national, plus internal profitability measures

• Aim for this evening is to understand who takes which stance, and why

Disclosure: Davy is a member of the Irish Stock Exchange and London Stock Exchange, authorised by the

Financial Regulator under the Stock Exchange Act, 1995. All prices as of close of previous trading day unless

otherwise indicated. For the attention of US clients of Davy Securities Limited, this third-party research report

has been produced by our affiliate, J&E Davy. Please see important disclosures at the end of this report.

A ‘capital consuming’ risk

Pension Deficits

Financials Analyst:

Emer Lang

emer.lang@davy.ie

+353 1 6148925

November 2014

11

Pension deficits: Investor issues

Issues

Volatility

External factors

Capital impact

Rating agencies

Valuation impact

Discount rate

12

Pension Deficits: Investor issues

• Magnitude of movement is unpredictable, creating volatility

• Does it make sense to use a corporate AA bond yield?

• Driven by external factors, frustrating for management

• Potential impact on bank/insurer valuations

• Tangible impact on bank/insurer capital under Basel 111/Solvency 2

• Impact on credit ratings

13

Pension Deficits: unpredictable

Investors ‘penalise’ companies for DB volatility

• A report by Llewellyn Consulting (Sept ‘14) suggested that the share prices of the FTSE 100

companies with the largest DB schemes were penalised. It found that ‘in the UK, the market

appears to give a large and significant weight to the DB pension net asset positions of FTSE

100 companies’. It found that a company’s market valuation ‘generally reflects the possibility

of an increased deficit’.

• They suggest from a practical perspective, many investors are unlikely to make formal

calculations of the inconsistencies in assumptions and market discount rates: i.e. it is more

likely they simply apply a rule of thumb, e.g. adding 20%-odd to reported pension liabilities.

Direction of deficit usually (but not always) apparent; magnitude less predictable

• E.g. in BOIs case the Nov 2012 IMS noted the deficit had risen from €1bn to €1.6bn reflecting

a lower discount rate (which was not disclosed). Corporate bond yields continued to decline

towards year end and the market expected a higher deficit. However the reported deficit was

€1.2bn.

14

Pension Deficits: Bank of Ireland’s experience

BOI secured

a staff deal

in 2010 but

rapid decline

in discount

rate in 2012

largely

offset

benefit

Another deal

was a

strategic

objective & a

prerequisite of

its capital

transaction in

Dec 2013

IMS signals

another (not

quantified)

increase in

H2 2014

15

Pension Deficits: AIB’s experience

DB pension fund

closed to future

accrual in 2013; all

staff transferred to

DC; one-off

curtailment gain of

€240m

Agreed hybrid

deal in 2007

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

0

200

400

600

800

1000

1200

2008 2009 2010 2011 2012 2013 H1'14

Def icit €bn Discount rate %

DB schemeclosed to accrual

Additional contributions

16

Pension Deficits: PTSBs experience

Rising deficit at

loss-making

PTSB prompted

bank to

implement a

radical solution

Discontinued

contributions

to/wound up the

defined benefit

staff pension

schemes in 2013

Current estimate

would be €500m

(CEO at recent

sub-Committee

hearing)

17

Pension Deficits: FBDs experience

Members of the

Group’s defined

benefit pension

scheme

agreed to a

restructuring of

pension benefits

and the

introduction of

pension

contributions in

2010

18

Pension deficits: directly impact pension cost

Pension as % of

total costs

2011 2012 2013

BOI 5.3% 4.3% 8.4%

AIB 4.8% nm nm

PTSB 11.4% 11.7% 5.7%

FBD 7.0% 7.2% 7.9%

• P&L charge vs. cash? Investors do not typically use cash-flow analysis for banks

• Pension costs vary as a % of total costs. Direction has been upwards, particularly from

2013

• AIB recognised a one-off curtailment gain.

• BOI is the only bank to retain a DB component, key to its 2nd deal in three years.

• PTSBs radical solution addresses both balance sheet & P&L

19

Pension Deficits: a management challenge

Bank commentary shows deficits have been an issue for management:

BOI

• 2012 results briefing: ‘Size of pension deficit and change in pension accounting rules will be a

headwind from 2013 - c.€40m impact; engagement on this issue has commenced.’

• Interim 2013: ‘We continue to work on actions to mitigate the current deficit in the defined benefit

pension schemes’

• Nov ‘13 IMS: Shared solution involves changes to members‟ potential defined benefits which, on a

fully implemented basis, would reduce the IAS 19 BSPF defined benefit pension deficit by approx.

€400m and would be income positive for the Group

AIB

• CEO David Duffy: ‘The cost of continuing to provide a large number of our staff with a defined

benefit pension has become prohibitively expensive for the bank.’

• Rationale for the closure of the DB schemes: the objectives of a return to profitability/providing a

return for the State over time; ‘the DB liability would have continued to grow over the next 10 years

to unsustainable levels; from a market perspective this could have had a negative consequence for

AIB’s capital; the Bank’s accounting, capital and funding volatility is helped by this change’

PTSB

• 2013 Annual Report: ‘One of the critical items that the Group has had to deal with during 2013 was

the impending material reduction in capital arising from pension scheme deficits. These pension

schemes had significant on‐going costs and substantial risk of this deficit level growing further’

• ‘Therefore, whilst pension fund risk could have been a material, capital‐consuming risk for the

Group, it is fully mitigated through the actions described above’ (i.e. decision to discontinue

contributions to/wind up the defined benefit staff pension schemes)

20

Pension Deficits: impact on banks

Deficits reduce TNAV; a key metric for valuing a loss-making bank

• It goes without saying a deficit is a bigger deal for a stressed bank

• In the absence of PEs and dividends, we rely on a sustainable returns valuation

model which uses TNAV as a base.

Deficits consume capital

• Under Basel 11 banks could add back pension deficits to regulatory capital;

• Basel 111 phases in the deficit deduction, but many investors are already looking

through to fully loaded metrics

• Existing deficits contribute to Irish banks screening poorly on FL ratios (bottom 10

in recently published ECB stress scenario results)

21

Pension Deficits: Market reaction to BOI moves?

2010 restructuring (Mar) 2013 restructuring (Oct)

Hard to pinpoint as on both occasions the pension deal was part of a broader, well

flagged capital package

22

Pension Deficits: a rating agency perspective

• Moody’s upgraded British Airways' rating to Ba3; stable outlook 9th May 2014

‘Although not expected currently, there could be negative pressure on the rating or outlook if

BA's earnings were to deteriorate, or if there were a material increase in the pension deficit’

• Moody’s changed to positive from stable the outlook for Lufthansa 28th May 2014

"We have changed Lufthansa's rating outlook to positive on the back of improvements to the

company's credit metrics over the past year. Such improvements reflect Lufthansa's reduced

leverage, as a result of lower reported debt, as well as a EUR1.1 billion reduction in the

company's pension deficit.“

• That pension deficits directly impact on credit rating agency views – they see it as

a genuine liability - has potential implications for banks’ funding costs

• Moody’s on BOI in Jan 2014

‘BOI’s latest pension deficit reduction plan Is credit positive.’

• Fitch on BOI in Feb 2014

BOI’s capital base is relatively weak with large deductions made for the GBP1.8bn 2009 perpetual

preference shares, as well as large deferred tax assets (DTAs) and pension deficit. The pension

agreement in October 2013 is expected to benefit CET1 capital by around EUR400m at end-

1H14 (80bp to the CET1 ratio). BOI’s pension deficit remains sensitive to movements in the

discount rate.

23

Banks Presentation

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Further important disclosures relevant to this material may be viewed on the Davy website

at www.davy.ie/disclosures.

For the attention of US clients of Davy Securities Limited, this third-party document has been

produced by our affiliate, J & E Davy

Pension Accounting Liabilities – A real world perspective

Oliver Holt

Alexander Hotel,

Wednesday 19 November 2014

Impact on general business balance sheets

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Pensions are to an Employer’s wealth as smoking is to your health!

When did we first know smoking was bad for your health?

A. 1912

B. 1948

C. 1964

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When did we first know smoking was bad for your health?

• In 1912, American Dr. Isaac Adler was the first to strongly suggest that lung cancer is related to smoking:

Isaac Adler. "Primary Malignant Growth of the Lung and Bronchi". (1912) New York, Longmans, Green. pp.

3-12.

• In 1948, British epidemiologist Richard Doll published the first major study that proved that smoking could

cause serious health damage: Doll, Rich; and Hilly, A. Bradford (September 30, 1950). "Smoking and

carcinoma of the lung. Preliminary report". British Medical Journal (4682): 739–48

• In 1964 the United States Surgeon General's Report on Smoking and Health suggested a link between

smoking and cancer. This eventually led to bans on certain advertising, and requirements for warning labels

on tobacco products.

http://en.wikipedia.org/wiki/History_of_smoking

27

When did we first know that Defined Benefit Pension Schemes

were bad for the Employer’s wealth?

28

A. 1912

B. 1948

C. 1964

Warren Buffet

2014

29

“Citizens and public officials typically under-appreciated the

gigantic financial tapeworm that was born when promises were

made that conflicted with a willingness to fund them.”

D. None of the above – we still don’t!!

When did we first know that Defined Benefit Pension Schemes

were bad for the Employer’s wealth?

30

14 October 1975

Berkshire Hathaway Inc. Annual Report 2013: Pg118 – 136 reprint of Warren Buffet’s 1975

memorandum to Katharine Graham, then chairman of The Washington Post Company, about the

pitfalls of pension promises and the importance of investment policy:

http://www.berkshirehathaway.com/reports.html

Investors….their perceptions

Two rules to increase wealth:

Rule no. 1 Don’t make any losses

Rule no. 2 Read rule no. 1

Risk is the enemy of the investor

Volatility is a bigger enemy

31

DB Pensions are a potentially significant destroyer of investors

wealth….

Deficits in the Defined Benefit pension schemes of the

largest Irish private and public sector bodies more than

doubled between January and August 2014, according

to an analysis by LCP

Despite +12% global equity, collective deficit:

eur4bn at 31/12/13 eur8.5bn at Aug – and still dis-

improving…

32

AA Corporate Bonds in the eurozone

iBoxx AA € bonds 25+yrs 20 – 15yrs 10yrs

31.10.2014 2.2% - 2.5% 1.8% - 2.2% 1.7% - 1.9%

30.09.2014 2.4% - 2.7% 2.0% - 2.4% 1.8% - 2.0%

31.12.2013 3.8% - 3.9% 3.5% - 3.8% 3.2% - 3.5%

How low can they go????

33

Impact of deficits on balance sheets….

What gets measured gets done: investors call management to account

Generally the decision to close/modify a scheme rests with management – not

investors

But management heavily influenced by their perceptions of what investors are

thinking

Like it or not, accounting numbers have become a key driver in strategic decision

making for pensions

34

Impact continued……

In terms of the efficient allocation of capital measurement rules don’t really matter so long as

everyone plays by the same rules for the same circumstance (assuming a linear relationship

between circumstances)…….

For DB pensions, accounting standard setters and enforcers have made sure there is now a better

understanding of the financial tapeworm

Bad accounting (actuarial?) practice drives out good practice very quickly

If investors can’t make sense of a number they tend to ignore it and look for compensation by way

of a better return: negatively impacts cost of capital

35

Fixing a deficit

Negative cash flow: to make good past service deficits, employer’s cash contributions exceeding current

accrual….where can that money come from in a business?

Kick the can down the road….

Cut benefits….and take the HR issues on the chin: problem in the public/semi-state sector

Close/wind-up the scheme

But where does the funding come from: will the Employer fund from own resources/equity – very expensive?

Borrow – but can they borrow at sufficiently low interest rates? What is the competition doing?

Closed to new members/future accrual – deficit and accounting not gone away

36

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