Defined benefit pension risk for European banks

In our last article, published in early April, we discussed the measures European banks have been taking to manage defined benefit (DB) pension risk, and how the nascent COVID-19 pandemic was likely to bring the capital impact of their long-term pension debt (totalling nearly €200bn across 25 surveyed banks) into sharper focus.

I thought it would be helpful at this point to consider, several months on and with the world having changed considerably, how this has played out. Perhaps the primary unanticipated development at a macro level has been the strong recovery in stock markets from the end of Q1, on the back of a variety of unprecedented stimulus measures taken by governments and central banks. Of particular interest is the EU’s recently announced plan to issue a significant amount of mutual debt - it is not clear yet how impactful this will be for bond markets, but it may present opportunities in the pension risk space.

The ECB has applied some of the measures available within the Basel III system to reduce pressure on bank capital, such as reducing the countercyclical buffer, postponing the triennial stress test, and reducing Pillar 2 capital quality requirements. This has enabled banks, for now at least, to keep their heads above water from a capital perspective, with many dividend payment aspirations now having been shelved. The recent failure of Baoshang Bank in China illustrates the tightrope banks may be walking.

Notwithstanding this, several banks’ mid-year results have shown significant losses, as net interest margins are squeezed, revenue streams dry up and provisions for non-performing loans (NPLs) are increased. Indeed the low profitability of European banks has been a concern for the ECB since before the COVID-19 crisis, with clear and continuing calls for consolidation activity to reduce costs and diversify revenues.

What has this meant for pension risk?

The challenge European banks are facing with NPLs actually plays into a more benign view for pensions. As corporates have started to struggle, the credit spreads on their debt (compensating investors for credit risk) have increased. Furthermore, inflation expectations have fallen – reducing the value of pension benefits which increase over time. In combination, these movements mean pension liabilities measured in line with IAS19 or other accounting standards have fallen or at least stayed broadly level. Taking into account the market recovery, this is likely to mean that the capital impact of many banks’ pension debt will have reduced over 2020 to date, which will be welcome in the context of the wider pressures they are facing.

However, the situation is complicated by the easement actions taken by central banks which, alongside some investors retreating to safe havens, have resulted in a sharp fall in high quality Euro sovereign bond yields – the closest proxy to risk free rates – at least offsetting the rise in credit spreads. The chart shows how the composition of accounting discount rates has changed materially over 2020 to date, which may have gone unseen.

IAS19 discount rate composition

This is likely to have led to a range of pension risk experiences for banks through the first half of 2020:

• Those who have funded their pension liabilities and, in particular, used those assets to fully or partially hedge their risk-free interest rate exposures will have felt the benefit of the credit spread increases, with limited damage from falling risk-free rates – driving an improvement in their net pension position, which ultimately determines the capital impact;
• Others who haven’t are still likely to have seen an improvement, but it won’t be as pronounced.

Of course, any temporary respite offered by markets doesn’t mean the long-term pension debt issue for banks has gone away. Furthermore, the average spend on pensions is 1.5% of revenue, which is likely to be material in the context of low cost-income ratios. Banks should continue to monitor their key pension risk metrics and use a holistic framework to build an executable strategy to mitigate their impact, such as Willis Towers Watson’s Strategic Navigator.

Five key dimensions to mastering pension risks globally

With bank capital and profitability expected to be under pressure for the foreseeable future and in the context of the potential for increased M&A activity, well-timed pension risk interventions can still be of material benefit in minimising the volatility of the capital position and the additional capital that needs to be held, e.g.:

1. Increasing inflation hedging to avail of current conditions
2. Diversifying investment strategy while markets are relatively benign
3. Increasing opportunities, where allowable and appropriate, for employees and pensioners to exchange pension for cash
4. Investigating liability settlement, based on potential for attractive market pricing
5. Reshaping current pension provision.

We are currently reaching out to our banking clients with a short pulse survey, to take a temperature check on how they are feeling about pension risk right now and what their key areas of focus are, especially with so much else going on within their businesses. Our next article will cover the associated findings. If you’d like to take part in that survey or would otherwise like to discuss how we can help you, please contact us.