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Citi: The U.K.'s Corporate Pension Hole Just Got a Whole Lot Bigger After Brexit

Top-ups for ballooning pension deficits could be a drag on growth.

The pension plans of companies in the FTSE 350 have been hit by a Brexit-induced double whammy of lower corporate bond yields and weaker growth that threatens to create an additional drag on the economy, according to new analysis from Citigroup Inc.

Those pension liabilities hit a record high of 813 billion pounds ($1.1 trillion) following the U.K.'s historic decision to leave the European Union, write Citi analysts led by Jonathan Stubbs, referring to data compiled by Mercer. Meanwhile their collective deficit rose from 56 billion pounds at the end of the first quarter to 118 pounds at the end of the second, largely thanks to a decline in the so-called discount rate.

U.K. and European companies generally discount their pensions liabilities using a rate based on high-quality corporate bond yields (usually those rated AA). Yields have moved lower in the wake of the Brexit referendum as the European Central Bank's corporate bond buying program and anticipation of stimulus from the Bank of England have boosted corporate bond prices, resulting in a U.K. discount rate of 2.75 percent at the end of the second quarter compared with 3.36 percent at the end of the first, Citi says.

That has helped make pension plans more expensive and resulted in the pension liabilities of FTSE 350 companies as a percentage of total market value reaching 40 percent at the end of the second quarter — the highest level over the past decade barring the financial crisis, when the ratio reached nearly 45 percent.

"With ultra-low bond yields after U.K.'s vote to leave EU, it is clear that U.K. and European pension funds have become one of the victims of the recent event," the Citi analysts write. "Investors are concerned that more companies are in danger of going bust as a result of their pension liabilities."

Source: Citigroup

While discount rates are pegged to high quality corporate bond yields, companies often have a significant degree of discretion in how aggressively they adjust such rates to take into account other factors. Assuming companies discount their pension liabilities based solely on the decline in the relevant benchmark in the first half of the year — while all other actuarial assumptions remain unchanged — results in a ballooning of liabilities for the 10 U.K. and European companies with the biggest deficits rising by as much as 66 percent, according to Citi's analysis.

Source: Citigroup

Ever lower bond yields combined with a weakening U.K. economy bode ill for pension plans and suggests companies may be forced to inject extra cash or, at the very least, announce significant jumps in their deficits, Citi adds. Corporate bond yields have drifted lower since the end of the second quarter with the rate on U.K. AA-rated corporate bonds of 15 years maturity or more dropping from 2.75 percent to 2.45 percent. 

"We expect large pension liabilities and deficits will stay high if interest rates don’t pick up. In this case, companies might eventually be forced to take action to address the issue, i.e. by increasing pension fund top-ups," the Citi analysts conclude. "This implies extra cash to divert into pension schemes, less investment capital to help business grow and possibly deterioration in credit ratings."

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