Milestone Reached for UK Corporate Pension Funding: Where to Next?

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1 Global Portfolio Solutions January 2014 Milestone Reached for UK Corporate Pension Funding: Where to Next? Scott McDermott Managing Director Kathryn Koch Managing Director Carolyn Tavares Vice President In our inaugural review of the UK corporate pensions market, we examine how defined benefit schemes of the FTSE 350 companies have fared in the past year and identify trends and best practices for the year to come. Headlines are painting a rosy picture for defined benefit schemes, with interest rates rising and equity markets continuing to rally this year. We estimate the aggregate funding level of UK corporate defined benefit schemes on an accounting basis has increased to 103%, as of 31 December 2013, up from 93% for fiscal year end (FYE) 2012 (Exhibit 1). While this increase is meaningful, some market commentators may be expecting even higher funding levels given market moves. We examine the causes of the divergence with these expectations. 1. Obligations Largely Unchanged. Despite significant increases in headline yields, discount rates for accounting valuations were more stable in We estimate that obligations have slightly decreased year-to-date, largely due to the changes in yields. 2. Strong Investment Returns Drive Funding Levels. Year-to-date, investment performance outpaced changes in liabilities. Higher funding levels should improve company sponsors balance sheets and reduce the need for sponsor contributions. 3. Getting the Investment Strategy Right. Small schemes are taking significantly more equity risk than large schemes for comparable funding levels. In contrast, larger schemes have higher funding levels than smaller schemes and are setting their investment strategy to reflect funding levels, i.e. they are following a journey plan. Exhibit 1: Year-to-Date Change in Funding Level 1 105% 9.5% 103% 100% 5.6% -3.3% -4.7% 93% 95% 2.1% 90% 85% 80% Changes in Discount Rates Changes in Inflation FYE 2012 Defined Benefit Obligations (DBO) change due to DBO Service and Interest Cost Cash Flows Realised Investment Returns End of Year For FTSE 350 UK defined benefit pension schemes. Source: GSAM, company annual reports. Based on accounting valuation. Cash flows include contributions and benefit payments. Milestone Reached for UK Corporate Pension Funding: Where to Next? Goldman Sachs Asset Management 1

2 Schemes with funding deficits, looking towards eventual immunisation, will need to acknowledge the need for investment returns while working within a framework for de-risking. As funding levels improve, schemes will be tested as to whether de-risking strategies are actually implemented. Currently there is disparity across schemes in addressing such issues. Irrespective of the current environment, the primary challenge for trustees remains the same: to seek and successfully deliver future investment returns greater than the discount rate used to value pension liabilities. This calls for a strong strategic focus from trustees in setting their investment strategy, and a robust approach by trustees to ensure the efficient and effective implementation of the strategy. 1) Obligations Largely Unchanged Schemes are looking to rising yields to improve funding levels by reducing the present value of defined benefit obligations (DBO). However, several factors are counteracting any benefit, causing obligations to remain largely unchanged. We estimate that aggregate DBO, as of 31 December 2013, is 432 billion, only slightly lower than the FYE 2012 value. This compares to the 11.1% rise in the prior year, when the aggregate DBO increased from 393 billion as of FYE 2011 to 436 billion as of FYE We will examine the primary causes of this inertia in DBOs high inflation expectations and largely unchanged discount rates as well as address the effects of changes in life expectancy, and service costs. Headline Rates Can Be Misleading After five years of declining discount rates, many investors have observed that headline interest rates have risen. From 2012 to 2013, the yield on 10-year UK government bonds has risen 137 bps (Exhibit 2). However, discount rates for corporate accounting purposes had a more modest increase. Over the same period, the increase in the yield on high quality corporate bonds was only 36 bps. There are two reasons for this discrepancy: First, 30-year government bond yields rose only 58 bps in comparison to the 137 bps rise of the 10-year yield. Since benefit payments extend many decades into the future, the longer-maturity yield is a more appropriate discount rate. Second, corporate credit spreads have compressed. As a result, despite the fact that headline gilt yields have risen, accounting discount rates for the 2013 reporting period may not increase significantly compared to Exhibit 2: Interest Rates (%) 2 Past Five Years Year-to-Date 6.0 Dec Dec ??? Dec-08 Dec-09 Dec-10 Dec-11 Dec Year Gilt Rate 30-Year Gilt Rate Barclays UK Corporate 15+ A-Rated Index Yield Year UK Government Yield 30-Year UK Government Yield Barclays UK Corporate 15+ A-Rated Index Yield Average Discount Rate for Companies Reporting on Dec 31 2 Source: GSAM, Plot Tool, Barclays. Plot tool is a proprietary analytical tool and database representing developed and emerging markets including the US, Europe, Asia, and Latin America for their respective Fixed Income, Equity, Foreign Exchange, Commodities, and Credit Markets covering thousands of cash, forward, futures, options, and swap instruments. Plot tool houses over 20 years of economic data. Milestone Reached for UK Corporate Pension Funding: Where to Next? Goldman Sachs Asset Management 2

3 Comparison to the US In comparison to the UK, US schemes have seen a more significant improvement in funding levels in We estimate that US defined benefit schemes have seen an improvement in funding levels from 78% at the end of 2012 to 93% as of 31 December In other words, the system-wide deficit has more than halved in about twelve months. In our view, the cause of the different US experience is due to both equity market returns and discount rates. The S&P 500 returned 32% in 2013, whereas the FTSE 350 returned 21% 3. Most UK pensions still have a home bias in their equity portfolios, meaning the allocation to UK equity is larger than market capitalisation weights would suggest 4. As a result, UK schemes have not benefitted from the US equity rally as much as they would have with a more global equity allocation. Similarly, discount rates in the US as measured by the yield on the Barclays US Government/Credit Long Index have increased 108 bps, in comparison to the 36 bps increase for UK discount rates. Contributing to the improvement in funding levels, US corporate sponsors continued to make notable contributions to their schemes despite funding relief instituted in 2012 under the MAP-21 legislation. Contributions were higher in 2012 than they were in 2011, and are expected to be even higher in We estimate that US corporate defined benefit schemes have improved their funding levels by about 15% in 2013, whereas funding levels of UK corporate defined benefit schemes have risen by 10% in the same period. That being said, it is worth acknowledging that UK funding levels are higher than US funding levels in aggregate. With an average funding level in the UK of 103%, many US companies would be thrilled to be average by UK standards. Repricing of Inflation Expectations Hurting Funding Levels On 10 January 2013, following a consultation period, the UK Office of National Statistics decided not to make changes to the Retail Prices Index (RPI) calculation which would have aligned it more with the Consumer Price Index (CPI) calculation (see box, Regulatory Trends, for additional information on RPI vs. CPI). This caused market expectations of RPI to increase by roughly 50 bps (Exhibit 3). In line with this, companies with a fiscal year-end after 31 December generally reported higher inflation expectations. The 2013 reporting period will likely reflect this with higher DBO values. Exhibit 3: FYE 2012 Inflation Expectations (%) Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep Year Breakeven Inflation Rate Company Disclosed RPI Assumptions 3 Source: GSAM, PlotTool. Reflects total returns. 4 Source: GSAM, Mercer, 2013 European Asset Allocation Survey. Average equity allocation for UK pension funds is 36% UK. In comparison, the UK allocation within MSCI World is 9%, as of October 31, For FTSE 350 UK defined benefit pension schemes. Source: GSAM, company annual reports, Bloomberg. Inflation expectations reflect the market-implied breakeven inflation rate based on the yield on nominal and inflation-linked UK government bonds of similar maturity. The economic and market forecasts presented herein for informational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this presentation. These examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially. Milestone Reached for UK Corporate Pension Funding: Where to Next? Goldman Sachs Asset Management 3

4 Also noteworthy is the discrepancy between corporate and market expectations for inflation. Although benefit payments can extend 80 to 100 years into the future, many company expectations for inflation are persistently lower than 30-year market expectations. If companies used RPI assumptions based on 30-year market expectations, we estimate DBO values as of 31 December 2013 would increase by 1.7% in aggregate, and the increase could be as large as 10% for some companies. The discrepancy between what corporate sponsors are assuming for inflation and the generally-higher levels embedded in market expectations represent a headwind for funding levels. Regulatory Trends In May 2013, the UK Minister of State for Pensions, Steve Webb, announced two changes to the statutory minimum pension requirements. For service accrued in the future, defined benefit schemes are no longer required to offer spouses pensions, nor do spousal pensions that are paid need to be indexed to inflation. Benefits accrued prior to the adoption of the changes do not change. This is the second measure since the Global Financial Crisis that allows for what is effectively a reduction in pension benefit obligations. In June 2010, Mr Webb announced that the statutory minimum pension increases for UK corporate pension schemes would be linked to CPI, rather than RPI. Historically, CPI has been lower than RPI by 84 bps per annum 6, to which a difference in calculation methodology is the largest contributor. Therefore switching the inflation linkage would likely result in a reduction in the statutory minimum pensions. Since the announcement in June 2010 regarding inflation linkages, a number of companies have opted to switch their scheme inflation linkage to CPI, and have benefitted from the reduction in inflation expectations. Not all trustees or pension schemes are willing or able to make the switch. Therefore while it remains to be seen how this year s announcement regarding spousal benefits will affect schemes, history tells us to expect that a number will seek to capitalise on this regulatory change. Life Expectancy Continues to Increase Steadily In addition to discount rates and inflation expectations, changes to actuarial assumptions, such as mortality, can cause the DBO to change over time. As life expectancy increases, benefit payments will extend further into the future, further increasing the DBO. Over the reporting period for companies in our sample, life expectancy for a pensioner in the UK currently aged 65 has increased 0.2 years since 2011 to 87.5 years. Exhibit 4 shows the spread in current life expectancy assumptions by sector. Exhibit 4: FYE 2012 Life Expectancy for Pensioners Currently Aged 65, by Sector Financials Oil & Gas Techn Health Care Telecomm Consumer Goods Utilities Industrials Consumer Services Basic Materials Maximum Minimum Average 6 Source: GSAM, Haver Analytics, reflects UK CPI and RPI from January 1990 through September For FTSE 350 UK defined benefit pension schemes. Source: GSAM, company annual reports. Milestone Reached for UK Corporate Pension Funding: Where to Next? Goldman Sachs Asset Management 4

5 Closing Schemes a Tailwind for Companies Two companies in the FTSE 350 closed defined benefit schemes to new entrants, and seven froze schemes to future accrual over the 2012 fiscal year. That leaves only 25 companies with a defined benefit scheme open to new entrants, equivalent to only 7% of all FTSE 350 companies. Not surprisingly, frozen schemes have the lowest service cost (Exhibit 5) 8. As more schemes close to new entrants or become frozen, companies should see service cost, and therefore pension expense from defined benefit schemes, continue to decline. Exhibit 5: Service Cost as a % of DBO Value and (Number of Companies) 9 2.0% 1.5% 1.85% (27) 1.76% (25) 1.30% (107) 1.17% (100) FYE 2011 FYE % 0.5% 0.26% (56) 0.23% (65) 0.0% Open Closed Frozen 2) Strong Investment Returns Drive Funding Levels Scheme assets increased in 2013, largely driven by strong investment returns. We estimate the growth in assets from FYE 2012 to 31 December 2013 to be 9.5%, bringing the aggregate asset value for the companies in our sample to 443 billion. This compares to an 8.2% growth in assets in fiscal year (FY) 2012, when assets grew from 377 billion to 408 billion. As a result, we estimate the aggregate funding level on an accounting basis, as of 31 December 2013, is 103%, compared to 93% for FYE 2012 and 96% for FYE Investment Outperformance Continues Schemes have benefitted from recent equity market rallies. The average nominal investment return for FY 2012 was 9.3%, which was higher than the average nominal expected return on assets (EROA) of 5.2% (Exhibit 6), although this lagged the 11% increase in DBO in FY However, we calculate that the strong investment returns continued in 2013, estimated at 9.5%. Exhibit 6: FY 2012 Expected Return vs. Actual Investment Return 10 20% Average Actual Investment Return 15% 10% 5% 0% Actual Exceeds Expectations Actual Lags Expectations -5% 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Expected Return 8 When companies have several UK defined benefit schemes, the status of the majority of the pension liability is used. As a result, the small service cost from frozen companies in Exhibit 7 is due to smaller schemes of the company that may still be open. 9 For FTSE 350 UK defined benefit pension schemes. Source: GSAM, company annual reports 10 For FTSE 350 UK defined benefit pension schemes. Source: GSAM, company annual reports. Expected returns are estimates of hypothetical average returns of economic asset classes derived from statistical models. There can be no assurance that these returns can be achieved. Actual returns are likely to vary. Please see additional disclosures. Milestone Reached for UK Corporate Pension Funding: Where to Next? Goldman Sachs Asset Management 5

6 Net Impact is Positive on Funding Levels The net impact of these factors slightly lower DBO and materially higher asset values is an improvement in funding levels on an accounting basis in While corporate sponsors focus on the accounting valuation, the ongoing and immunisation valuations are also important guideposts for pension strategy. An ongoing valuation is used to establish recovery plans and contribution schedules. An immunisation valuation reflects the cost of hedging the DBO risk by matching the interest rate and inflation sensitivity with UK nominal and inflationlinked government bonds. An ongoing valuation uses a discount rate based on the asset allocation plus a margin for sponsor covenant, whereas an immunisation valuation uses a gilt-based discount rate to reflect the cost of fully hedging the interest rate and inflation risk of the DBO. Using the expected return on assets and the 30-year gilt yield as approximations for the ongoing and immunisation measures, respectively, we estimate that the funding level is currently 117% on an ongoing basis and 86% on an immunisation basis (Exhibit 7). Exhibit 7: Funding Level Under Different Valuation Methods % 110% 100% 90% 80% 70% 60% 106% 117% Ongoing (Expected Return on Assets) 93% 103% Accounting (AA-Rated Corporate Bond) FYE 2012 YTD 2013 (E) 76% 86% Immunisation (30-Year Gilt Yield) Sponsor Contributions to Decline The improvement in funding is positive for corporate sponsors in more than one way. In addition to reducing the drag on balance sheets, full funding on an ongoing basis will cause sponsor contributions to decline in future due to the reduction in deficit contributions. This is consistent with sponsors estimated contributions for 2013, which are lower than realised contributions for 2012 (Exhibit 8). Exhibit 8: Company Benefit Payments and Contributions ( billion) FY 2011 FY 2012 Estimated Benefit Payments Contributions Net Cash Flow Exhibit 8 also demonstrates that schemes paid out more cash in benefit payments than they received in sponsor contributions. While sponsor contributions are expected to decline, benefit payments are likely to continue to rise due to the aging of baby boomers as well as companies offering enhanced transfer values. The resulting net outflow could cause challenges for schemes, as they look to meet benefit payments either through investment income or by liquidating part of the assets. As a result, schemes, particularly those that are mature, must be conscious of the portion of the portfolio that is invested in illiquid assets. 11 For FTSE 350 UK defined benefit pension schemes. Source: GSAM, company annual reports. 12 For FTSE 350 UK defined benefit pension schemes. Source: GSAM, company annual reports. Contributions reflect company estimates, Benefit Payments and Net Cash Flow reflect GSAM estimates. Milestone Reached for UK Corporate Pension Funding: Where to Next? Goldman Sachs Asset Management 6

7 3) Getting the Investment Strategy Right Take Risk Within a Journey Plan As funding levels improve, schemes will be tested as to whether de-risking strategies are actually implemented. Exhibit 9 compares debt allocations as of FYE 2012 to our estimated funding levels, as of 31 December The line through the exhibit represents a generic journey plan with a 20% allocation to debt at a 60% funding level, rising linearly. This generic analysis demonstrates that there are a number of schemes with debt allocations far below the implied journey plan. Exhibit 9: FYE 2012 Allocation to Debt by 2013 Estimated Funding Level 13 Schemes with Assets < 500 million Schemes with Assets > 1 billion Allocation to Debt Allocation to Debt % 80% 100% 120% 140% 0 60% 80% 100% 120% 140% Funding Level Funding Level The under-allocation may in part reflect the prevalence of yield-based de-risking triggers. According to a KPMG survey, 73% of Liability-Driven Investment (LDI) mandates with triggers are based on yields, while only 15% are based on funding level triggers. 14 We advocate designing a journey plan with de-risking triggers based on the funding level, as these are more outcome oriented. In comparison, yield-based triggers create an incomplete feedback loop and miss one of the central benefits of an LDI programme, namely protecting funding levels. 15 While appropriately focused on managing liability risk, we also believe the journey plan should allow for some rerisking, at least in the form of institutionalised rebalancing. Schemes Looking for Alternative De-Risking Strategies The de-risking trend of decreasing equity allocations continued in FY In lieu of equities, schemes are increasing allocations to debt and other asset classes. This latter category typically includes hedge funds, diversified growth funds, commodities, and other alternative asset classes. Anecdotally, we have also seen increased interest in what we term crossover assets, which are assets that should provide the returns normally associated with the return generating part of the portfolio and at the same time possess some liability-hedging properties. Crossover assets include asset classes that are common to many schemes portfolios, such as real estate, as well as those less common such as infrastructure, commodities, and non-core fixed income. 13 For FTSE 350 UK defined benefit pension schemes. Source: GSAM, company annual reports. 14 Source: 2013 KPMG LDI Survey: Exploring the Evolution of the UK LDI Market. KPMG, June Take the hypothetical example where yields remain relatively stable at 4% but equities rally 20%. For a scheme with 50% in equities and a 90% funding level, this would equate to an improvement in funding to 99%, all else being equal. Yet no de-risking trigger would have been met even though the funding level changed by 9%. Milestone Reached for UK Corporate Pension Funding: Where to Next? Goldman Sachs Asset Management 7

8 The impetus behind many of the discussions we have on crossover assets is the level of interest rates. With rates at 50-year lows, many schemes are looking for de-risking strategies that do not entail purchasing more UK government bonds or swaps. While higher yields should go some way towards reducing funding deficits on an immunisation basis, we believe it will not be sufficient to eliminate them completely. Over the past 50 years, the level of yields was largely driven by higher inflation. From , average long duration yields were 7.9%, but inflation was 6.8% 17 With the Bank of England targeting 2% inflation, we believe yields will remain anchored. Funding-based triggers may be more appropriate in a world where the Bank of England succeeds in meeting its inflation target. Accounting Trends Several IAS 19 accounting changes came into effect at the beginning of 2013 which will affect the way companies disclose information regarding defined benefit schemes. There are two main aspects of the changes: Balance Sheets The first change affects companies balance sheets by requiring funding positions to be fully marked-to-market, removing the corridor option which effectively capped the size of the deficit or surplus. While most companies in the FTSE 350 have declined to use the corridor option and already engage in markto-market practices, those in the minority could experience mark-to-market losses for fiscal years following 1 January Profits The second change primarily affects pension expense and company profits. Pension expense has three primary components: growth in DBO due to members earning another year of pension benefit ( service cost ), growth in DBO due to interest cost, and growth in assets due to expected investment returns, which is an offset to liability growth. The IAS 19 change requires companies to use the same EROA as the discount rate used to calculate interest cost, which will be combined into a single net interest cost. Since the average EROA is 5.22%, higher than the average discount rate of 4.43%, this means a reduction in this offset, and therefore a higher pension expense and lower company profits. For FY 2012, the companies in our survey reported a total pension expense of 3.4 billion, consisting of 23 billion in service and interest cost, offset by 19 billion in expected return on assets. Adjusting the offset for the IAS changes, we estimate pension expense would have been 6.2 billion in FY 2012, a 2.9 billion increase. We believe that both of these changes are incentives to de-risk. Funding level volatility will be more transparent to companies that previously used the corridor approach. The previous rules using the EROA to offset pension expense incentivised companies to keep allocations to higher returning assets, such as equities. Removing this link between pension expense and EROA will remove that incentive, and could lead schemes to reduce holdings in equities. Small Schemes Take More Risk In comparison to large schemes, smaller schemes are less tied to a journey plan (Exhibit 9). Divergence in behaviour is not just limited to debt allocations. Schemes with more assets, which tend to have a more material impact on sponsor balance sheets, have significantly less equities than smaller schemes (Exhibit 10). At the extremes, schemes with assets of at least 5 billion have 20% less equities than schemes with assets of less than 100 million. 16 This period ( ) begins with the end of World War II and ends when the Bank of England began targeting inflation. 17 Long duration yields reflect the 2 ½% Consolidated Stock yield, which is a perpetual bond issued by the UK. Source: DMO, Bloomberg. Milestone Reached for UK Corporate Pension Funding: Where to Next? Goldman Sachs Asset Management 8

9 Exhibit 10: Comparing Schemes by FYE 2012 Asset Size 18 Asset Size ( million) Average Asset Size Aggregate Funding Level Asset Allocation (%) Aggregate Materiality 19 Equity Debt Real Estate Cash Other < % 4% % 12% , % 18% ,000-5,000 2,195 92% 23% > 5,000 15,399 94% 52% There is also variation between schemes over time. In FY 2012 schemes with assets of less than 5 billion decreased allocations to equities, while schemes with at least 5 billion maintained or, in some cases, increased allocations to equities. In short, despite the low level of yields and decline in funding levels through 2012, smaller schemes continued to de-risk. Choose a De-risking Strategy The result of these trends higher discount rates and strong asset returns leading to higher funding levels is that we expect schemes to continue to de-risk. Although de-risking is a long-term trend in pension strategy, uncertainty exists as to the form de-risking will take and when de-risking will occur. While de-risking strategies will continue to evolve, there are currently three main categories: Scheme design closing and freezing schemes, offering enhanced transfer values Annuitisation transferring pension risk to third party, typically an insurance company Asset allocation decreasing equity holdings, increasing crossover assets, increasing fixed income and LDI, extending duration of existing fixed income assets, and improving the quality of duration matching Most companies have made design changes, by closing or freezing their pension schemes. Fewer companies have offered enhanced transfer values or other liability management exercises, such as pension increase exchanges and flexible retirement options. As more schemes freeze to future accrual and there is increased regulatory clarity, we expect to see more liability management exercises. More common are annuitisations through buy-ins or buy-outs. Annuitisations, in particular buy-outs, are attractive to companies as they result in a full transfer of the pension from the balance sheet both the assets and the obligations to a third party. Annuitisations can be costly; obligations are typically valued at a government bond yield. Furthermore, there remain uncertainties as to who is ultimately responsible for the pensions should the insurance company not be able to meet them. Despite these concerns, anecdotally we have seen an increase. While we did not collect data in our survey on the number of companies that have done such risk transfers, next year we intend to do so. Asset allocation de-risking strategies have been quite prevalent, as evidenced by the significant shift away from equities and towards debt over the past eight years 20. Changes to collateral requirements for over-the-counter derivatives may increase the cost of LDI strategies. However, while this may slow down the increase in LDI, it is unlikely to completely reverse. Instead, more schemes may search for asset allocation strategies that reduce risk without a corresponding reduction in returns, such as crossover assets or other uncorrelated return-seeking strategies. Such strategies may be beyond the governance capacity of many schemes, which may in part explain the rapid up-take of fiduciary management seen in the UK over the last five years. It is most likely that companies will employ a combination of all three strategies as they work towards their respective funding goals. As the UK economy continues to improve, we expect a positive environment for UK defined benefit schemes in 2014, with inflation relatively stable, rates rising gradually, and equity markets continuing to deliver positive returns. Against this benign backdrop, the challenge will be for schemes on both the trustee and corporate side to follow through with journey plans and be disciplined about de-risking strategies, despite better prospects for investment returns. 18 For FTSE 350 UK defined benefit pension schemes. Source: GSAM, company annual reports, reflects FYE 2012 data. 19 Measured as ratio between pension liability and company market cap 20 Allocation to equities decreased from 61.1% in 2006 to 35.1% in Allocation to gilts and fixed interest increased from 28.3% in 2006 to 44.8% in Source: PPF / The Pensions Regulatory, The Purple Book Milestone Reached for UK Corporate Pension Funding: Where to Next? Goldman Sachs Asset Management 9

10 Appendix Explanation of Analysis Our analysis is based on data collected from the defined benefit pension schemes of the companies in the FTSE Pension information is disclosed in company annual reports according to International Accounting Standards, specifically IAS 19. Of the companies in the FTSE 350, 220 have defined benefit pension schemes, and of that group, 190 clearly disclosed information regarding their UK defined benefit schemes. The remaining 160 companies either did not have or did not disclose information regarding schemes in the UK. We collected the following information on the 190 companies with UK defined benefit schemes: key actuarial assumptions including discount rates, inflation expectations, and mortality, sensitivity to changes in these assumptions, pension expense, benefit payments, contributions, funding position, and asset allocation. Based on the most recent filings by these 190 companies, our sample group represented approximately 40%, or 408 billion, of the pension assets for the total schemes covered by the Pension Protection Fund in the PPF 7800 Index 22. As a result, our analysis focuses on this 40% portion of the UK defined benefit pension market, which we believe to be a representative sample. Companies included in our sample group report on different fiscal cycles, with the majority (102) reporting in December. Despite this inconsistency, we did not adjust for the date of disclosure. Variability in market conditions is accepted in favour of a broader sense of the pension market. Year-to-date extrapolations adjust for differences in fiscal year-ends. International accounting standards for pension schemes (IAS 19) prescribe that defined benefit obligations should be discounted to a present value using high quality corporate bond yields. Discount rates for the companies in our sample group largely followed the yield on the Barclays UK Corporate 15+ A-Rated Index. Changes in the present value of the DBO throughout the document are estimated using company disclosures regarding the sensitivity of the pension scheme DBO to changes in discount rate and inflation assumptions. Although this is not a required disclosure, of the 190 companies in our survey universe, 96 disclosed discount rate sensitivity, of which 83 also disclosed inflation sensitivity. On average, a 1% decrease in discount rates, keeping inflation assumptions constant, increases the DBO by 19%. Conversely, a 1% increase in inflation assumptions, keeping the discount rates constant, increases the DBO by 13%. 21 The constituents are as of December 31, Source: PPF 7800 index, as of December 31, Milestone Reached for UK Corporate Pension Funding: Where to Next? Goldman Sachs Asset Management 10

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