Falling interest rates may not be good news for a few companies including public sector banks (PSBs) which are offering defined benefit pension schemes.
According to an analysis by Edelweiss, lower interest rates are likely to negatively impact the profit & loss (P&L) and cash flows of companies offering defined benefit pension plans. Since most public sector banks are offering such plans, their pension obligations are likely to rise significantly on account of drop in interest rates.
On an aggregate basis, the likely impact of drop in discount rates (benchmark yield) by 1% will result in pension obligations increasing by Rs 3800 crore , constituting 15.7% and 2.4% of last reported aggregated profit and net worth of public sector banks (PSBs), respectively, said the report .
However on the positive side, gains in the bond portfolio will more than offset the impact of increase in pension obligations. On an aggregated basis, the likely gain on bond portfolio(assumed 6% yield on the benchmark) could be 15-30% of net worth, pointes out the report.
Defined benefit pension plans offer guaranteed payouts to employees post retirement, which is a function of last drawn salary and number of years of service. Companies take periodic charge to the P&L and also make periodic contribution to the fund which is based on actuarial assumptions like discounting rate, expected return on plan assets, expected salary hikes, etc.
Since AS-15 requires impact of change in actuarial assumption(s) to be recognised in P&L, any change in actuarial assumption(s) can significantly impact the amount being charged to P&L as well as to the periodic contribution to be made by the company to maintain the funded status of the pension fund.
AS-15 states the discounting rate used to determine the present value of post-retirement obligations should be determined by reference to market yields at the balance sheet date on government bonds. With declining interest rates, actuarial assumptions with respect to discount rate and expected rate of return on plan assets will be revised. The present value of defined benefit obligations is likely to increase with decline in long-term rates. On the positive side, lower interest rates will also lead to appreciation of fair value of pension assets.
However, the magnitude of increase in DBO is likely to be higher than appreciation in the value of pension plan assets because of: Gap between present value of benefit obligation and fair value of plan assets which is termed as unfunded status of the benefit plan. Decline in interest rates will result in this gap widening further as present value of benefit obligation will increase more than the fair value of plan assets. As on March 31, 2008, almost all the public sector banks (PSBs) were running deficit in their pension plans.
Because of long-term nature of pension liabilities (25 years) and non-availability of government securities with maturity of more than 10 years, banks are also likely to have significant duration mismatch in their pension assets and liabilities (liabilities being higher than assets).
This will again lead to higher increase in present value of DBO than increase in the value of plan assets. The increase in net liability is likely to be higher due to combined impact of deficit and duration gap. However, some banks are maintaining significant portion of pension assets in their own fixed deposits (FD).
?Since the FDs are self issued, we are of the view that their maturity will be same as that of pension liabilities; hence, the accounting impact of duration mismatch will not be recognised to the extent of pension assets being represented by the bank?s own FD,?? finds out the analysis.