The profits of FTSE 350 companies could shrink by £2bn by 2017, as plummeting bond yields push up the cost of funding defined benefit schemes, financial services consultancy Mercer has found.
Research by the firm pointed out that the cost of funding the schemes of the UK's 350 biggest companies had already increased by £2bn since the start of 2016, which it put down to record low corporate bond yields.
Mercer pointed out that in August, AA corporate bond yields, as measured by the Markit iBoxx >15 year index, fell to a record low of 1.89 per cent per annum. That was almost two percentage points down on the figure at the 2015 end-of-year figure of 3.68 per annum.
It corresponded with a collapse in UK gilt yields following the Brexit vote in June, when 10-year gilts fell below 1 per cent for the first time ever.
Warren Singer, Mercer’s UK head of pension accounting, said companies with DB schemes were now spending around 40 per cent of employee pay on DB pensions, which he said was four times as much as was being spent on defined contribution schemes.
He said that a £2bn drop in profit was "material", given total profits for FTSE 350 companies in 2015 stood at £84bn, according to The Share Centre figures.
Mr Singer said companies that had not yet closed their DB schemes therefore needed to think seriously about whether to do so.
“The key question is whether you expect 30 years of stagnation in the UK, as implied by the UK bond market. We have seen in Japan this scenario is possible but the governor of the Bank of England has stated that UK bond yields are distorted by an investor community as a whole that is taking out insurance for extreme risk events," he said.
"He [the governor] believes there will be adjustment and growth without question. However, if employers believe in a low growth world, they may find it unsustainable to allow employees to continue building up new DB pension savings.”
But Alan Baker, head of DB risk at Mercer, said switching to DC schemes also carried risks, since they were at the mercy of the same economic conditions as DB schemes.
He urged trustees and employers to engage in "specific strategic thinking rather than following the herd", saying: "In some cases where the covenant supports investment risk, the ultimate cost of providing DB pensions may be lower than currently suggested by the high quality corporate bond yields that must be used for financial reporting of pension costs."
The comments came as a number of parties are looking for ways to mitigate the DB funding deficit - which according to Hymans Robertson currently stands at around £1trn.
The Work and Pensions select committee is currently preparing an inquiry that will look at the issue, and is expected to recommend allowing under-funded schemes to reduce the rate of annual pension increases.
Earlier this month Hymans Robertson claimed the deficit could be slashed by a third if schemes linked annual increases to the consumer price index rather than the retail price index.
Others - including fund manager Neil Woodford - have urged DB schemes to ween themselves of fixed income and up their exposure to equities.
