Pension obligations: time for de-risking instead of time to breathe

The pension obligations of DAX companies are funded to almost 83 percent—a record high. According to a Mercer analysis, pension assets increased by approximately €6 billion in 2024 compared to the previous year, from approximately €258 billion to approximately €264 billion. Because the discount rate remained roughly the same or increased only slightly, the value of pension obligations in the IFRS financial statements of DAX companies decreased from €324 billion to approximately €320 billion.

However, risks still lurk that could significantly impact corporate results and balance sheets: Pension obligations could increase due to a lower discount rate, people are living longer, and the inflation rate is also exacerbating the situation. If inflation rises, payments and provisions grow. Such a "level increase" remains irreversible – because negative inflation by no means reduces pensions.

Inaction is therefore not a sensible option for employers. Instead, now is still a good time for de-risking. A relatively high discount rate means companies can reduce pension risks relatively cheaply.

De-risking works in the long term, allowing companies to plan, transfer, and manage pension obligations. A wide range of options are available for this. Unfortunately, in practice, companies often view these risks in isolation. However, they should evaluate and implement pension risk hedging strategies holistically, as numerous parameters play a role, some of which interact – making the process all the more complex.

To decide which de-risking options are appropriate for a company with its specific goals and characteristics, an overview of possible courses of action is needed. In principle, companies can influence the risks associated with pension obligations as well as with the assets that finance them.

Changing pension commitments is complicated, and the options for structuring them are often limited. The most comprehensive solution would be to buy out pension obligations through severance payments and buyout solutions. However, such a step is only permissible under certain circumstances.

In principle, ongoing benefits from company pensions that companies first paid out on or after January 1, 2005, are subject to a severance payment ban. This severance payment ban also applies to vested benefits if the employment relationship has ended. Exempt from this rule are severance payments for small entitlements, contractually vested entitlements, entitlements during an ongoing employment relationship, and entitlements accrued as part of the reimbursement of contributions to statutory pension insurance. Severance payments are also permitted through liquidation insurance and as part of a court settlement.

One solution would be to establish a pensioners' association. In this case, companies transfer their liabilities to pensioners to a legally independent entity, thus completely outsourcing them. This is a purely corporate transaction. However, it creates a second, non-operational company.

This allows the transferring companies to reduce their balance sheets and release them from liability after ten years. This applies at least if they met certain minimum capital requirements when converting or transferring liabilities.

Another option is for companies to change the pension plan by closing it or converting it to a defined contribution solution. Both options are difficult to implement. Companies must involve stakeholders, especially employee representatives, and they must also take existing commitments and vested rights into account.

While it is possible to terminate (employer-funded) pension plans for newly hired employees at any time because they are a voluntary social benefit provided by the employer, employees' right to a company pension plan through salary conversion remains intact.

Asset-side options

When companies finance pension commitments within the company, the pension obligations remain on the balance sheet as provisions. By definition, they are covered by balance sheet assets that are not explicitly allocated and are not protected against insolvency. Companies that do so should always consider whether this should continue, especially given the risks on the balance sheet.

Another approach is to build up so-called plan assets, which companies outsource to external providers. These can be pension funds or trusts, such as contractual trust arrangements (CTAs). The pension provisions on the balance sheet are released – in whole or in part.

Companies can more easily manage pension risks with plan assets through investment strategies such as asset-liability management (ALM), liability-driven investments (LDIs), or cash flow-driven investments (CDIs). These strategies are flexible, can be implemented quickly, and offer an optimal starting point for taking advantage of the current interest rate environment and then acting quickly when capital market conditions are favorable.

If companies want to implement them, they should simplify the three core functions of plan assets and the three associated basic strategies, which are applied not only exclusively but also in combination: Hedge, Grow, and Pay. How companies can optimally allocate the three basic strategies depends on factors such as the maturity of the pension system, the capital market environment, and the level of funding. The latter is considered a strong indicator for taking certain measures.

Indicator funding level

• If the ratio of pension assets to pension obligations is low and the objective is to reduce the coverage gap, an investment with a growth-oriented focus, i.e. a grow strategy, is recommended.

• As the coverage ratio increases, the strategy should gradually transition to a hedging strategy, for example, through liability-driven investments. This is also beneficial when the funding ratio is very high or above 100 percent, in order to stabilize it.

• In a closed pension system, plan assets decrease because contributions and investment income alone cannot cover pension payments. The focus should now be on securing payouts and thus a pay strategy using cash flow-driven investments.

Indicator balance sheet versus cash flow

To find the right strategy, companies can also consider whether to focus on the balance sheet or cash flow. From a balance sheet perspective, it makes sense to use the available risk budget as a target. An example of this is the value at risk of pension risks, which impact equity. If the risk budget is low, a hedge strategy is recommended. If it is high, earnings-oriented growth strategies are possible and sensible.

With a purely cash flow perspective and a high funding ratio, the focus is on paying out pensions and matching cash flow—a pay strategy. If the funding ratio is low, companies must take a certain amount of risk to close the funding gap. Pure cash flow matching doesn't allow this. A pay or grow strategy with a certain return orientation is required.

Once cash flow and balance sheet targets have been achieved, the ultimate de-risking goal comes closer: a complete liquidation, for example through a buyout.

Valuation of plan assets

According to International Financial Reporting Standards (IFRS), companies value plan assets at fair value. Fluctuations in interest rates or capital markets directly impact pension obligations. However, it is possible to hedge plan assets with market instruments. If discount rates rise, pension provisions fall – and vice versa.

The German Commercial Code (HGB), on the other hand, uses an average discount rate calculated over several years. Interest rate changes have a significantly more moderate effect, which reduces the volatility of pension provisions in the balance sheet, but makes controlling the coverage with plan assets more difficult. However, there are ways to account for portions of pension plan assets using book values. This usually stabilizes the coverage in the HGB balance sheet.

Conclusion: Act now

During the low-interest-rate phase, de-risking through investment strategies was expensive. Even if the German Commercial Code (HGB) interest rate lags behind market trends, as long as interest rates remain at current levels, de-risking remains worthwhile. However, the window of opportunity can quickly close, and the question arises: If not now, when?

About the author:

Olaf John has been Director of European Client Investment Solutions at L&G since May 2024. His official title is European Client Solutions Director. Prior to joining, John led commercial investment solutions and the German office of Mercer Global Investments. Prior to that, he was Head of European Business Development at Insight Investment.