How strong is your lending covenant?

Brian Spence

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When in comes to lending money to a business or financing a corporate transaction it’s pretty important to be able to get a good feel for its value to identify the risk exposure.  There’s certainly a huge amount of information available from a variety of sources but for most the starting point is a set of company accounts which will provide a reasonable picture of a companies finances, but can you rely on the figures where a company currently offers or historically offered a final salary pension scheme. All too often lenders are prepared to accept what they are told about pensions without further research and this can be a dangerous approach.

The audit standard FRS17 has become increasingly accepted over recent years although there is still a significant divergence in opinion about it ranging from necessary evil, to pain in the proverbials, to providing a useful measure of a potential liability.  If nothing else at least it has given us a starting point to identify the extent of any liability, how material it is and to measure pension liabilities on a consistent basis between companies – or has it!!!

There does now appear to at least be a general acceptance amongst finance directors that it needs to be produced, possibly even in some cases requiring some gentle persuasion from company auditors.  The question now however has moved from should it be produced to just how accurate and consistent a measure of pension liabilities is it?  This question has become much more important over recent years as FRS17 has become more widely utilised as a measure to value pension liabilities on everything from sales & purchase and corporate lending, to setting scheme contributions.  It has therefore become more important than ever that an accurate and realistic assessment is achieved.

There undoubtedly seems to be an element of blind acceptance among finance directors and auditors that whatever they are provided with on FRS17 is a ‘fait accompli’ without actually realising the degree of standardisation which is employed by companies producing numerous calculations and the potential level of variation in assumptions which could be acceptably used.  For most companies it is pretty much a given that the assumptions used will not reflect the specific position of the company involved.

Why is this an issue I hear you cry? As I mentioned above the FRS17 figures are now used for numerous other purposes and primarily because minor differences in the assumptions used can produce pretty material differences in the final results.

By way of example there are a number of key variables used in calculating the FRS17 figures, namely the assumed discount rate, salary inflation and price inflation and if we look at published sources in general these over around the last 12 months have really only varied by around 0.2%, 0.3% and 1% respectively.  A couple of other areas where assumptions need to be made, but in this case not disclosed, are in relation to life expectancy and the commutation of pension for tax free cash.  There are undoubtedly very significant differences in approach to these latter issues amongst actuaries preparing FRS17 figures.  If we take a scheme with assets of about £5m and liabilities pretty evenly distributed between actives, deferreds and pensioners we could reasonably see the scheme deficiency vary by about £2m depending upon the assumptions used.  The assumptions used would range from a relatively weak basis to a relatively strong basis but both sets of assumptions could certainly be justified.

The difference in deficit of £2m for a business and its backers could be very material, especially with results now being very visible on the company balance sheet.  This variability purely represents movements in the liability values but there are also potential variabilities in the calculation of the value of scheme assets, particularly where insurance policies are involved.

It is important to recognise that it is the company directors who have responsibility for their FRS17 disclosures in their company accounts and it seems wholly sensible to me that as part of the process, the directors and financiers should be questioning their actuary, possibly in conjunction with their auditor, over the suitability of the assumptions used in their case and over what flexibility, if any, is possible in their assessments. 

Historically, primarily for convenience more than anything else, FRS17 figures have tended to be carried out by the actuary advising the pension scheme trustees however this is not compulsory and there may indeed be arguments in some cases for the figures either being compiled by an independent actuary or for an independent actuary to at least review the assumptions and make recommendations on their suitability to the employer.

This is an area of very significant importance now for both the company directors and lenders and needs to be given considerably more attention going forward.

ENDS

Brian Spence

Post by Brian Spence

Fellow of the Institute and Faculty of Actuaries and Society of Actuaries in Ireland, scheme actuary, professional pension trustee

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