This year is likely to bring more unwelcome news for members of company pension schemes and finance directors grappling with accounting disclosures. In fact, that is a bit of an understatement.
Improving world stock market returns in 2009 will have helped the asset side of the pension balance sheet, particularly for those pension schemes with a meaningful equity exposure, albeit it has been a bit of a volatile ride. This may have given some finance direction a false sense of optimism.
However this good news is likely to be more than offset by a very significant reduction in bond yields since the 2008 year end. Pension accounting standards such as Financial Reporting Stadnard 17 (FRS17) and International Accounting Standard 19 (IAS19) require liabilities to be discounted using AA corporate bond yields of an appropriate duration to the pension scheme liabilities.
One common measure of this is the Markit 15 year iBoxx Corporates AA 15 year + index . During the course of last year, this fell from about 6.7pc per annum to about 5.5pc per annum. This meant that figures produced at 31 December 2008 factored in a much higher risk of default than applies today, resulting in what may be viewed as an artificial reduction in the accounting liability disclosed, and therefore improvement in the funding and balance sheet positions, other things being equal. At the time it was a welcome offset to sick asset valuations, but it is likely to make the resultant impact of the 2009 figures all the more stark.
The impact that this will have on individual pension schemes depends mainly on the age profile of the membership. It will also depend on the extent of any margin that was deducted from the rate used at the previous year end to allow for the effect of the “credit crunch”. Assuming a discount rate of around 6.5% p.a. was adopted at 31 December 2008 and discouting other factors at play (for example changes in the inflation and longevity assumptions), for a young scheme with a typical benefit structure and average weighted age of say 45, this will increase the liability value by about 30%. For a more mature scheme, with an average age 55, the increase is about 20%.
How pension liabilities are valued in accounts is at long last being recognised by analysts and investors as being very significant. It is capable of distorting a company’s financial position and should be looked at closely, frequently with some degree of scepticism. Indeed the FRS17 basis has long since been discounted by the Pensions Regulator as too weak a basis to be credible for funding a final salary pension scheme. Funding on an FRS-type basis was in vogue when the new pensions funding regime came into play in late 2005, but it has now more or less been discredited.
Recent research has suggested that the Royal Bank of Scotland and Lloyds may have been underestimating pension obligations in their statutory accounts by in excess of £24bn combined. The survey by AlphaValue suggested that both organisations were using too high a discount rate in their accounting disclosures, therefore reducing their scheme deficits. This is an issue not just for the very largest companies but for any company disclosing pension liabilities in their accounts.
The UK’s Accounting Standards Board (ASB) in its January 2008 discussion paper “Financial Reporting of Pensions” proposed replacing the AA corporate bond discount rates used for calculating scheme liabilities with a risk-free rate of return, such bas government gilts or a swap rate.
A move to a risk-free basis would have an even more significant impact on the company balance sheet. Currently, this would result in an annual discount rate of about 4.3% in contrast to 5.5% mentioned above, and an increase in liabilities of 30% for the younger scheme mentioned above and 20% for the more mature scheme in addition to the increases referred to above.
In a supplementary report to its earlier report entitled “The Financial Reporting of Pensions – Feedback and Redeliberations”, the ASB confirmed its view on discount rates and stated: “The ASB, in considering concerns arising from the use of AA corporate bond rate in the UK at this time, affirmed its view that the discount rate should reflect only the time value of money, and therefore should be the risk-free rate. In its view, the risk associated with the size and variability is more appropriately addressed through disclosure”. However, it is believed that the International Accounting Standards Board (IASB) has at this stage decided not to provide additional guidance on how to determine the discount rate.
Never has it been more vital for finance directors to review the basis on which their disclosures are calculated. The company directors are responsible for the basis of the disclosures in the company accounts. FRS17/IAS19 requires the assumptions to be derived on a best estimate basis after taking actuarial advice. However, it is common for the pension disclosure calculations to be carried out using many of the same assumptions used by the pension scheme trustees for funding purposes. And yet the assumptions used for scheme funding are required to include margins for prudence such as the allowance made for longevity improvements of future salary increases – companies may have recently revamped their policy on the salary review process, resulting in lower expected increases than in the past, but this may not have filtered through to the pension funding plan. It could be argued therefore that these calculations are not best estimates and overstate the employer’s accounting liability as far as these assumptions are concerned.
Ensuring the use of best-estimate calculations based on the employers specific circumstances may be an area worth investigating as a possible way of mitigating some of the likely increase in the year-end liabilities and protecting the company’s balance sheet position.
For information regarding pension accounting computations and disclosures contact Ian Campbell on 0141 331 1004 or email firstname.lastname@example.org
Issued on behalf of Spence & Partners by Blueprint Media
This article was featured in the Your Money supplement of the Daily Telegraph on 27th Feb 2010
Date: February 2010