Monday, 20 November 2017

    A rough guide to calculating a pension fund’s liabilities

    Rising scheme ‘deficits’ due to falling corporate bond yields have fuelled debate over the imperfect business of accounting for pension fund liabilities, finds Luisa Porritt

    Workplace Pensions Live 2017

    Coping with stubborn deficits is just one of many topics that will be debated at Workplace Pensions Live, our flagship annual event in on 10-11 May in Birmingham.

    The event is free for scheme managers and trustees to attend. Click here for more information.

    DB schemes in deficit and thereby eligible for entry into the UK’s Pension Protection Fund (PPF) are on the rise, according to the latest PPF 7800 index. Of the 6,057 schemes in the index, 4,995 schemes were in deficit as at the end of March, with the aggregate deficit increasing on the previous month. Total liabilities outstripped total assets by £245bn.

    calculator index

    One of the driving factors of this declining position has been the continuing fall in UK gilt yields. “Recent market conditions have seen a good performance on the stock market but bond yields have fallen, pushing up pension fund liabilities to new highs. The bad news has outweighed the good,” says Tim Marklew, partner at financial, actuarial and business consulting firm Lane Clark & Peacock (LCP).

    On 30 January, UK government bond yields hit a record low”

    On 30 January, UK government bond yields hit a record low of 1.32% and have since hovered at about 1.5%, still a historic low. AA-rated corporate bonds, which carry more risk so present higher yields, are also yielding at historic lows of between 3% and 4%.

    This has a significant impact on the calculation of pension plan obligations. Interest rates on high-quality corporate bonds are used to determine a plan’s expected risk-free return in the future, or the discount rate. If the discount rate falls, a pension plan needs more assets today to generate sufficient investment returns to pay a projected amount of benefits in the future, or so the theory goes.

    Impact of quantitative easing

    Since the introduction of quantitative easing in the UK, returns have reduced dramatically and employers have had to put more money in pension schemes as a result, says Helen Forrest, DB policy lead at the National Association of Pension Funds (NAPF). While asset purchasing has artificially suppressed gilt yields, equities markets can be exceedingly volatile, she says. For example, last month the FTSE 100 broke past the 7,000 mark for the first time.

    Yet under accounting rules, pension funds have to submit mark-to-market valuations, or ‘fair value’, using a snapshot of the actual value of assets at a certain point in time, impacting on the reported profits of plcs and giving a potentially distorted picture of a scheme’s overall funding position.

    Since the introduction of quantitative easing in the UK, returns have reduced dramatically and employers have had to put more money in pension schemes”

    Most commentators say it is a useful indicator in the absence of a better method. However Iain Clacher, Associate Professor in Accounting and Finance at Leeds University, believes this approach is led by dogma at the International Accounting Standards Board (IASB) rather than what is reliable. Mark-to-market means that while schemes face ‘deficits’ today due to low bond yields, once interest rates rise they will report a high surplus, meaning these snapshot figures are far from economic reality, he says. “Pension liabilities can jump by £30bn in a week in a [volatile] market; there is no way that reflects economic reality. The assets are still there, so the fund has not accrued any real liability.”

    Clacher thinks it would be simpler and more relevant to report on cash flow when assessing pensions’ liabilities, as it is easier to assess how much needs to be paid in to and out of a scheme over a five to 10 year period. The rationale for this is that companies typically last that long, while cash is a hard number not reliant on gilt yields, he adds.

    Paul Geeson, a partner at Deloitte, disagrees that mark-to-market is an unreliable approach. “It’s worth what you can sell it at,” he says, adding it is valid to use the latest information available.

    Changes in international accounting standards: IAS19

    In spite of these areas of contention, Marklew at LCP thinks that in many ways, pensions accounting is simpler than it was a few years ago. “Previously, there was a choice between fundamentally different accounting approaches, such as the corridor method [whereby an unanticipated gain or loss could be smoothed out by a company on its balance sheet over time]. Now, without that, under IAS 19, the process is fundamentally similar.”

    Pensions accounting is simpler than it was a few years ago”

    IAS 19 is the international standard used for financial reporting by a parent company and referenced by international investors. The UK revised its reporting framework, known as Generally Accepted Accounting Practice (UK GAAP), at the beginning of this year to fall in line with international standards. These changes have significant implications for pensions accounting.

    Abolition of FRS 17

    Accounting rule FRS 17 was abolished from 1 January 2015. Most smaller UK companies not listed on the stock market used this approach. But under FRS 17, small firms - and subsidiaries of larger parent companies that were subject to the same rules - often did not show their pension scheme liabilities on their balance sheets. Under the new rules, companies are either subject to international standard IAS 19 or a simplified UK version of the same standard, FRS 102. This could have a massive impact on the balance sheets of firms which were not previously reporting pension fund figures, amounting to an estimated overall £1.5bn cost to UK firms, with implications for dividends, banking covenants, remuneration, credit ratings, and PPF levies, says Marklew.

    Changes following the move from FRS 17 to IAS 19/FRS 102

    • Changes to cost in Profit and Lost (PNL) for all schemes due to abolition of ‘expected return on assets’
    • Multiemployer schemes have to record a deficit for the first time – they did not under FRS 17
    • For companies undergoing ‘special events’, such as buy-ins or redundancies, there could be an effect for schemes under the new standards
    • Change in rules affecting ability to recognise schemes’ accounting surpluses on the company balance sheet
    • Companies paying contributions to schemes with funding deficits face complex rules under IFRIC 14, this can mean extra liabilities in some cases

    IFRIC 14

    A complex add-on to the IAS 19 rules, this means that in some cases where a company has recorded a surplus, it would instead have to show a deficit in view of future payments to its pension scheme. This is an area of contention, as it begs the question how far ahead into the future companies need to look.

    Changes to these rules are expected to be announced by the IASB in the coming months”

    Doing so means exploring unlikely hypothetical situations such as whether in 100 years’ time individuals would get their money back, even though by then existing scheme members would have died. “It’s a legal lottery,” says Marklew, adding that of two comparable companies with similar pension schemes, one could end up recording a surplus and another a deficit.

    Changes to these rules are expected to be announced by the IASB in the coming months. But Marklew thinks it’s unlikely these changes will resolve all the current issues, and would most likely create new ones.

    Triennial funding valuations and prudence

    To complicate matters further, the valuations trustees produce are an entirely different set of numbers used for a different purpose. Trustees are interested in the funding level and scheme contributions, whereas a company lists its pension scheme liabilities to meet accounting standards and has to think about how this will look to investors. “When thinking about pension scheme liabilities, there isn’t any true value,” says Paul Geeson, a partner at Deloitte. “The value needs to be appropriate for the purposes you are going to use it for.”

    There is a danger of becoming overly prudent”

    Trustees are told by The Pensions Regulator (TPR) to be ‘prudent’ in their assumptions when setting an expected return on assets, so they will tend to underestimate. This has led to employers having to pay in more contributions. Rather than using a ‘best estimate’ basis, as a company would in its accounting procedures, trustees are forced to adopt a neutral estimate, which in reality may be a surplus.

    Another way in which trustees can implement prudence is in setting mortality assumptions. There are others, but then there is a danger of becoming overly prudent if all these assumptions are applied at once. Instead, trustees can tailor how they factor in prudence according to a scheme and its sponsor’s circumstances.

    How to do that is not a straightforward question for all schemes. Some already have a strong ‘employer covenant’, or an understanding of the extent of the employer’s legal obligation and financial ability to support its DB scheme now and in the future, and this informs the degree of risk that can be taken in an investment strategy, says Forrest at the NAPF. Others need to now build that relationship.

    JARGON BUSTER

    ■ Quantitative easing: The government’s programme of issuing newly created money in exchange for bonds. QE has forced bond yields down, causing scheme liabilities to rise.

    ■ Mark-to -market accounting: Taking a ‘snapshot’ of the value of the scheme’s assets and liabilities using market prices on the date the scheme accounts are written.

    ■ FRS 17 and IAS 19: The UK and international accounting standards that cover reporting on pension schemes.

    ■ Corridor method: An accounting measure that allows large gains or losses on scheme assets or liabilities to be ‘smoothed out’ over time.

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