Transparency in pensions

Peter Williams unpicks the devil in the detail of pension accounting

Paul Boyle, the first chief executive of the newly expanded UK Financial Reporting Council, recently gave a presentation at a pension conference to finance directors and treasurers entitled “Managing your pension liability”. One section of the talk was called “The magic telescope” or, as Boyle put it, “How to make very big things appear very small”.

The essence of this idea is that accounting for pensions is still more about sleight of hand than it is about honest presentations of the facts. As John Hawkins, the former head of finance and risk at Invensys and now a pension writer and consultant, puts it: “Essentially, the finance director can still work his magic on pension fund deficits. Especially if on the balance sheet he concentrates on mortality expectations and on discount rates. And, when it comes to the income, there is much that the FD can do on expected investment returns.”

So is accounting for pensions the last great area for creative accounting? Well, maybe. But if that is the case then it is probably not the fault of the finance director or the standard setter. Indeed, the blame cannot be laid at any one door. The fact remains that pensions are complicated and, so, therefore is the accounting.

As Boyle said: “This is not about FRS 17, Retirement Benefits, or its international equivalent IAS 19, Employee Benefits; this is not about investment strategy. The drivers of pensions liabilities are salary increase, additional years of service, life expectancy improvements and discount rates.”

For a subject, which by any stretch of the imagination cannot be accused of setting the pulse racing, pensions rarely seem to be out of the headlines. After a lengthy transition FRS 17 came into force in the middle of 2003. Around the time it was issued, the then UK Work and Pensions Secretary, Alistair Darling, summoned Sir David Tweedie, then chairman of the Accounting Standards Board (ASB), to express his view that the accounting standard was ruining the pension industry. It was a classic case of shooting the messenger. FRS 17 has helped a slowly dawning realisation among politicians, corporates and would-be pensioners that the present systems of pension provisions are unsustainable. And many of us are in for a poverty-dominated old age.

But now, after having seen the deficits FRS 17 has produced, questions are being raised over how the numbers have been calculated. One of the major changes under FRS 17 is that pensions liabilities and assets are no longer confined to the footnotes of report and accounts, but now move to centre stage where any surplus or deficit immediately becomes an integral part of the balance sheet.

Such a material liability on the balance sheet has an impact on share price, dividend flexibility and loan covenants. The pension liability has become the new poison pill. Richard Farr, leader of the pension team at PricewaterhouseCoopers, says: “There is a lot of flexibility in FRS 17. What we are suggesting is greater disclosures.” Farr worries that hostile bids are being blocked because the would-be takeover team cannot get the information they need to assess the pension issue properly. Quite a few deals have foundered on the premise that you may fancy the company but you won’t take on the pension risk. Bob Scott, partner at actuarial outfit Lane Clark & Peacock (LCP), says: “Pension fund deficits continue to have a major impact on the way many FTSE 100 companies operate. Those companies with significant FRS 17 deficits on their balance sheets may well find themselves restricted in terms of the dividends they are able to pay to shareholders and the capital they can raise for refinancing. Pension deficits will also play a significant role in merger and acquisition activity and are already curtailing potential deals.”

But what exactly is the risk? Probably no one really knows. Unique in the balance sheet, the pension liability (or asset) depends entirely on the use of actuarial assumptions. If accounting is a grey area, then accounting mixed with actuarial practices becomes decidedly murky. Change the assumptions even by apparently a tiny amount and the balance sheets numbers can shift dramatically. Consultants Pension Adviser Review recently published FRS 17: The Finance Directors’ Guide to Actuaries and their Assumptions. Pension Adviser Review pointed out that the directors of the company are responsible for the accounts and the accounting policies - and, hence, the assumptions used in coming up with the pension numbers. However, any sensible board is going to take advice from professional actuaries on the sort of assumptions they should be making.

There are three key assumptions that finance directors and their boards need to consider and agree on before the numbers can be crunched and the pension deficit or surplus calculated.

• First, the amount of money the pension fund will have to pay out will depend partly on the salaries of employees. So what salary increases are they likely to get before they retire?
• Secondly, how long are pensioners (and dependant spouses) likely to live?
• Finally, defined benefits scheme liabilities are discounted at a rate that reflects the time value of money and the characteristic of the liability. FRS 17 says: “Such a rate should be assumed to be the current rate of return on a high quality corporate bond of equivalent currency and term to the scheme liabilities.” Pension Adviser Review found that, in the fourth quarter of 2004, the assumed discount rate across all companies varied from a low of 4.85% to a high of 5.09%, a spread of 105 basis points. A spread of this magnitude represents a difference in pension liabilities of as much as 15% or more.

When the total deficit of pension assets to pension liabilities for S&P 500 companies amounted to $185bn and to FTSE 100 companies £58bn (figures from Mercer Human Resource Consulting) for the 31 December 2004, then you can see the odd percentage point here and there really matters.

One emerging point directors should note: companies should be wary of playing too fast and loose with changing assumptions. The sponsoring company directors and the trustees should be aware of falling foul of as yet untested anti-avoidance provisions under the newly-introduced Pensions Act 2004 which are designed to ensure sponsoring companies don’t rip off the pension fund.

One accounting standard setter who declined to go on the record, but who had been heavily involved in drawing up FRS 17 and is still involved in standard setting, agrees the standard wasn’t perfect. He told accounting & business: “There is a lot more information in FRS 17 than there was in SSAP 24 [the previous accounting standard]. There are various assumptions that companies have to make and that means that there are still some mysteries, but accounting for pensions is getting better.”

It does seem that the disclosures around accounting for pensions will improve in the long run. Sir David Tweedie, now chairman of the International Accounting Standards Board (IASB), recognises that IAS 19 is flawed and is due a makeover. When that will happen is not clear. Part of the problem is that the IASB is trying to march in step with the US Financial Accounting Standards Board (FASB). And, according to John Hawkins, the US accounting standard is a horrible cross between FRS 17 and SSAP 24.

It is clear that accounting for pensions is never going to be perfect. The figure in the balance sheet is a snapshot of obligations that will not actually kick in for decades. But Hawkins has some strong ideas on how to make the best of a difficult job. He would like to see the compulsory disclosure of the mortality tables used so it is clear how long companies think employees and pensioners will live. He also wants the actual rather than the expected return on investments put through the income statement. Finally, he wants pension liabilities to be discounted using a risk free rate rather than using a high grade bond rate.

Hawkins said: “The eminent economist, Jack Treynor, first explained why a risk free rate should be used over 30 years ago - he was right then and he is still right.”

Such moves will not make pension accounting crystal clear. Nothing will do that. But it could help to take away the sense of the black art.

Peter Williams is a journalist and a chartered accountant. He writes on accounting, financial reporting and auditing issues.