07 November 2017 by John Stittle
Growing pension reporting rules have contributed to the demise of defined benefit schemes
If there was an award for the financial reporting standard that has hurt companies’ balance sheets and the retirement plans of employees the most, there would be an undisputed winner.
The impact on reporting pension schemes by IAS19 Employee Benefits shows no sign of abating. The deficits of defined benefit pension schemes of FTSE 100 companies over the last decade have continued to increase – despite billions of pounds being shovelled into these black holes.
And now a new International Accounting Standards Board (IASB) pronouncement threatens to introduce more technical reforms that may impact company balance sheets even further.
In the UK, present day chief financial officers can only look back with envy to the pre-1988 company-reporting framework for final salary based pension schemes.
In that era, professional accounting bodies might have occasionally issued general guidance to accountants and companies, but there were no specific accounting rules or accounting standards being imposed on finance directors. Matters soon changed.
SSAP24 Accounting for Pension Costs was issued in 1988 and simply, but robustly, introduced formal regulation. Companies were required to write off any pension fund deficits to their income statement over the average remaining service life of employees to retirement.
Even greater regulation and more onerous reporting arrangement came in the UK during 2001 with FRS17 Retirement Benefits and later globally with IAS19. For the first time, the deficits (or surpluses) in defined benefit pension schemes were explicitly required to be recognised in company balance sheets.
Unfortunately, this increasing regulation has been hard for companies and damaging for employees. Companies have been saddled with massive pension deficits in their balance sheets, which depleted their net assets and led to the abolition of many defined benefit schemes.
Staff have lost a sound, predictable pension and been transferred to a risky defined contribution (or money purchase) scheme, with the level of pensions being mostly dependent on the performance of
the underlying pension investments.
A recent report on UK pension schemes has revealed just how stark the position is now. The author LCP, an actuarial firm, flags the substantial cash companies are using to fill in the shortfalls in defined benefit schemes.
The company pointed out that the combined FTSE 100 pension fund assets were £608 billion in June 2017, but the corresponding liabilities were estimated at £625 billion. These FTSE 100 companies have already paid over £150 billion into their pension schemes over the last decade.
Even so, pension schemes’ funding position today is bleaker than a decade ago. Since 2007, the combined total of these FTSE 100 pension funds moved from a £12 billion surplus to total deficit of £17 billion in June 2017.
It is no wonder that pension provision is now a top concern of chief financial officers. Most companies have already taken steps to reduce financial exposure to the risks associated with defined benefit schemes.
Indeed, LCP points out that no FTSE 100 company offers a traditional final salary defined benefit scheme for new staff. Increasingly companies are reducing or even stopping further accruals of benefits for existing employees too.
“Many companies saddled with massive pension deficits in their balance sheets have abolished defined benefit schemes”
By June 2017, only four FTSE 100 companies – Croda, Diageo, Johnson Matthey and Morrisons – continued to offer a diluted defined benefit scheme to new staff. Even then, these four firms either swapped final salary for average salary or used other criteria.
For existing staff, the position is increasingly precarious. Although the LCP report noted that 50% of FTSE 100 companies offer existing staff some defined benefit scheme, they are also now often based only on a career average salary or have restrictions like a pensionable capped salary or limitations on pension increases.
The major problem with accounting for pension schemes lies not with their investment assets but with their liabilities. Pension funds have liabilities and legal commitments to pay pension benefits not only to retired pensioners, but to current staff who may become pensioners years later.
IAS19 obliges companies to apply a discount to determine the present value of the pension scheme’s future liabilities.
The standard states this discount is based on the yield obtainable on a ‘high quality’ corporate bond or sometimes sovereign debt. The lower the yield the lower the discount rate – giving a higher reported level of pension scheme liabilities.
A major problem for companies is that this discount is not constant because bond yields can vary – sometimes significantly. LCP points out that in 2008 bond yields on AA-rated bonds reached around 7.5%, but fell to a low of 2% in early 2016 – subsequently rising slightly before falling again in 2017.
This short-term yield volatility can cause many problems. At a 7.5% yield the deficits of many funds will evaporate, but within a few years interest rates can fall again and the deficits reappear.
In contrast, pension fund liabilities extend decades into the future. Using IAS19 rules, some actuaries and accountants argue there is a mismatch. Pension fund deficit are, in effect, adopting a short-term measure by using yields that can quickly change to determine the value of long-term pension fund liabilities.
There were virtues in SSAP24, which adopted a long-term perspective in accounting for deficits. Although the standard was often faulted in the early 1990s, it did recognise pension fund
deficits would be amortised over many decades – and not subject to money markets’ short-term whims.
In addition, SSAP24 avoided the need for companies to recognise pension fund deficits in their own balance sheets – therefore putting less pressure on boards to abolish defined benefit schemes. The current IAS19 is often criticised for obliging companies to recognise large pension fund deficits in balance sheets – often leading them to under-capitalise.
Significantly, the LCP report argues that the discount used to determine these liabilities may be ‘overly conservative and the use of a more robust method can lead to smaller liability values’.
Typically, pension schemes are expecting to operate over 80 years, but there are few ‘true corporate bonds’ available over 30 years. Whereas many conventional models for discounting are influenced by changes in gilt yields, LCP believes that its own model based solely on bond yields shows discount factors currently used by most companies to be 0.3% too high.
That may seem a small figure but, given the long timescale and size of pension fund liabilities, it is estimated its use would lead to a 5% reduction in pension fund liabilities.
Just when companies and pension fund members thought matters could not become more serious there comes possible amendments in the form of IFRIC14. This guidance, from the International Financial Reporting Interpretation Committee has the potential to increase pension fund liabilities even further.
Many international financial reporting standards are complex to implement. As such, the IASB is increasingly forced to issue guidance and clarification on implementing the accounting rules.
“The PLSA warned employees there was only a 50% chance that the pension schemes would pay out their promised pension levels”
In 2015, the IASB proposed that if pension fund trustees had ‘a unilateral power’ to wind up a pension scheme then companies could not assume the trustees could continue to run this scheme until the last member dies. By itself, this proposal meant companies might have greater commitments and incur larger liabilities on balance sheets.
There are further concerns. LCP explained that in late 2016 further changes were proposed to IFRIC14 which could affect more companies. The IASB is proposing that companies identify whether the pension fund trustees have the power to settle or buy out the benefits of a pension fund – rather than establishing whether trustees have the power to wind up the scheme.
As LCP’s Jonathon Griffith pointed out, it is more common to find trustees do have the power in pension trust deeds to settle or buy out liabilities – rather than having powers to wind up a scheme. If this technical change is implemented in IFRIC14, LCP warns ‘many more companies will have their balance sheets impacted’.
At this stage it is unclear which pension schemes will be affected. LCP cautioned that the outcome may largely depend on the precise wording of the pension scheme trust deed – what the actuaries term ‘a small print legal lottery’.
More worryingly, this summer, consulting firm Mercer warned that 55% of defined benefit schemes in the UK were cash flow negative. Most of these schemes fail to generate a high enough income stream from members, employers and investments to meet their liabilities.
Mercer point out that cash flow deficits mean pension schemes increasingly need to dispose of investments to fund pension commitments. A major market correction could further lead to the forced sale assets at depressed valuation, heaping more burdens on the schemes.
This autumn the Pension and Lifetime Savings Association predicted the financial position of many pension schemes could harm many of the remaining 3 million employees still involved with defined benefit schemes. The association warned employees there was only a 50% chance that the pension schemes would pay out their promised pension levels.
Overall, the battle to save final salary defined benefit schemes is almost lost. Within half a century the UK has shifted from having the most extensive provision of these pension schemes in Western Europe, to most companies abolishing or planning to abolish them.
With the Bank of England increasingly hinting that interest rates will rise, the position of pension funds may improve. The last decade has seen exceptionally low yields, but in the long-term these yields will rise and reduce or eliminate many pension fund deficits.
By then it will be too late. Defined benefit schemes will have been finally killed off by IAS19, low bond yields and potential IFRIC14 changes, not to mention interference by politicians and tax changes. The crucial question is now, how will employees obtain an adequate and risk-protected level of retirement income?