Strategy & Operations » Leadership & Management » ACCOUNTING – Why the importance of valuing your pension fund

Pension schemes have very big numbers and they cause equally large accounting problems. The result is that accounting for pension costs has made about as much progress as actuaries have on improving their image. According to actuaries Bacon & Woodrow, FTSE-100 companies between them have pension schemes with assets amounting to a modest £70bn. As a company’s balance sheet is often dwarfed by the assets of its pension scheme and pensions costs can have a correspondingly significant impact on the accounts, the sensible FD has only one coherent thought: predictability. In a Bacon & Woodrow survey of FTSE-100 FDs, 85% thought the ‘P’ word was “very important”. Which is a shame, because under the new International Accounting Standard (IAS) and the latest Accounting Standards Board (ASB) discussion paper on pensions, volatility is the name of the game. The idea of a defined benefit company pension schemes is theoretically quite simple. You promise your employees a certain level of pension when they retire. Employer and employees chip in cash regularly to fund the pension scheme and then you calculate how much you have to pay out. If the assets and the liabilities get too out of kilter you just put in more money, or stop paying until the two are in balance. Measuring the assets is quite simple. The really difficult bit is deciding what your liabilities might be in 30 or 40 years’ time and then discounting that back to present values to ensure there is enough in the kitty. Equally difficult is to work out how to treat the gains and losses. The difference between the international position and the UK position is relatively minor. The biggest disagreement between the stance adopted by the International Accounting Standards Committee (IASC) and the thinking of the ASB is over the discount rate for liabilities. The two standard setters agree that much of the volatility of pension costs – “actuarial gains and losses” – can be mitigated using an appropriate discount rate in valuing liabilities. However, while the IASC’s standard IAS 19 suggests using the rate on high-quality, fixed-rate corporate bonds, the ASB would prefer to use the rate of return appropriate to the pattern of the scheme’s obligations. At the moment the ASB admits it doesn’t know quite what that discount rate is and is looking to actuaries for guidance on appropriate rates for different classes of liability. The argument over which discount rate to use seems fairly arcane: the problem with the internationally accepted method – effectively a risk-free bond rate – is that a pension scheme believed by both its sponsoring company and its actuary to be fully funded could show a deficit under this approach. This means more real expense for the company topping up a deficit which it may legitimately consider to be non-existent. On the other hand, whether actuaries will come up with answers for the ASB on the “appropriate portfolio approach” remains to be seen. While the ASB has been rather hemmed in by the IASC on the discount rate issue, it has apparently won the battle over market valuations versus actuarial values – a fight that the ASB would have been determined to win anyway. After all, its discussion paper released three years ago floated some of the ideas which, although rejected at home at the time, now look certain to be accepted. The ASB’s critics are saying that under the pretext of international harmonisation, and with a certain amount of phoney hand-wringing, the ASB is forcing through the market valuation approach. So despite the discount rate disagreement, the ASB is probably not too unhappy with the situation it finds itself in. It dislikes SSAP 24, a standard which was creaking even before it ever hit the standard books. The standard is unfashionably flexible and depends heavily on actuarial judgements. Actuaries calculate pension costs using long-term assumptions about employment costs and inflation which means that pension costs are relatively stable – or artificially smoothed, depending on your point of view. But SSAP 24 still has its supporters. Some FDs are still arguing that these employment costs, effectively deferred salaries, are as long term as they come. It’s pointless looking in the Financial Times once a year to find out what the assets are worth, trying to make a meaningful valuation of liabilities and then pouring in cash in a desperate attempt to get the two to balance, wrecking the profit and loss account on the way. Those who say the pension valuation exercise should not be a regular crisis are happy to be labelled “smoothers”. But smoothing is a real no-no as far as standard setters are concerned. One of the ASB’s founding principles is that accounts should reflect commercial and economic reality. Smoothing the ups and down of your pension costs cuts directly across that aim. However, the sop to anxious FDs, which conveniently fit in with ASB thinking, is to allow the result of the volatility to be fed into the statement of total recognised gains and losses (STRGL) – “struggle” as it’s known in some FDs’ offices. The big question is whether the ups and downs of the pension scheme should be dumped into the STRGL and quietly ignored or whether it should then be fed through to the profit and loss account over the average remaining service lives of employees. That, says the ASB, is part of a wider debate on an innovative use of STRGL and at the moment its mind is open. As for pension costs, in this instance, as in every other, accounting should reflect economic and commercial reality not drive it. But the new accounting may do the opposite. One way to stabilise costs would be to move towards money-purchase benefits where costs are certain although benefits are not. According to the Bacon & Woodrow survey over 65% of FTSE-100 FDs would change their pension scheme’s investment strategy. And as these guys control combined assets of £70bn just think of the effect that would have on the stockmarket.