After all the reams of newsprint dedicated to the horrors associated with final salary pension fund liabilities, pensions research company Blacket Research has shone a spotlight on a previously hidden benefit of final salary schemes. It seems they can be great news, given the right circumstances – if you want to window-dress your accounts.
This is quite a novel thought, given that the UK has invested more than two decades of strenuous work in fine-tuning our accounting standards so that an FD’s scope for creative accounting would become vanishingly small. One thing accounting standard FRS 17 was not supposed to do was create fresh opportunities for scamming the numbers.
By simply tweaking one or two of the assumptions underlying your pensions reporting you could – in certain circumstances – increase your reported profits by as much as 10%. Impossible, you say? Auditors would jump on it. The City would see through it. The company would get pilloried. Perhaps and, then again, perhaps not. Or not immediately.
The point here is that Blacket has identified what environmentalists and chaos theorists like to call the butterfly effect; in essence, small micro changes that result in huge macro movements.
Roger Brown, a director with the company, explains that a change of just 10 basis points (0.1%) in the assumptions a company makes about the long-term returns on equities can result in a 1% movement in profits. So a 100 basis point change, say, which might mean moving to an 8% return where previously you had been content to stand on 7% could, for some funds, create a 10% addition to profits.
Initially, Brown says, when Blacket started the task of going through FTSE accounts and analysing corporate assumptions on pensions reporting, it expected to find a great deal of commonality. In fact, it found a staggeringly wide range of assumptions. “Our basic assumption was that there would be a small variation among FTSE companies in something as specific as the scheme’s expectations on the likely return on equities. In fact, we found a considerable range of assumptions.”
Brown’s point is not that UK companies are window dressing their accounts. Blacket is trying to alert FDs that when the company makes assumptions about its final salary pensions scheme, those assumptions have a direct impact on the reported figures. “If we focus on, say, The Big Food Group, which now has the Icelandic Pension Fund inside it, this company has a relatively cautious policy with respect to equity returns, at just 6%. If it simply moved its equity return rate to the start of the upper quartile range, our analysis shows it would increase its reported profits by 10%.”
Similarly, Brown points out that the RAC could increase its profit by 5%. “Basically, the more conservative a company is, the bigger the impact of a move towards the upper-quartile of the range of assumptions on equity returns made by FTSE companies,” he says.
So, by optimising the FRS 17 assumptions from an accounting perspective, a company could have a dramatic impact on its reported figures. Moreover, it can achieve this without making its change of assumptions so extreme that people cry foul. It won’t work for every company as you need a large pension fund in relation to the size of the company.
The converse effect can work as a barrier against moving to a more conservative approach on equity returns by companies with a history of overestimating returns. To swing from a bullish top-quartile set of assumptions to an ultracautious bottom-quartile approach could wipe a significant percentage off the company’s profit.
Blacket’s real aim and reason for being in business is to help FDs come to a better understanding of what Brown calls short-term risks. When companies seek to understand the risk implications of their final salary pension schemes, they are almost always told to focus on long-term risk analysis. From an FD’s perspective, Brown argues, the more important risks are the short-term risks.
He points out that if you take a long-term view of stock market volatility, for example, you get a pretty stable bar graph year on year. If you switch to a short-term graph of market volatility you can get a 100% change in your measure of volatility in a year. So his key message is, focus on short-term as well as long-term risk. The window dressing issue is just an aside – an interesting observation. An analyst might take a different view. “FRS 17 has been beneficial. It brought considerable transparency into pension funds. Now they are coming on to the face of the accounts and have a massively high profile,” he says.
Another contentious issue highlighted by Blacket is the discount rates used when the FD takes the liabilities of the pension scheme into the accounts at present value. Should the discount rate be the equivalent of an AA-rated corporate bond of similar duration to the pension fund? If you discount back at a particular rate one year, and then you pick a slightly smaller discount rate the next year, the size of the liability rises. A slightly higher discount rate means the size of the liability decreases.
Brown’s point is that if you take a scheme with a duration of 15-to-20 years or longer, when you discount back over that kind of timeframe, small changes in the discount rate can have a large impact. Again, 10 basis points either way can change the liability of the fund by as much as 1.5%.
“For the top 25% of companies with large schemes relative to the size of the company, a change on the discount rate can impact the liability of shareholder funds enormously,” he says. Of course, there is much less scope here for variation, since the discount rate prescribed by FRS 17 sits off the AA bond rate. But there is scope for FDs to make small decisions which can have gigantic effects.
Orlando Harvey Wood, a pensions partner at Deloitte, points out that the latitude allowed to FDs by FRS 17 should cancel itself out over time. “There is no single right answer for something like a return on equities. The UK has taken the position that companies have some freedom to make decisions, but they must declare what they’re doing,” he says.
As of 2005, FRS 17 becomes mandatory and not just a disclosure-type entry. The way the return on equities works under FRS 17 is that the company books an expected return on equities against its pension liabilities on the P&L. Then, if it has overestimated that return, it books the deficit back again.
FRS 17 demands that companies show a five-year history of these bookings. This way, the user can see if the company has been consistently overoptimistic by seeing if they are perpetually having to register a deficit, thus making it easier to spot window dressing.
However, Harvey Wood points out that the history addendum is not that simple to read. Four years of deficits and one year where the assumptions undershoot market performance could simply mean the markets have moved against an ‘innocent’ company.
Brown says it will be interesting to see if the range of assumptions used by FTSE companies becomes narrower, or whether FDs start going for assumptions that make their companies look good in the short term. “My guess is we will see the range of acceptable assumptions narrow over time,” he says.