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Accounting for pensions: Chris O'Brien and Margaret Woods explain why boards should see the arrival of FRS17 as a sign that they should get more actively involved in fund management.

A survey reported in the Independent on May 10 last year revealed that 14 companies in the FTSE 100 had recognised deficits of more than 1bn [pounds sterling] in their pension funds. BT recorded the largest of these at 5.1bn [pounds sterling], followed by BAE Systems, where the deficit had increased by 1.2bn [pounds sterling] in 2004 alone to 4.3bn [pounds sterling]. At the same time two of the UK's largest banks, Lloyds TSB and the Royal Bank of Scotland, were also facing pension woes, with deficits of 3.2bn [pounds sterling] and 2.8bn [pounds sterling] respectively.

The statistics give some idea of the scale of the potential crisis, but they don't tell the whole story. These figures were measured in accordance with FRS17, which states that financial statements should "reflect at fair value the assets and liabilities arising from an employer's retirement-benefit obligations". In practice, this means that the assets of a fund are shown at market value and the liabilities are valued by discounting projected future cash flows at a rate equal to the yield on a AA-rated corporate bond.

At the time of the survey the implementation of FRS17 was incomplete: by the middle of last year 74 of the FTSE 100 had yet to adopt it fully. Many were still reporting according to SSAP24, which is more relaxed about the valuation process. It allows the use of actuarial assumptions that are inconsistent with current financial conditions and it doesn't require pension fund deficits to be shown on the balance sheet. Consequently, the fair value of the deficits faced by SSAP24-reporting companies remained hidden within their notes to the accounts.

The full adoption of FRS17 or the recent revisions to its international equivalent, IAS19, will make it much easier to assess the size of the total shortfall facing UK firms. Whatever that final figure might be, it's time for boards to take a more active role in managing their firms' pension funds.

By bringing the pension fund liabilities on to the balance sheet, FRS17 helps to clarify the potential cost to a company of fulfilling its commitments to retired employees. Facing up to such harsh economic realities can prove painful evidence of the market's reaction to new pensions information has emerged in the form of a number of aborted takeovers. In the case of both Marks and Spencer and WH Smith, the bidders withdrew partly because the firms' expected future costs of meeting their pensions liabilities became clear.

The state of a company's pension fund may, therefore, have implications for its share price, credit rating, borrowing costs and access to funding for future expansion, so it cannot easily be ignored. If it cannot be ignored, it should be actively managed.

The significance of the changes in practice introduced by FRS17 stem from the key requirement that a pension fund's surplus or deficit is reflected directly on the balance sheet, subject to certain recoverability limitations in respect of the assets. Changes in the year-end balances are then reported in either the statement of total recognised gains and losses (STRGL) or the P&L account, depending on the nature of the reasons for the change. Not surprisingly, perhaps, the value of assets and liabilities in a pension fund hinges on actuarial assumptions about current economic conditions, wage inflation, life expectancy and so on. Changes in such assumptions create what are termed actuarial gains or losses under FRS17, which bypass the P&L account and are recognised in the STRGL.

The 1.2bn [pounds sterling] increase in BAE Systems' pension deficit clearly illustrates the implications of this approach. When valuing its fund for the 2004 financial statements, its actuaries conducted a ten-yearly review of their mortality assumptions and raised their estimate of the post-retirement life expectancy of an employee retiring at 65 from 16 to 19 years. This change alone increased the fund's liabilities by 800m [pounds sterling]. The "loss" created through such an increase in liabilities is classed as a form of comprehensive income and passed via the STRGL rather than the P&L account.

It may be tempting, therefore, for accountants in a company to discount actuarial assumptions because they have no direct impact on the business's core performance statement. But to do so would be to ignore the wider economic implications of any revisions to these estimates. There are firms--BAE Systems, MFI and Uniq, for example where the equity assets of the pension funds represent more than 30 per cent of their market values. In such cases, disentangling the pension fund risk from the company risk is virtually impossible and any changes in pension fund values could have massive implications for investors. As a result, a company should not rely wholly on external auditors or actuaries when it comes to re-evaluating its pension fund. Instead, boards should consider asking challenging questions and deciding what information they require to understand the finances of its pension scheme and the risks associated with alternative courses of action.

Accountants can ask their consulting actuaries a number of simple questions. Let's look at two examples affecting either side of the balance sheet. On the liability side, mortality assumptions can, as in BAE Systems' case, significantly affect the valuation of a pension fund. Under FRS17 there is no requirement to disclose these, but it's still an issue that companies need to understand, because it can affect their decisions in the future.

A board should consider asking the actuaries the following questions:

* What's the assumed life expectancy of members of our pension scheme?

* How do your assumptions compare with the mortality rates that the UK as a whole has experienced?

* What if our employees are in an occupational group whose life expectancy is different from the UK average?

* How have you taken into account future increases in life expectancy?

* Will these future changes affect both pensioners and current employees?

* How sensitive is the valuation of our pension fund's liabilities to alternative mortality assumptions?

Such questions aren't intended to undermine the role of the actuarial experts in the valuation process. Instead, they allow the board to make its own assessment of the reasonableness of their underlying assumptions and the implications for the company.

Pension funds are like any other investment portfolio where the risks can be managed, so knowing the mortality assumptions may help boards to make risk management decisions. For example, should the mortality risk be insured, or would it be a good idea to buy a longevity bond'? After all, managing mortality risk is not a core risk of most companies, so why should they wish to retain it'?

On the asset side of the balance sheet, the board needs to ask questions about the investment strategy of the pension fund. It's arguable that firms should focus as much on their pension assets as they do on any of their other assets, but there is a problem: the investment strategy is determined by the scheme's trustees. In the interests of good governance, therefore, the audit committee should hold regular meetings with a representative of the trustees so that details of their pension investment strategies can be fed back to the board.

A key issue for trustees when they're deciding where to invest pension funds is how to determine the equities/bonds mix. They may be well acquainted with the higher risks associated with a bias towards equities, but under FRS17 these risks move to the balance sheet via the annual valuation process. Despite this, equities still dominate pension portfolios, perhaps indicating how much they hope that a stock market rally will eliminate the deficits created by earlier falls in share prices. But hope is not enough. There's a strong case for boards to get more actively involved in pension fund investment decisions.

The financial press reports regularly on how concerned both the private sector and the government are about the so-called pensions crisis, but the corporate response has been largely defensive so far. Many employers have closed their final-salary schemes to new members, thereby shifting the risk of poor fund performance to their workers. Others are negotiating with trade unions to increase employee contributions. At a national level, the government is talking of raising the retirement age to 70.

All of these actions help to reduce the risks to employers of poor pension fund performance, but none of them tackles the core problem. Leaving major assets in the hands of trustees, who may or may not be experts in investment and risk management, and accepting the valuations of external experts such as actuaries indicate a hands-off style of management. Does this represent the adequate protection of both shareholder and employee wealth?

FURTHER INFORMATION

CIMA recognises the concerns caused pension fund deficits and the potential risk that these deficits can pose to sponsoring companies-particularly their ability to implement strategy effectively. The institute's technical department has established a group of senior profession to discuss the issues arising and how organisations might manage them,

Margaret Woods is a senior lecturer in accounting and finance at Nottingham University Business School, where

Chris O'Brien is director of the Centre for Risk and Insurance Studies.
COPYRIGHT 2006 Chartered Institute of Management Accountants (CIMA)
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2006 Gale, Cengage Learning. All rights reserved.

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Title Annotation:TECHNICAL MATTERS
Author:O'Brien, Chris; Woods, Margaret
Publication:Financial Management (UK)
Geographic Code:4EUUK
Date:Apr 1, 2006
Words:1520
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