John Plender: An easy way out of a hole

But it is only for the privileged few

The Financial Services Authority sports an accumulated deficit in its latest balance sheet of £67.4m. This arises because it has a pension fund deficit of £80.6m, as measured by Financial Reporting Standard 17.

Among other things, the deficit reflects a very aggressive asset allocation policy whereby 80 per cent of the portfolio goes into equities.

The FSA is not too worried about running such a deficit alongside a very low level of reserves because it has statutory powers to raise fees from the firms it regulates. The scheme trustees are also reviewing asset allocation and expect to move gradually to lower risk assets in the medium term.

Yet its clients in the City could be excused for feeling less happy. This is, after all, a clear case of moral hazard in which risks have been run on the basis that regulated financial institutions will be forced to come to the rescue if things go wrong.

In fact, the City has already been obliged to stump up, because fees have been raised to pay for deficit reduction contributions. Note, too, that the FSA operates under a much more relaxed capital regime than the one it imposes on the insurers it regulates.

I make this point not because the FSA is being hugely rapacious. The deficit reduction contribution in 2004-05 will be £5m, which is small in relation to its total fees of £236m. But there is an important principle involved, which is relevant to other much larger parts of the pension fund system. Many who now forecast a decline in pension fund equity holdings make the assumption that there will be a lesser decline among local authority pension funds than in the private sector. This is worrying. Can it be right that local government is permitted to engage in risky investment policies while relying on council tax payers to fund any resulting deficit?

Surely not. Whitehall is aware of the dangers of moral hazard in relation to its proposed pension protection fund. But it also needs to think about how to protect people from bodies that can tax their way out of pension deficits that result from morally hazardous high- risk investment strategies. I predict big increases in council tax to pay for chunky pension deficits.

Opt out of options

In the heated debate on whether stock option costs should be charged in the profit-and-loss account, small high-tech companies are portrayed as unfortunate victims of the accountancy watchdogs' allegedly misguided zeal.

Yet a forthcoming study from UK-based Halliwell Consulting on executive pay in the pharmaceuticals and biotechnology sector suggests that it is not necessarily so.

Stock options are often said to be particularly suitable for small biotech companies. With little revenue it appears to make sense for them to pay low salaries and benefits, while granting options in the hope that one blockbuster drug will send the share price sky-high, thereby delivering a bonanza to option holders. Yet from 2000 to 2004, share prices have fallen and the options are under water.

The result, as the consultants point out, is that some companies are running into hostility from institutional investors as they try to rebase the options. Others are up against their dilution limits.

Disillusioned executives who perceive their options to be worthless are susceptible to poaching by rival companies. So remuneration committees have raised total cash compensation while share prices have been declining, to prevent human capital walking out of the door. The link between performance and reward thus becomes tenuous.

Moving to compulsory expensing of options would probably end their use in biotechs. But Halliwell's number crunching shows that the volatility of some smaller company share prices in the sector is so great that the potential option cost in the profit-and-loss account is almost as high as the cost of providing a plain vanilla share award under a Long Term Incentive Plan (LTIP). Its calculations also show that unless a biotech company expects its share price to grow by as much as 40 to 50 per cent a year, executives will receive more value with less dilution at the same cost in the profit- and-loss account if they use LTIPs rather than options. So waving goodbye to options would do less damage in high tech than many think.

Fair values stabilise

If you dislike IAS 39 on financial instruments and think fair value accounting is destabilising, take a look at the latest Financial Stability Review.

Ian Michael, of the Bank of England, cites the US Savings and Loans crisis as evidence to the contrary. Traditional accounting meant the mismatch between variable interest rate deposits and fixed rate mortgages showed up only gradually through negative annual net interest income. A fair value approach would have shown much earlier that the true economic value of the S&L's fixed-rate mortgages was below that of the deposits. Fair value accounting, says Mr Michael, might have lowered the fiscal bill. Sounds plausible to me.

john.plender@ft.com

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