Pension fund accounting is a tricky business. Calculating the liabilities of a pension plan is complicated, based as they are on future interest rates, inflation and the likely longevity of the pensioners. Calculating the value of assets is relatively easier (though not entirely straightforward), but if the joint calculation comes out showing a deficit, life becomes hard for both pension fund and corporate sponsor.
The UK’s National Association of Pension Funds is so wound up about the issue, it is planning a summit to try to come up with new ways to report what a pension fund’s liabilities are.
“Current accounting standards have been very damaging to defined benefit provision, leading many companies to close their schemes,” NAPF chairman Lindsay Tomlinson said at its recent conference. “Pension funds are long-term institutions but today’s accounting standards fail to reflect this.”
Although the pension funds and their corporate sponsors may struggle to cope with the implications of current practice – whereby pension fund assets and liabilities are calculated at current market values – in principle, investors should benefit from greater disclosure.
“The huge debate is to what extent should a liability for 10 or 20 years’ time be reflected in accounts today,” says Bob Parker, senior adviser at Credit Suisse. “Are we getting this right? We probably are.”
Mr Parker was scathing about corporate sponsors’ and pension funds’ desire to state their pension liabilities in more favourable terms. “I don’t believe in being too nice about stating debts.”
In recent years, there has been increasing standardisation of how companies are expected to report pension funding, and it is to a large extent based on mark-to-market valuations of both assets and liabilities.
“The direction of travel is pretty clear, towards more disclosure and better disclosure,” says David Fogarty, European head of Mercer’s financial strategy group.
Although there seems to be consensus that pension funding levels are useful information for investors, there is some disagreement around whether the current format is sufficient.
John Broome Saunders, an actuary at BDO Stoy Hayward, approves of the principle that liabilities should be made plain to investors, but suggests simply stating the current assessment of their value is insufficient.
“The key thing to bear in mind is you’ve got to build in the risk associated with pension liabilities,” he says. “In reality, a better way of assessing the quantum of that uncertainty would be the buy-out valuation.”
More and more pension funds have been looking at the option of buy-out, paying an insurance company to take on the scheme’s liabilities, but the market is still nascent in the UK.
This is the obstacle to what Mr Saunders describes as “the only truly objective market measure” of the cost of pensions. It may be truly objective, but the market is not sufficiently liquid for prices to be reliable. Mercer and Pension Corp have each recently launched indices intended to show the market cost of buy-outs, but neither has a long history or a large number of data points.
“The buy-out value is not that helpful, because it depends on the current appetite for buy-out. That market has come and gone over the financial crisis,” says Gordon Clark, an Oxford professor and pensions expert.
Mr Fogarty is more positive about the suggestion, looking forward to a time when a more developed buy-out market will mean prices are more reliable.
Prof Clark points out that whatever the failings of mark-to-market pension accounting, it is an improvement over the free-for-all that used to exist. “Thirty years ago, accounting conventions made it difficult to have a comparable basis,” he says. “Mark-to-market, love it or hate it, is a much easier way of understanding the situation. I think it has made an appreciable difference to the valuation of stocks.”
According to Mr Fogarty, accounting standards such as FRS17 and IAS19 are not so much intended to give total understanding of the value of a pension fund as to make it possible for investors to compare one company with another, confident that reported accounts are based on the same standards.
The mechanism by which investors take account of pension liabilities is not entirely straightforward.
“What you’ll find is that while equity analysts aren’t focused too much on pension deficits, credit analysts do pay attention to it,” says Mr Fogarty.
“The transmission mechanism is the credit rating agencies, which factor in pension deficits in rating company credit. That is reflected in the credit spreads [how much it costs a company to borrow money] and that in turn is reflected in the share price,” says Mr Parker. “It puts pressure on companies to do the right thing and put cash contributions into the pension fund.”
Actually doing something about a pension deficit can bump up a share price, say commentators.
“If people do something positive, it can have a beneficial effect,” says Mr
Despite this reward for good behaviour, the link between pension liabilities and share prices is clearly not direct. Possibly there is an unspoken calculation going on on the part of investors, suggests Ben Inker, head of asset allocation at GMO. “Perhaps investors are thinking ‘if a company is facing a truly unbearable pensions burden, it may become the taxpayers’ problem, or the retiree’s problem.”
Even if this is the case, investors do not seem to want a return to old-style pension accounting, whatever the pension funds call for.