| Pension deficits and IAS 19: an opportunity to restart from scratch |
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| 25/07/2004 | |
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Could narrowing pension deficits be just an illusion? At the dawn of the mandatory implementation of FRS 17 & IAS 19, pension deficit issues are coming back to the front stage in full force, with corporates facing a crucial management decision as to whether to outsource or fund their deficit. The reduction of their pension deficit could depend on that. According to a report by actuaries Mercer Human Resource Consulting, FRS 17 final salary scheme deficits in FTSE 350 firms fell from £74bn to £64bn over 2003. Since the beginning of the year, the rise in bond yields has added to this mellow illusion. But growing liabilities due to a downward pressure on bond yields used to actualise liabilities and increased allowances for longevity now put at risk the reduction of pension deficits. A report by Stephen Cooper, an analyst at UBS Investment Research indicates that the FRS 17 deficit for FTSE 100 DB schemes has increased from £52bn at 31st December 2003 to £56bn at 30th June 2004, and that the funding rate has fallen from 83 % to 82.5 %. "Pension liabilities are very sensitive to change in real discount rate; for each 10bp difference in it, we estimate a 1.5 % to 2 % difference in gross liability," states UBS Investment Research, Deficits are structural. FTSE 100 aggregate pension funding  Coming into force on 1st January 2005, the new accounting treatment of pension schemes, especially for defined benefits ones, has a direct impact on corporate balance sheets. On average, pension deficits represents only 3 % of company's market capitalisation, but the figure is 20 % or more for one out of ten companies. Some pension funds, such as BT and Royal Mail, whose spectacular deficits add up to £10 billion, were hit by the consequences of though new accounting rules. "The impact of pension deficits on company value is far greater for a small but significant minority, and shareholder and member interests can diverge sharply. Resolving issues in these situations remains a bigger challenge", says Tim Keogh, a senior partner at Mercer. And the markets will only address part of this problematic issue, at least as long as UK pension funds remain heavily weighted towards equities. This is complicated by the fact that the UK, along Japan, is the Western country where the population is growing older at the fastest pace. "More companies now realise that deficits will not go away by themselves. They are gritting their teeth and recognising the need to increase contributions", said Tim Keogh, senior partner at Mercer. That was reflected by the median contribution paid by companies, which exceeded the value of new benefits accrued by 18% in 2003, while 18% of employers more than doubled their pension fund contributions. Some companies have indeed gone to great extent to reduce their pension fund shortfall in 2003. Several, like Marks & Spencer, issued bonds to refinance the deficit. British Airways, whose two staff pension funds are £930bn in the red, is now making annual top-up payments of £130m to narrow the deficit. Once in a lifetime But rising contributions are only a minor element in the toolbox to fix the pension deficit problem. The transition of European listed companies to IFRS and the first application of the IAS 19 on employee benefits give corporates a one-time opportunity to reduce dramatically their pension funding shortfalls on their balance sheets. Indeed, under IFRS 1 (First Time Application standard), corporates have the option not to apply the retrospective accounting treatment. In short, there is a "grandfathering" clause on actuarial gains and losses (i.e. the difference between observed and estimated data and hypotheses, including experience adjustments and the effects of changes in actuarial assumptions). Provided that the option is exercised for all the company's pension schemes, present and past actuarial gains and losses can be accounted once in deduction of capital at the date of transition on 1st January 2005, instead of being entered as expenses in the income statements of the following fiscal years. Hence, the actuarial net debts (i.e. gross discounted pension liabilities minus assets at market value), that is, the deficit, can be significantly reduced. Key drivers of changes in aggregate FTSE 100 pension funding  Companies can then start on the basis of re-estimated assumptions for the calculations of liabilities and assets. Unfortunately, there is no magic involved in this operation, and capital can end up largely reduced. Past the transition mark, either the company will fund its deficit, or outsource it to an insurer. In the former case, the company accounts for the net liabilities, that is the gross pension liabilities discounted with AA corporate bond benchmark minus assets at market value of the pension scheme. For the subsequent deficits of post-employment benefit schemes, the "corridor" method included in the IAS 19 still allows to smooth the deficit over time in the limit of the maximum amount of 10 % of the discounted debt, or 10 % of the assets value. In the latter scenario, corporates can mitigate their own financial risk and, hence, diminish the actuarial debt burden that is taken into account under FRS 17 & IAS 19. But the cost of external management is one reason for resisting outsourcing. In any case, with these standards, corporate will still face volatility of equity and bond markets. Directors of finance will have to pick the less expensive option. After having long been considered as a HR issue, it seems that pension funds have definitely become a fully-fledged financial issue. This e-mail address is being protected from spam bots, you need JavaScript enabled to view it |
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