| Pension liabilities: Valuation issues are still unresolved |
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| 09/10/2005 | |
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Even if all listed European companies are now subject to the International Financial Reporting Standards (IFRS), it is still difficult to have a clear picture of what their global pension liabilities might definitely look like. The accounting of defined contribution schemes raises numerous technical questions, some of which have yet to be agreed upon by the investment and accounting communities. The actuarial assumptions to be used, as well as the valuation of actuarial debt and hedging assets are amongst the most hotly debated issues at this time. An investment manager has even frontally attacked the FRS17, the UK's pension accounting standard based on the same principles as the IAS19. According to SEI Investments, the discount rate used under the FRS17 and the IAS19 is arbitrary since it does not take into account the market-determined cost of capital for the sponsoring firm. This actuarial rate, which is the average yield of a double-A rated corporate bond, would be too low for the majority of UK and European companies, whose average rating is triple-B. Such a situation, says SEI Investments, leads to an overestimation of the true corporate pension deficit, or an underestimation of the surplus that is reflected in company accounts. The weighted average cost of capital, which discounts the liabilities of the sponsoring company at a rate reflecting the level of risk of its operation, could be a better coefficient. According to SEI's calculations, the total FTSE 100 FRS17 deficit, which is at £37bn, would then be reduced to zero. "Yes, it does mean the value of pension liabilities reduce when a firm becomes riskier and its cost of capital rises. However, although the firm's pension liabilities decrease, the value of a firm's assets as a whole are also marked down, and pensions are still likely to be higher relative to the value of the firm as a whole. In this sense pensions continue to represent a burden which is as heavy or heavier than before", commented Andrew Slater. Deficits So far, data published on deficits continue to vary widely. According to data published at the end of 2004, the combined pension deficits of the 50 companies listed in the DJ STOXX 50 stands at €116bn, the same as the previous year. Lane Clark & Peacock, an actuarial consultancy, said that the pension liabilities of those 50 companies were over €500bn. However, the information provided by those various companies is hardly comparable due to the differences in the methods used to process those numbers: in the DJ STOXX 50 alone, 12 different accounting standards were used in 2004 and only 8 companies were using the IFRS (6 in 2003). In any case, widening deficits have left corporate pension schemes scrambling for alpha, as shown by the sudden interest in alternative investments products that come along with the promise of boosted returns and decorrelation. According to JP Morgan Chase's analysis, assuming no contributions are made, a typical plan will need to produce 5-10% asset growth per year (depending on interest rate developments) in order for their funding level not to deteriorate further. Pension deficits in the Eurostoxx 50  Source: Lane Clark & Peacock, Accounting for Pensions UK and Europe, Annual Survey 2005 Agreed principles Some of the pension liabilities valuation and recognition principles under IAS19 are widely agreed upon. There are three of them: · DB scheme post-employment liabilities are evaluated under a system called "projected unit credit", which uses a set of realistic demographic and economic assumptions as well as an actuarial rate close to the rate of high quality corporate bonds (usually double A). · The valuation of hedging assets is made on a mark-to-market basis. If the assets are outsourced (e.g. to an insurance company), then they should not show up in the assets of the company. However, the discounted liabilities still have to be subtracted from the assets. · Pension costs include both service and interest costs, which can be compensated by the expected return of the assets. Until now, the gains and losses resulting from the real and actuarial assumptions are written off and included in the costs of pensions. The actuarial gains and losses are due to the difference between the actual numbers and those estimated, or to any change in the assumptions. They are deferred in time and accounted for in the balance sheet as expenses or revenues to be distributed. They are not amortised if, once added up, their total remains within the limit of 10% of the actuarial debt and 10% of the hedging assets. If they exceed this limit, the excess sum is spread out over the average residual activity duration of the scheme's users. Outsourcing & conversion The one thing that many companies take for granted is the higher debt that could show up on their balance sheet as a result of those new accounting standards. That's leading many of them to ponder outsourcing. The offloading rationale is simple: better to outsource a funding deficit than to bear it as a dark spot on a balanced sheet. This is all the more true with rating agencies closely monitoring those deficits and including it in the global amount of debt of the issuer. All companies with defined benefit (DB) schemes, as opposed to the ones with defined contribution (DC) schemes – whose risk is borne by the employees and not the company – are exposed to this pension risk. Outsourcing as a way to fend the pension issue is not limited to countries where the IFRS are applied since most recent local accounting standards deal with the pension issue similarly. Companies in the UK with the FRS 17 and the US with the FAS 87 are subject to a rule similar to the IAS 19, the pension fund-related IFRS standard. Philips, the Dutch electronics manufacturer, recently outsourced to Merrill Lynch Investment Managers the asset management of its €13.5bn pension fund. Before that move, the French carmaker Peugeot had been one of the first to shed its pension risk. Peugeot first made the decision in 2002 to replace its third-pillar French DB scheme by a DC scheme. This new scheme was immediately outsourced to a life insurance company in a bid to offload the pension risk. In keeping with its international dimension, the carmaker then closed the DB schemes of its British subsidiary for its recent employees. Peugeot now only creates new DC plans. At the same time, it has raised the employee contributions to its remaining DB schemes by 3-4%. Accounting issues Outsourced DC schemes, according to which a sponsor company pays contributions to an external entity (such as a life insurance company or a pension fund) in the name of its employees without specifying any level of benefits, does not present any particular accounting difficulty under the IFRS. The actuarial risk is entirely borne by the employee and the sponsor company's contributions are accounted for as expenses. The only complementary information that has to be published is the global amount of the employer's yearly contributions. National pay-as-you-go schemes, which are for the most part mandatory, are included in this category under the IAS19: for the sponsor company, the financial responsibility is limited to the payment of social contributions. The company bears no pension liability in the event of an employee's departure. In a DB scheme, the actuarial risk and risk of the assumptions used to set the level of those benefits are supported by the company. Under the IAS19, those future benefits have to be funded so as to manage them during the activity period of the scheme members. This kind of scheme is more frequent in the UK, the US, the Netherlands and Germany, though the recent trend has been to convert them into DC schemes, which are less of a burden for the sponsor company. Insurance-based retirement scheme, under which a sponsor company pays insurance premiums so as to fund a post-employment DB scheme, can be either considered as a DB or DC scheme. If the insurance company or the external partner is the only entity to bear the risk of the scheme, then the sponsor accounts for the premiums as contributions to a DC schemes. On the other hand, if the sponsor is still held responsible for employee's benefits, or if it commits to make up for any shortfall in the insurance company's benefits, then the scheme has to be accounted as a DB one. M.N. |
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