Drive for clearer accounting continues
13 October 2008
Since pensions were first dragged onto company balance sheets in the UK almost a decade ago with large parts of the industry kicking and screaming, the hullaballoo has rarely died down.
That move, by the UK Accounting Standards Board caused a furore in part because of its timing. Although many did not in principle like the light shed on scheme funding, the most immediate problem was that it came into force as the dotcom bubble burst, meaning that tumbling stock markets savaged the value of pension holdings, making deficits look even larger.
Accounting rulemakers believe that by making the funding, and how it is managed, clearly visible on the balance sheet, investors and other company stakeholders will have a clearer picture of the risks and demands of pension schemes.
However, many in the industry have linked the accounting changes with the significant rise in the closure of defined benefit schemes to new entrants in recent years as companies feel they can no longer face the risk of these volatile liabilities skewing their balance sheets. In the UK, less than a sixth of DB schemes are now open to new entrants, down from half in 2003, shortly after the ASB’s rules were introduced.
The more recent introduction of similar rules in the US by the Financial Accounting Standards Board in 2006 has attracted less controversy, perhaps because the switch from DB to defined contribution plans was well under way. But talk of convergence between US and international accounting standards may heat up the debate in the US as tighter rules are put on the table for discussion.
This year, the UK’s ASB came back with another suggestion that could have a dramatic effect on reported funding levels; in a paper produced in January, the board suggested changing the rate at which future liabilities are discounted – a move that will make the liabilities look bigger.
The good news for scheme sponsors is that the ASB no longer sets their accounting rules; that is now down to the International Accounting Standards Board.
The bad news is that Sir David Tweedie, the man blamed by newspapers for “destroying” pensions when he led the ASB in introducing the previous changes, has moved from the ASB to head its international counterpart, which is considering altering its rules on the topic.
That pensions pose a volatility risk to balance sheets is not in doubt. Recent market gyrations are a case in point. According to Watson Wyatt, the actuarial consultants, the combined schemes of FTSE 100 companies had a deficit of £12bn (€15bn, $21bn) at the end of August, but by the middle of last month, that had swung to a £7bn surplus.
The reason was a surge in corporate bond yields – which links directly to the ASB’s latest proposals. The future liabilities of a scheme are currently discounted to their present value using a blend of AA-corporate bond yields, which are designed to reflect the returns expected on fund assets.
However, in the current crisis corporate borrowing costs have spiked sharply higher as investors have demanded higher returns for the greater risk they perceive. In spite of that rising risk, the bigger number has served to reduce scheme deficits, meaning it has worked in the opposite way to that intended, since expected fund returns have not changed and if anything given the current market, are under some threat.
What the ASB has proposed is using the much lower “risk-free” rate, usually the yield on long-term government bonds. The suggestions triggered a wave of protest at the extra burden this would place on schemes as their reported deficits leapt overnight.
The National Association of Pension Funds said the idea could double the liabilities reported by “young” pension schemes while Pension Capital Strategies, a consultancy, calculated the “risk-free” rate would have raised the combined deficit of FTSE 100 schemes from £8bn to £100bn.
Although the ASB no longer has the power to change the rules directly, it does have a high profile in the pensions accounting world and strong links with the IASB. The IASB’s own current review has focused on removing “corridor” accounting, which allows some smoothing of the effect of market moves. But in a second phase, it is likely to address the thorny issue of discount rates.
“Given the revolution that has already been launched by pensions and accounting standard setters in their drive to reflect economic reality, it is easy enough to see more changes coming,” says Dawid Konotey-Ahulu of Redington Partners, a pensions consultancy, who warns that if anything, the credit crunch will speed up the ongoing trend towards making full market volatility transparent for investors.
IASB watchers say there are criticisms of its current proposals, which include new methods for classifying schemes, but that it would be unfair to say the pensions world was speaking with one voice.
“There are grumblings about how accounting has forced the closure of DB schemes, and I’m sure there will be more, but the experts don’t actually speak with one voice on this, you get some widely divergent views,” says one accounting rulemaker, who staunchly defended the central premise of transparency in what must be a warning to anyone hoping to change accounting’s current path.
He adds: “It’s the job of accountancy to portray as fairly as possible the true economics of what is going on. DB pensions have always been expensive to provide and they’ve only become more so given longevity and other factors. Accounting has just made that cost more transparent.”