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Home > Balance Sheets Best Practice > Pension Schemes: A Unique and Unintended Basket of Risks on the Balance Sheet

Balance Sheets Best Practice

Pension Schemes: A Unique and Unintended Basket of Risks on the Balance Sheet

by Amarendra Swarup
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Executive Summary

  • Pension schemes are often the most overlooked part of a company’s balance sheet, despite the large hidden and complex risks they can pose. Some of the unique risks within pension schemes are exposure to interest rates, inflation, market risk, and longevity.

  • The problem is particularly acute for defined-benefit pension schemes—common in many developed countries—where the benefits are predetermined, are often index-linked, and can be passed on to dependents. The present cost of bearing these risks has risen sharply in recent decades, and many companies have closed their pension schemes to new members.

  • In the short term, changing economic, financial, and demographic perceptions can materially alter the valuation of a pension scheme’s assets and liabilities from one day to the next, potentially leaving many finance directors with an uncontrolled liability on otherwise well-managed balance sheets.

  • The waters can be muddied further by another fundamental problem: for most schemes, liabilities are calculated infrequently using ad hoc or out-of-date assumptions, which can often present a less than prudent valuation of the true costs.

  • Options to manage and even reduce these uncertainties are now appearing. The key is to have a proactive and realistic approach to the risks that are being carried on the balance sheet.

Introduction

The only function of economic forecasting, the late American economist J. K. Galbraith once noted, was to make astrology look respectable. And, knowingly or not, it’s a belief that’s endemic in the corporate world.

The overriding concern is to find the hidden value in companies—whether in their balance sheet or in their intellectual property—and extract it in the most efficient way possible. Every financial and operational risk is carefully studied and, where possible, mitigated. Lines of credit are negotiated at known terms to suit the company’s horizon. Capital structures are continually redrawn to maximize efficiency. Balance sheets are scrutinized line by line and operations are streamlined.

There is no obsession with predicting GDP, or agonizing over the evolution of the labor market over the next decade, for example. No, these are all nebulous questions for economic forecasters to ponder. For the seasoned financial director, the wider economy only matters insofar as it affects that all important cash flow.

Yet, hidden in that otherwise well-managed balance sheet might be a host of unconstrained liabilities that threaten to undo the most meticulous business plan and expose companies to a whole host of unknown risks—all housed within an often overlooked pension plan.

The problem is particularly acute for defined benefit schemes—occupational schemes where the pension benefits are fixed in advance and are often calculated as a proportion of an employee’s final salary. Many include provision for dependents such as widows, and can even be indexed to inflation. These proved to be enormously popular in the aftermath of the Second World War, when many companies saw them as an effective way to defer compensation for workers to future years. However, these schemes placed a host of unintended and poorly understood risks with the sponsoring employer, such as exposure to longevity, to future interest rates, and to the capricious whims of financial markets.

In recent decades, as companies found themselves confronted with declining employment and a growing retiree problem, the present cost of bearing these risks has escalated sharply, and many have closed their pension schemes to new members. Furthermore, pension schemes and, in some jurisdictions, their associated healthcare liabilities, are increasingly a growing factor in corporate finance transactions.

A potentially attractive merger or acquisition may become unstuck because of the pension fund, or, worse still, an existing company may hit difficulties as the full cost of the pension obligation becomes known. The abortive takeover of Sainsbury’s in the United Kingdom and the well-publicized troubles at General Motors in the United States are but the most visible tip of the proverbial iceberg, and are indicative of a problem that can consign businesses to a slow decline.

But more than just eroding stockholder value in the present, defined benefit schemes are also a danger to a company’s long-term survival in an increasingly competitive global economy. Many management teams now face the problem of maintaining a set of financial commitments made in another era, when assumptions and expectations were vastly different. These commitments are difficult to measure—let alone anticipate—and they are tied to the health of the corporate sponsor of the pension fund, which is legally required to underwrite any deficit. If the company does go under, the responsibility of meeting at least part of these liabilities may then be transferred to governments and taxpayers. This may create additional problems, as pension scheme members will likely receive reduced benefits, and the addition of significant numbers of liabilities to the government balance sheet is eventually likely to become politically unpalatable.

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