Accounting standards affect how pension liabilities are reported in company accounts. FAS 158 requires that the net of pension fund assets and liabilities are reported in the main accounts. Traditional accountancy measures allow a more subjective measurement, and relegate pension information to the accounting notes.
The real issue is how a company calculates and values the projected liability—which depends on the discount rate selected, the actuarial assumptions relating to future inflation, wage increases, and, most importantly, the expected longevity of employees.
Accounting measures and buyout measures of pension liabilities differ. Finance directors need to be aware of both types of measure, their assumptions, and the interaction between them, as they can impact pension strategies and, consequently, financial reporting.
With a pension plan, companies agree to provide certain benefits to their employees, by specifying either a defined contribution (where a fixed contribution is made to the plan each year by the employer, with no promises as to the future benefits that will be delivered by the plan) or a defined benefit (where the employer undertakes to pay a certain benefit to the employee at some point in the future). Under the latter, the employer has to put sufficient money into the plan each period such that the amounts, with reinvestment, are sufficient to meet the defined benefits due as plan members retire.
With a defined contribution plan, the firm meets its obligation once it has made the prespecified contribution to the plan, and its valuation on the balance sheet is reasonably straightforward. With a defined benefit plan, the firm’s obligations are much more difficult to estimate, since they will be determined by a number of variables, including the benefits that employees are entitled to (which will change as their salary and employment status change), the prior contributions made by the employer (and the returns they have earned), the expected retirement date of employees, and the rate of return that the employer expects to make on current contributions.
As these variables change, the value of the pension fund assets can be greater than, less than, or equal to the pension fund liabilities (which include the present value of promised benefits). Recent changes to accounting regulations have increased the transparency of pension funding, and this has sparked an increased debate about the goals of defined benefit pension funds. The stakeholders of a pension fund (sponsor, trustees, and the various classes of pensioner) often have different goals, and therefore require the asset and liability information to be presented using different assumptions. These assumptions can materially affect both profit and loss (P&L) and balance sheet statements.
A pension fund whose assets exceed liabilities is an overfunded plan, whereas one in which assets are less than liabilities is underfunded, and disclosures to that effect have to be included in financial statements. When a pension fund is overfunded the firm has several options: It can withdraw the excess assets from the fund, it can discontinue contributions to the plan, or it can continue to make contributions on the assumption that the overfunding is a transitory phenomenon that could well disappear by the next period. When a fund is underfunded, the firm has a liability that must be recognized on the balance sheet.
In late 2006, the Financial Accounting Standards Board issued its final Statement of Financial Accounting Standards No. 158 (FAS 158), which deals with the rules for reporting the obligations and expenses of pension plans, retiree health plans, nonqualified deferred compensation plans, and other post retirement benefits. Among many changes, FAS 158 moved information about the funded status of pension plans and other postretirement employee benefit plans from the footnotes of the financial statements to the balance sheet itself. The idea behind FAS 158 was to create more transparency and to make information about pension plans and other postretirement employee benefit plans available to investors. It requires companies to include on the balance sheet the full net value of pension assets and obligations. These are to be measured as the difference between the fund assets and the projected benefit obligations. A company does not have to show the full value of assets and the full value of liabilities—just the net of the two. If the fund assets are higher than the pension obligation, it will show as an asset; if not, it will be a liability.
Before FAS 158, the effects of certain events, such as plan amendments or actuarial gains and losses, could be given delayed recognition in the balance sheet. Alternatively, market returns could be smoothed over several years rather than recognized at once. As a result, a plan’s funded status (plan assets less obligations) rarely reflected the true position and so was not reported on the balance sheet. FAS 158 requires companies to report their plan’s funded status, which is likely to cause reported pension liabilities to rise significantly. The traditional actuarial approach is incorporated to a degree in International Accounting Standard 19 (IAS 19), which means that the balance sheet generated on an IAS 19 basis does not necessarily reflect the full net asset or liability position of the pension plan. Whichever accountancy basis is adopted, the real issue is how to identify the projected benefit obligation.
Typically, the assets held by the sponsor’s pension fund are liquid, have publicly accessible pricing data, and are subject to market value fluctuations. The liabilities, however, are rarely traded, are particular to the individual pension scheme, and, depending on the valuation method adopted, can be considerably less volatile. Assets are measured at market value, whereas the discount rate for valuing liabilities is based on the actuaries’ assessment of long-run returns on the assets in the pension fund.
Calculating Accounting Liabilities
The projected benefit obligation is the actuarial present value of the benefit obligations made by the pension plan. This liability, according to most accounting standards (FRS 17, FAS 87, IAS 19), is calculated by reference to the yield on AA corporate bonds. These in turn are affected by movements in interest rates, and also variations in the cost of credit.
This accounting measure of liabilities makes no allowance for the actual investment policy pursued by the pension scheme. It does, however, include actuarial forecasts of inflation, expected future salary increases, and current longevity assumptions. These assumptions are taken as being best-guess estimations, and often cause keen debate between a corporate sponsor’s actuaries and those advising the trustees during the triennial funding discussion. The rate of inflation and forecast salary increases are usually fairly straightforward and based on recent experience, but forecasts of longevity lead to more discussion. Longevity has been increasing exponentially since the Second World War, and actuaries have consistently underestimated life expectancy. Any increase in assumed life expectancy will increase the liability of the pension fund and thus increase the annual contributions required by the sponsor, as well as increasing the total liability on the balance sheet. It is estimated that an increase of one year of life expectancy will add approximately 7% to pension liability. Given that life expectancy for a 65-year-old male is improving at the rate of one year’s increase in life expectancy in every five years, this has the potential to have a huge impact on corporate investment plans.
The assumptions made about inflation, salary increases, and longevity are a key subject of discussion when trustees and sponsor debate proposed future funding strategies for the pension plan. The other key topic for discussion should be the expected investment returns from the asset strategy undertaken by the trustees. Both the actuarial assumptions and the investment risk assumed by the pension fund are likely to greatly influence the size and scale of future sponsor contributions.
The funding strategy is normally assessed on a going concern principle, resting on the assumption that the sponsor will be around for many years and is able and willing to provide the support necessary to the pension scheme if the investment strategy produces returns below those expected, or if life expectancy or any of the other actuarial assumptions exceeds the forecast. There are a number of factors that should be considered by both sponsor and trustees in determining how much risk there is to the ability of the pension fund to meet its future liabilities:
Covenant or sponsor business risk: The stronger the covenant (the lower the business risk), the more risk can be taken with the pension fund investment and the less conservative the actuarial assumptions need to be.
Maturity of pension scheme: The longer the funding period (i.e., the younger the potential beneficiaries or pension scheme membership), the more investment risk can be taken without compromising the security of the final benefit payments. Conversely, the higher the longevity risk which a younger scheme incorporates, the greater is the risk that even minor improvements in life expectancy will cause a large movement in the value of future pension promises and, hence, liability on the balance sheet.
Surplus: The larger the accounting surplus, the more investment risk can be taken. Conversely, with a large deficit there will also be pressure to take increased investment risk.
The minimal risk approach argues that assets should be valued at market prices and that liabilities should be valued consistently using the market returns on appropriate assets and conservative longevity assumptions. The optimal asset allocation would then be determined using horizon matching. This uses bonds, with their reliable cash flows, to meet current and near-maturing pension obligations (using a strategy called cash flow matching), and equity and property, with their growth potential, to match long-maturing liabilities that grow in line with earnings (using a strategy called surplus management). This second strategy is justified because of the long-run constancy of factor shares in national income (which makes capital and land ideal long-term matching assets for a liability that is linked to the return on labor), and because of the positive long-run equity risk premium and mean-reversion in equity returns (which implies that long-run equity returns are more stable than short-run returns). Such an asset allocation should mean that changes in pension liabilities caused by moves in interest rates, inflation, or longevity are matched by a mixture of bond and equity returns, thus immunizing the balance sheet from any unexpected changes in value of either asset or liability metric. With a stable balance sheet, planning future pension contributions can be done with more certainty, thus limiting the impact of volatile contributions on the P&L.
Another, different, way of calculating the pension position is based on the assets required to buy out the pension liabilities at a specific point in time. This can be thought of as the market price of passing all the liabilities of a pension fund to a specialist insurer. Five years ago, this only happened in the case of insolvency, but increasingly niche insurers are starting to specialize in pooling longevity risk and offering prices to remove all pension assets and liabilities from a sponsor’s balance sheet. The buyout deficit shows the additional funds needed if the accrued liabilities were to be settled by purchasing matching annuities from these insurers. Under UK legislation, this is also the contingent debt that could be served on the sponsor by the trustees of the pension scheme, should the sponsor decide to discontinue the scheme.
The volatility of this measure is dictated by the terms on which insurance companies are prepared to deal. Annuities are usually priced at yields well below the prevailing yields on government bonds and with a cautious view of future longevity trends. Therefore, the liabilities assessed on this measure are significantly higher than those assessed on the accounting and funding measures.
The current accounting methodology has three main impacts. First, balance sheets have become more volatile due to the inclusion of net pension assets or liabilities, which are dependent on publicly traded debt prices. This volatility may trigger loan covenants or borrowing limits, or otherwise affect corporate behavior. Second, the P&L retains some volatility due to pension impacts, since changes in the balance sheet funding position affect the level of sponsor contributions and, hence, flow through to the P&L. Finally, financial statements have increased in complexity as noncash pension items are now included. Some items, such as the current service cost and amortization of past service costs within operating cost, the unwinding of the pension liability discount, and the expected return on assets within financing costs, are highly complex in themselves.
There is no doubt that the accounting measure has been, and continues to be, hugely influential in corporate decision-making and short-term risk management. It provides the basis for funding discussions with the trustees and is therefore important for cash flow management, particularly in companies where the corporate covenant is not strong. The buyout measure of pension liabilities is becoming more important, since the discharge of all pension obligations by the sponsor is growing in desirability as the full risks of longevity increases are increasingly recognized. Additionally, trustees often find that a buyout, with the security provided by a regulated insurer rather than a corporate sponsor, is a goal for pension funding in itself. Buyout pricing also establishes a target for a closed defined benefit scheme (over a suitable time horizon).
Therefore it is vital that finance directors monitor the development of assets and liabilities using both accounting and buyout measures, as well as understanding the assumptions that each employs and interactions between them.
Making It Happen
A defined benefit pension scheme is one where the employer promises to pay a certain benefit to the employee on retirement. It is funded by contributions to a pension plan and the investment return on those contributions while the employee is working, which, over time, the employer hopes will match the benefits promised.
Both the assets and liabilities are accounted for on the corporate balance sheet, introducing a complicated variable into financial reporting that usually has little to do with the main business of the employer.
Assets are valued using market rates, but future liabilities are valued by selecting a discount rate and making assumptions about future inflation, wage increases, and longevity.
Each of these factors (inflation, wages, and longevity) can have a large influence not only on the financial information reported, but also on the strategy and risk tolerance of the pension fund and its stakeholders.
Because of this, it is vital that the employer understands a variety of different measures for the pension liabilities, such as the accounting/funding basis and the buyout liability, as these can impact how the pension fund assets and liabilities are ultimately reported on the balance sheet each year.