Pensions - A Balance-Sheet Issue

It is tempting to think that when equity markets are rising, pension deficits should be declining, or that a reduction in the exposure to equities in the pension scheme should reduce the volatility. The reality is that liabilities matter as well and they can also move substantially over short periods.

Recent experience is that liabilities have got more expensive not just because of the creeping improvements in longevity but also because the typical UK pension scheme still has a high exposure to interest rate and inflation risks, both of which have been moving in the wrong direction for some time.

The principal risks in pensions arise from movements in equity markets, interest rates, inflation and longevity.

The headline results, often measured by the level of pension deficits, tend to be very volatile; they incorporate a number of risks in varying proportions, some of which often move against each other, and sometimes substantially over very short periods.

PENSION LIABILITIES

Whatever the metrics for risk monitoring and decision-making, it is essential to understand the underlying drivers for movements in pension liabilities as well as assets.

Despite many similarities with corporate debt, the liability streams from pension promises are not uniquely defined, either in terms of timing or by amounts.

There are many uncertainties surrounding liability cash flows and no financial instruments available to hedge, or even price, some of the risks (especially salary escalation and longevity). In practice, therefore, liability valuations are subjective and there is a range of different liability measures to serve different purposes.

ACCOUNTING MEASURE

Many observers focus on the accounting measure (FRS17 or IAS19) because of its ready availability and comparability between companies.

This is the measure by which pension deficits enter the corporate balance sheet and income statement, and therefore it affects all measures of corporate profitability, share valuations, credit-worthiness, the cost of capital or ability to pay dividends.

Liabilities are prescribed by the accounting standard to be calculated by reference to the yield on AA corporate bonds, which are affected by movements in interest rates and also in the cost of credit.

The accounting measure of liabilities makes no allowance for the actual investment policy pursued by the pension scheme.

In practice, the majority of UK pension schemes have approximately 60% of their assets in equity-type investments and therefore, on this measure, there is a considerable mismatch between assets and liabilities, and consequently a high level of volatility.

LIABILITY AGREEMENT BETWEEN PARTIES

Another important measure of liability is that agreed between the sponsor and trustees for the purposes of funding, which normally has an impact on the sponsor's cash flow.

The funding strategy is normally assessed on a going concern principle, particularly 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.

It recognises that the cost of the pension benefits (including elimination of any existing deficit) will be financed by a combination of future contributions and investment income.

The level of appropriate investment risk, its potential consequences for members and sponsor and its affordability are all part of the equation.

It is common to calculate the liabilities by reference to the long-term return expected from the scheme's investments, with a suitable margin for caution.

Typical discount rates may be 1% to 2% higher than those under the accounting measure, and therefore the deficits are correspondingly lower.

Movements in the stock markets normally cause a reassessment of the future yield based on the new market values and, as long as the underlying investment and economic fundamentals remain unchanged, assets and liabilities should move in the same direction, thus making the overall result more stable than for FRS17 (or IAS19).

BUY-OUT DEFICIT

A further metric gaining increasing significance in the management of pension schemes is the buy-out deficit.

This is a measure of the additional funds needed if the accrued liabilities were to be settled by purchasing matching annuities. 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 over future longevity patterns, and therefore the liabilities assessed on this measure are significantly higher than those on the funding and accounting measures.

HORSES FOR COURSES

So, which is better? That depends on the purpose. There is no doubt that, recently, the accounting measure has been hugely influential in corporate decision making and short-term risk management.

This is also the measure favoured by the new Pensions Regulator, who has considerable power to act in the event of corporate activity that could be perceived as detrimental to pension scheme members.

The funding measure influences the timing and amount of cash into the pension scheme and is therefore important for cash flow management, particularly in companies where the corporate covenant is not strong.

The buy-out measure is important as the funding objective of choice for the members and it also establishes a hurdle for the end game in a closed scheme (over a suitable time horizon).

Under new UK legislation, trustees have significant powers and are expected to behave like major creditors, so the buy-out measure should feature more in any negotiations involving funding and investment strategies, and also in any dialogue trustees may seek to protect the interest of pension scheme members in corporate actions.

In practice, therefore, finance directors need to monitor the development of assets and liabilities on all three measures, as well as understand the interaction between them and the significance on their objectives and business metrics of the main components of pension risk.