The Pensions Void

There is a certain irony that just when investors are apparently being given unprecedented clarity due to the first year's implementation of IFRS, their view of a UK company's financial position is actually clouded by the unquantifiable liabilities of defined benefit pension schemes.

Nobody doubts that the corporate liability for pensions has grown in recent years, largely for two reasons.

Firstly, life expectancy today exceeds the actuarial expectancy at the time the majority of defined benefit pension scheme promises were made; in addition, lower real interest rates have meant that those liabilities represent a larger real liability today – a liability now reflected under IFRS in companies' accounts.

"On top of this," says Philip Broadley, finance director of financial services provider Prudential and chairman of The One Hundred Group, "the assets that back those liabilities, if held substantially in equities, fell steadily from 2001 to 2003 and have since taken some time to recover to the point where asset values are now back at a five-year high."

"Thus, the economic reality is that the defined benefit promise of companies has grown in real terms in recent years, and the assets that back it may have fallen. The difficulty is in determining how that liability is best measured and how companies can best respond to the challenge of funding that liability and their obligation."

MEASURING THE GAP

Broadley says that he chose these words carefully because while almost everyone would agree that the liability has grown, there is far less agreement on how the liability should be measured and he suspects that there is no single right answer.

"If you asked me, I would answer as an accountant in a way that might infuriate many people," he says. "That answer would be 'it depends'. It depends on what you are trying to measure and it also depends on the degree of certainty you are trying to apply."

"Inevitably if you are trying to ascribe a value today to liabilities that will unfold over decades, it is very difficult, if not impossible, to establish a single measurement that accurately reflects the value of that liability."

Broadley agrees that at the very time when greater clarity is being demanded, the issue of pensions accounting confronts investors and regulators with the greatest challenge. Published accounts should attempt to value the liabilities of pension schemes according to certain assumptions, which are then defined.

The accounts can then go further by providing investors with data on the impact of changes to those assumptions.

"So if the longevity of all our pensioners improves by a year, how much more would our liability be?" he asks. "If the interest rate we are using to discount our liability changes by 50 or 100 basis points, what would the effect be?"

"Those are the things you can do to help illustrate the challenge of actually managing the pension obligations that companies have created for themselves."

UNSTABLE ESTIMATES

Broadley is doubtful about the usefulness of a recent exercise that sought to ascribe a value to the movement in total UK pension fund deficits in the single quarter from 31 December 2005.

"I am unclear as to whether in making such an estimate, the preparers of those figures are trying to show simply how volatile this sort of accounting method is or whether they are purporting that this sort of accounting method is an accurate reflection of the change in pension fund liabilities over a three-month period."

For Broadley the exercise underlines the near impossibility of ascribing a long-term value to pension fund liabilities today. "It merely indicates that if I put forward an estimate of my pension fund liability, it could have moved significantly – 10%, 20%, maybe even 30% between one reporting period and the next," he says.

However, while the obligations facing companies are absolutely real, they will be discharged over decades, with employers working with trustees to decide the combination of cash contribution they want to make compared with the level of investment risk they are prepared to take, and the further risks that will be attached to the assessment of that risk.

A LONG-TERM SOLUTION

Broadley's particular worry is that it must be recognised that the pensions problem will need to be resolved or it will resolve itself over time, with unpredictable consequences. "My concern is that if you slam on the brakes and say this must be funded very quickly, you will actually create problems of widespread significance across the economy as a whole, problems which are arguably avoidable," he explains.

"This is because if employers and trustees have the flexibility of time to resolve funding positions, then they can do so without an undue drain on the sponsoring employers' profits, cash flow and dividends."

"My point is that if we recognise that we have a pension obligation that will unwind in a generation or more, then the funding for that should arguably come over that generation."

"The risk from a public policy point of view is that if pension fund deficits are to be funded over a short period, it can only be done by reducing free cash flow available to service dividends, a situation in which all pension funds would ultimately suffer."

"This will create a sort of vicious circle; investment income is lower than we thought, therefore we need to increase our contributions, therefore we have less profit available for dividends. Would we then be surprised if a vicious circle develops and we create a short-term funding crisis, which could have been avoided had we recognised the period of time available?"

RAIDING THE PIGGYBANK

Commentators surveying the pensions mess rarely seem to refer to the trend 20 years ago of companies removing what they then saw as surpluses in their pension funds and/or declaring contribution holidays.

While this never equated to Robert Maxwell's criminal plundering of the Mirror Group pension funds, it is now clear that the many companies who skimmed what they took to be excesses from their funds displayed serious errors of judgement and behaved recklessly.

It appears, however, that no one has yet chosen to do the math on the degree to which the present crisis would have been lessened had that money stayed put.

"Where this happened," says Broadley, "the shareholders benefited from a higher free cash flow, which was either invested in other shareholder activity or paid to the shareholders themselves as dividends. I regard that as part of the cause of the general effect. Those companies which decided to take from pension funds at the time may now have a bigger problem."

GOVERNMENT RESPONSE

Both the pace and method of resolving pension funding will depend to a large extent on reporting regulations and on the UK's new pension fund regulator. The One Hundred Group of finance directors can be expected to have input here as it is also having on the currently delayed Operating and Financial Review (OFR), the principles of which have, with some exceptions, been embraced by leading UK corporates.

"Large companies," says Broadley, "have already done much of the work in preparing for narrative reporting."

"Until UK Chancellor Gordon Brown surprised everyone by abandoning the measure in favour of a less detailed business review in the directors' report, the markets too were looking forward to the result."

The One Hundred Group continues to press the Department of Trade and Industry (DTI) over the provision of a 'safe harbour', which would protect directors whose narrative projections did not work out.

"Our view remains that this is an important area," says Broadley, "and that the quality of narrative reporting could be improved if directors could act in good faith and put forward their proper point of view, as they see it at the time, and not be judged to a similar standard as a prospectus with the benefit of hindsight. The 'safe harbour' protection is something that we have long held to be important and we have been disappointed that our views and those of others weren't taken up originally."

POLITICAL PROCESS

The Company Law Reform Bill is still being debated in the House of Commons. A DTI source said that although there is still a way to go, and it is never a good idea to second-guess the will of Parliament, the department is confident the Bill should pass in the autumn of 2006, coming into force in 2007 following a period of consultation with stakeholders.

Currently, however, companies are limiting themselves with their OFR-style narratives. "The difference is that narrative reporting is still largely devoted to a review of what happened in the reporting period," says Broadley. "It is much more limited in what it is saying about developments in the future," he says.

"This has to move forward in a way that is open, encourages experimentation by companies and avoids statements that are so heavily 'caveated' as to become difficult to read and understand. That is why the 'safe harbour' provision is important, because it will mean that OFRs can be written by management rather than being written by management, then rewritten by lawyers."

IFRS: HELP OR HINDRANCE?

When it comes to the extra information now required under IFRS, Broadley believes that the jury is still out: "The effort that has gone into converting publicly listed company accounts has been an exercise that will have cost, on the basis of what companies have told the market, tens if not hundreds of millions of pounds across Europe."

"It is already evident that the consequence of the adoption of IFRS is to add multiple pages to a company's annual report in terms of additional narrative disclosure in note form. I am far from clear myself as to what use users are making of that information and whether they are getting any benefit from it. I don't think that that will become clear for some time."

TOO MUCH INFORMATION

"Transparency does not necessarily come from more disclosure. I think that that is where there is an interesting point of principle between the International Accounting Standards Board (IASB) and many of us as financial directors and preparers. The IASB's view does seem to be that more information is generally helpful and that it is for the market to decide what it wants to do with that information."

Broadley says that the view both of investors in Prudential and his fellow finance directors suggests that what the markets are actually saying is: "No, give us less, but be more focused on what we really want to understand, which is the information that you yourselves use to manage the business. That's what we really like to see."

In Broadley's opinion, prescriptive note disclosure is not obviously going to lead you in that direction. Indeed, the sheer superabundance of data can militate against transparency and understanding.