| Companies may continue to face deficits on their pension schemes into 2004 despite rise in equity markets. |
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| Despite the rise in equities experienced by global markets during 2003, some corporate pension funds may still be disclosing deficits on their pension schemes under Financial Reporting Standard 17: Retirement Benefits, writes Brendan Sheridan, in this overview of the significance of fluctuating investment markets for the pension schemes of our major corporates. |
Deferral of full recognition requirements
Many will be glad of the respite given by the deferral of the full recognition requirements of FRS 17, with decisions still to be made by the International Accounting Standards Board on what form of accounting should be adopted with effect from January 2005. Many believe that full recognition may be the adopted position. With transition to International Financial Reporting Standards in 2005, at a minimum for our listed companies, restatement of comparatives gives very real meaning to the pension scheme valuations at December 2003 which will be the transition date for many companies.
Review of top listed companies
A review of the most recently published financial statements of ten of the top Irish listed companies shows that the majority experienced falls during their reporting period of in excess of 20 per cent in the value of assets in their defined benefit schemes with an overall fall from €9.3billion to €7.2billion. The impact of the investment market slump was also felt in the valuation of pension scheme obligations with the discount factor used by companies to estimate the ‘present value’ amounts being reduced by approximately 10 per cent. The discount factor is based on the yield from bonds of equivalent terms and maturity. The reduction in discount factor, combined with the increased service obligations – another year older, increased liabilities by €1.1billion. All in all, a worsening in the position of these companies’ pension funds of some €3billion – 35 per cent of their opening asset values – with an overall deficit in excess of €1.5billion.
It is fair to say that the longer a pension scheme has been established with funds accumulating, the greater the financial impact of investment market fluctuations is likely to be. The longer established banks and industrials have undoubtedly been hit hardest and we have already seen one of them, AIB, fully recognising the position with a net pension liability of €537 million included in its 2002 balance sheet. To date, AIB has been the only Irish listed company to fully adopt FRS 17. A number of others have substantial pension fund deficits which, if recognised in their balance sheets, would in some cases reduce net assets significantly.
The more recently formed groups which are amongst the top ten have perhaps less of a concern in absolute financial terms but will be hopeful that the ground lost in 2002 will be substantially recovered in 2003.
A similar impact has been experienced by other listed companies, semi-state bodies and, indeed, many companies in the private sector.
A complex process
The pension scheme valuation and accounting process is complex. Companies and their actuaries are grappling with such variables as longer-term investment return rates and a range of financial assumptions, much of which are outside the control of the company. The degree of success in making predictions in these areas is measured under FRS 17 by disclosure of experience gains and losses, and their trend. Again, the most recently available financial statements show a worrying trend, with eight of the companies having experienced losses in excess of 25 per cent when expressed as a percentage of pension scheme liabilities – the lowest of the ten being at 18 per cent. By far the biggest contributory factor to this was the shortfall in actual investment returns against the expected returns which had been predicted at the beginning of the year.
The importance of determining the appropriate financial assumptions and expected rates of investment return from an accounting perspective is that the amounts to be included in the profit and loss account, under a full recognition regime, are based on the expected outturns with experience gains and losses brought directly to reserves through the statement of recognised gains and losses. In periods of volatility in investment markets, this may pose some questions regarding the level of reported earnings.
In those companies with the largest funds, in terms of asset size, a 1 per cent move in investment yield between actual and expected could give rise to an amount of in excess of €20 million and, in total, for the ten companies subject to our review could have an impact on reported earnings of some €70 million based on the levels of assets disclosed in their most recently published annual reports.
The need for an appropriate investment strategy
As one would expect, given their ability for greater long term growth, equities form by far the largest proportion of pension fund assets. Most of our top ten companies have at least two-thirds of their funds invested in equities. While experience sustains the belief that equities have longer term growth potential, it is also true that they are subject to greater short-term volatility.
A quest to minimise this short-term volatility may lead to companies moving to other types of investment which are less prone to significant fluctuation. While this may achieve more consistent pension scheme valuations, it may lead to greater difficulty in growing the size of the funds available to meet pension scheme obligations. The consequences of this may be a need to raise the levels of contributions to be made by companies, and quite likely their employees, or a fundamental questioning by companies of their ability to make defined benefit pension schemes available to their employees.
We must endeavour to avoid short-termism in considering the message from the pension scheme valuation information disclosed by companies in their financial statements. While this may be difficult, given the obvious sensitivity of this for investors and employees, we should bear in mind that it is a reflection of what is happening in the underlying investment markets. These markets are in themselves subject to substantial movement in both directions on an ongoing basis.
Thankfully, we saw some recovery in equity markets during 2003, which should hopefully go some way towards restoring the value of pension scheme assets. The consequences of any significant reduction by pension schemes in the level of their investment in equity markets, in an effort to avoid short-term volatility, are far-reaching. Prudent management of pension scheme obligations is critical for all employers with defined benefit schemes, including the adoption of appropriate investment strategies. |
Brendan Sheridan is a director in financial reporting services at Deloitte.
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| Article appeared in the December 2003 issue.
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