Disclosing pension risk: remain silent and be thought a fool or speak and remove all doubt?
07 December 2016
It should come as no surprise that defined benefit pension risk affects the value that an external investor will pay for a business. Estimating the scale of the impact is a matter for some debate as there is not a single answer to the question of how large are the pension liabilities. The answers include what's disclosed under IAS 19, what the trustees estimate the liabilities to be using prudent assumptions for determining cash contributions, and what an insurer would charge the trustees to take the pension obligations off their hands. There is nothing new here.
What is new, however, is that pension deficits are expected to have risen significantly at this financial reporting season when compared to last year. This is because pension obligations are discounted under IAS 19 using high quality corporate bond yields. The impact of the falls in these yields over the past few months has meant that liabilities have generally risen much faster than the pension scheme assets, often even when the trustees have put in place strategies to match the funding liabilities. If pensions are material to the business then investors might start asking management about their pension strategy and, specifically, whether they have pension risks under control. The concern from investors will be that pensions are not being managed properly and that the pension deficit could lead to increased cash demands with an impact on business investment or dividends.
How management explains pension risk and their strategy forms part of the pension disclosures in the financial statements. The requirement for risk-based disclosures was part of the principles-based approach brought in for revised IAS 19, effective from 2013. These additional disclosures included detail on the choice of investments, future cash requirements and information about risks to which the scheme exposes the company.
The changes to IAS 19 disclosure requirements were generally seen as an opportunity for companies to explain their pension scheme risks and, crucially, how such risks are being managed, in order to assuage investors’ potentially unchecked fears and provide more context generally. However, experience has been markedly mixed.
There are many examples of good practice in reporting on pension risks, but these largely existed before the revisions to IAS 19. Many companies retained a more minimalist approach in their pensions note, meeting the requirements of the accounting standard but nevertheless prone to making boilerplate statements about pension strategy and disclosing only what is necessary. Companies that are transparent about pension risks and their plan to manage them, providing such a plan exists, should expect a better reception from investors.
But this was one of the key discussion points at the time – was there a danger of saying too much? In other words, and to repeat a quote sometimes attributed to Abraham Lincoln, was it better to remain silent and be thought a fool than to speak and remove all doubt? This, as well as management time pressures on financial reporting and the lower priority that pensions has often received in the past (the pensions note generally resides towards the back of companies’ accounts), all probably contributed to the lack of real progress on pensions disclosures.
There is unlikely to be any change in disclosure requirements of IAS 19 in the short term – not least because these things take time – but companies can still go above and beyond the requirements in order to get ahead in the investor game. Indeed, providing good, sensible disclosures on pensions is something that we would strongly encourage. Explaining pension scheme risk management as you might present to a CFO, rather than using opaque, generic wording, would be a positive step forward. And, with the pain emerging on key pensions numbers as a result of bond yield falls, perhaps this is a way to soften the blow.