Don't be fooled by the emergence of pension accounting surpluses
July 16, 2018
Actuaries are using more sophisticated approaches to setting the discount rate for IAS 19 financial reporting purposes. These approaches might involve the removal of certain bonds from the index that are arguably not corporates such as university bonds. In addition, actuaries may include corporate bonds which are rated AA by only one of the main credit rating agencies and redrawing the yield curve for AA corporate bonds at longer durations where there are no bonds in the index.
In almost all cases, the impact of changing approach is to increase the discount rate and, as a result, the measured accounting liabilities can be materially lower. This in turn leads to larger accounting surpluses (or smaller accounting deficits). Of course, the accounting position is a measurement based on current market conditions. It could all change if the bond market moves, which it inevitably will over time through economic cycles.
Whilst accounting surpluses may be higher as a result of methodology changes, that does not mean the underlying economics of the pension scheme have changed. Pension schemes still need to pay benefits out of assets, returns on those assets and future contributions. None of these components have changed under the new discount rate methodologies and so the expected cash outflow is the same. The cost of taking pensions completely off balance sheet also has not changed as this is driven by insurance pricing not pension accounting. And, according to PwC research, investors are more concerned about the relative size of the pension obligations and risk compared to the scale of the business rather than the size of the accounting surplus or deficit. Indeed, the most sophisticated investors primarily look at the emergence and risk of pension scheme trustees’ cash demands over time.
The overall message for readers of financial statements is beware of higher accounting surpluses or reduced deficits, particularly where the primary cause of the movement is a change in discount rate methodology. It doesn’t necessarily mean the pensions problem is closer to resolution or that the underlying risks are different than before.