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OPDU Report 25
- November 2008 In this time of turmoil in financial markets it seems strange to raise the problem of too much surplus in pension schemes. But changing accounting standards mean that this as a real problem for many companies. The “problem” arises when a company is unable to get any economic benefit from a surplus in a pension scheme. In these circumstances, changing accounting standards now mean that such surplus will be deemed “irrecoverable” and cannot be credited to the balance sheet. Irrecoverable surplus can therefore represent wasted company contributions. PCS Market Analysis The latest PCS analysis of the pension schemes of the FTSE100 shows that a staggering 20 companies are now reporting an irrecoverable surplus. Total reported irrecoverable surpluses in the FTSE100 now total £2.4 billion. This is a huge increase of 140% over the position just 12 months ago. The top ten largest reported irre-coverable surpluses in the FTSE100 are as follows:
In the case of British Airways the above irrecoverable pension surplus is more than half of the equity market value of the company How has this situation come about? The accounting standard which governs the reporting on pension schemes for the large majority of companies is IAS19. This standard treats the pension surplus or deficit (net of deferred tax) as a balance sheet asset or liability of the company. However, it does make it clear that there are restrictions on the asset that can be taken to the balance sheet. The standard states: “An asset may arise where a defined benefit plan has been overfunded or in certain cases where actuarial gains are recognised. An entity recognises an asset in such cases because: In plain English, this means that the maximum surplus that can be treated as an asset on a company’s balance sheet is the value of possible future refunds and reductions to future contributions. However, for many pension schemes, refunds of surplus funds are unlikely to be possible. Moreover, the number of employee members of pension schemes is dwindling as schemes are closed to new entrants (and, increasingly, closed to all future accrual). This means that the value of any reduction in future contributions may be limited. All this means that the maximum surplus that can be treated as a balance sheet asset may well be limited. Last year the International Accounting Standards Board (the IASB) clarified the circumstances under which a company can recognise the value of a possible reduction in future contributions as a balance sheet asset. This clarification was published in a statement – IFRIC 14. This states that for pension surplus to be treated as a balance sheet asset, companies must have either an “unconditional right” to a refund (which means they do not need the consent of a third party) or have “sufficient scope to reduce future contributions”. However IFRIC 14 also included “clarification” on the impact of a “minimum funding requirement” (we interpret the “minimum funding requirement” to include the UK’s Statutory Funding Objective (SFO) and the Schedule of Contributions). Under this new clarification, an IAS19 surplus could be reduced, if the trustees’ funding (SFO) basis is more prudent (ie produces a higher liability) than the IAS19 basis. In addition, an IAS19 deficit could be increased (or surplus reduced) to allow for the requirement to pay the contributions set out on Schedule of Contributions. These “minimum funding requirement” effects only happen if there are restrictions on the company’s use of surplus. But it is already clear that IFRIC 14 will affect a large number of companies. IFRIC 14 only applies for periods beginning on or after 1 January 2008. However companies who do not adopt IFRIC 14 for 2007 accounts may well be under pressure from their auditors to explain what impact IFRIC 14 would have had if it had been adopted. Compass Group was the first FTSE 100 company to adjust its accounts (for its year ended 30 September 2007) for IFRIC 14, resulting in a £92 million increase in its overall pension deficit. So what should companies be doing? If companies are affected by the “problem” of an irrecoverable surplus, they likely need to rethink their approach to the management of their pension scheme. Essentially, if companies want to avoid destroying shareholder value there are 3 possible options:
2. Reduce risk in the pension scheme investment strategy - Why should shareholders allow risks to be taken in the investment strategy if they get all the grief and cost of any deficit on the downside, but none of the surplus on the upside? Of course, the problem many companies perceive with this option is that reducing risk in the investment strategy also reduces likely investment returns and, potentially, has a negative impact on the company’s P&L. 3. Alternative funding strategies which shelter contributions for trustees, but give companies the opportunity of a refund if there is a surplus and the contributions are not needed – Companies and trustees are increasingly looking at such strategies. Typically these either involve the use of an escrow account or a specially constructed investment vehicle. Escrow accounts do have some problems - payments into them are not tax deductible, they are not deemed to be assets of the pension fund and often there are restrictions on the investment strategy. Hence there has recently been a growth specialist alternatives. One such alternative is the Pension Support Bond from Occupational Pensions Defence Union Limited. This is a capital redemption bond providing security for pension funds while preserving assets for sponsoring employers. The Pension Support Bond is funded by contributions from the company and is a trustee asset of the pension scheme, but part (or all) of the assets held within it can be refunded to the employer, if they are not needed by the trustees. The Pension Support Bond is not the only such vehicle available to companies and trustees – there is an increasing choice available and we at PCS expect to see a significant growth in the use of such vehicles over the next few years. Charles Cowling
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