Accounting for De-risking
Traditionally labelled as slow-moving, the UK pensions market has been developing relatively quickly in recent years. A combination of underperforming global stock markets, low interest rates and increasing life expectancies has seen pension deficits at historical highs in the UK, Europe and in the US. Meanwhile, regulatory and accounting developments have fundamentally altered the way that defined benefit (DB) pension exposure impacts corporate sponsors and affects the reported profitability of the business. Pension managers are therefore seeking more sophisticated ways to analyse their pension risks, and looking at methods for de-risking, such as transferring the liabilities away from their balance sheet into the insurance and capital markets.
As pension schemes begin to look beyond simply investing in a broad portfolio of equities and bonds, perhaps considering buy-in/buy-out opportunities or longevity swaps, there is a growing requirement for more accurate, up-to-date and sophisticated pension risk management tools. The latest innovations in pension risk analytics enable sponsors and trustees to regularly measure and stress-test pension scheme liabilities and monitor the effectiveness of de-risking strategies in much the same sophisticated way that companies have become accustomed to managing their other financial and operational risks.
Yet there remains a key accounting obstacle to more substantial de-risking of company pension schemes – the preferential treatment of pension asset returns within the sponsoring company’s financial reports. Whether a company reports under UK, US or international accounting standards, there are three main components to pension profit and loss accounting: service cost, interest cost and expected return on assets (ROA). The two cost elements are straightforward, providing for additional benefits earned by current employees and the discount rate applying to future liabilities. But the expected ROAs – a credit to the profit and loss calculation that reflects the expected long-term return on pension scheme assets – represents a problem to managers trying to remove risk from their scheme.
This provision is designed to provide users of financial reports with an indication of expected performance of the pension scheme assets. In practice, however, the expected ROAs provides companies with an incentive to hold higher risk assets, perhaps without proper consideration for the risk attached to them.
This allows pension schemes invested in higher-risk assets, such as equity or property, to take advanced credit for anticipated long-term outperformance of these investments, which for many companies means allowing for an equity return in the region of 8%. If, however, actual equity returns differ from the expectation, any reported gains or losses will not immediately be visible in the profit and loss account.
Within the current accounting structure, therefore, there is significant positive profit and loss benefit to a company from holding riskier assets in its pension scheme. For many companies, this is a key feature that frames pension investment strategy decisions. Although the investment strategy is ultimately a decision for the pension scheme’s trustees, corporate sponsors often negotiate with trustees with a view to retaining the positive profit and loss impact of holding riskier assets. Even when other factors point clearly to a path of de-risking, the profit and loss implications can often result in a more aggressive investment policy.
The International Accounting Standards Board (IASB) is currently reviewing IAS19 and has indicated the need to revisit the expected ROA component of pension accounting. This is unsurprising, as the allowance for expected outperformance on pension assets has long been the focus of much criticism. The board has now put forward proposals to remove expected ROAs from the profit and loss calculation, with the interest cost component reduced to reflect interest on the pension deficit, rather than on total existing liabilities. If implemented, this change would effectively remove the accounting benefit of holding riskier pension investments.
Where a pension scheme is relatively large in comparison to the size of the company, one obvious outcome of this change will be a material impact on reported profit. For example, the FTSE 100 would see a fall in reported profit of around £8bn. However, many equity analysts already adjust financial disclosures to eliminate this accounting anomaly so the fall in reported profit may not be the most significant outcome of the proposed changes.
Moreover, the largest impact of the IASB proposals may well be positive. The change will remove a significant obstacle to implementing further de-risking of many corporate pension schemes. No longer will companies have to consider the benefits of de-risking against the profit and loss accounting implications.
The Financial Accounting Standards Board (FASB) (responsible for setting accounting standards in the US) is working jointly with the IASB towards a common pension standard, making it likely in the long-term that both bodies will remove this incentive for holding riskier assets and allow companies to focus on managing their pension risk more effectively.