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The Actuary The magazine of the Institute & Faculty of Actuaries

FRS17 an equity analyst’s perspective

It may come as a surprise but, as an equity analyst, the thought of spending a significant amount of time evaluating a new accounting standard is not something that fills me with excitement. Equity analysts tend to be industry experts and financial analysts, but not always accountants, and I have yet to meet one that has been an actuary in a previous life. So when an accounting standard change comes along that relates to the valuation of company pension schemes, there is always going to be a degree of indifference from research analysts (or some would argue a ‘head in the sand’ mentality). A company’s products, markets, and management are much more interesting than are their pension schemes.
Nevertheless, FRS17 has demanded a significant amount of evaluation over the past year or so and, although I stand by my original point, this accounting change is clearly different. It is important to the work we do as a group of analysts and important to the investors we support.

Bad timing?
FRS17 is different not least because of its timing. Following a high-profile series of accounting scandals in the US, the scrutiny of detail (and particularly balance sheet detail) is at its height, while stockmarket declines and low bond yields mean pension fundamentals are arguably at their weakest. I would say that, even though the implementation of FRS17 seems to have been surrounded by new uncertainty (at least over timing), it has started a debate about pension valuation that is unlikely to go away. Equity analysts and fund managers now understand that this is a critical matter for them as well as for the companies that need to fund these schemes.
The knee-jerk reaction is to say that accounting standards rarely affect underlying value. We would usually agree, and there is a mountain of academic evidence to back us up on this one. What accounting changes often do, however and FRS17 is no different is to change the level of disclosure of information that is the basis of these external valuations.
With FRS17 we are inundated with a mound of new information on pension scheme funding levels and strategies that promises to be updated on an annual if not more frequent basis. The wisdom of this approach can be debated but, now the financial community has seen the impact, it is hard to see us going back to the old days of infrequent revaluations, limited disclosure, and opaque smoothing methodologies.
But the key question is what are people (of which equity analysts are just one interested group) going to do with this data in the valuation of companies? We would argue there are at least three schools of thought in the marketplace that we see today: procrastination, conservatism, and pragmatism.

The different schools of thought
– Procrastination In our view there are a surprisingly large number of people the majority within companies themselves who are relatively happy with the current system of disclosure and this group is not enjoying the new-found data. To them, FRS17 brings uncertainty, volatility, and a possible change to tried and tested methods for equity valuation. They are being helped by its slow introduction (if at all) but we believe they will one day be hit by the new standard. Harmonisation of accounting standards is coming and SSAP24 looks doomed in its current form. Capital markets are increasingly global, and I believe the UK will struggle to sustain a standard that is incompatible with the rest of the world.
– Conservatism At the other extreme are the cautious ones, among whom we would include ourselves (but not all equity analysts). As a group, we take the view that FRS17 offers clarity and simplicity, and so is an opportunity not to be missed by analysts.
Under the new standard, we are to be presented with a present value of a liability (kindly calculated using complex assumptions over many years into the future and carefully discounted using appropriate discount rates we hope) and the real value today of assets we understand (principally equities and bonds). Surely just deduct one from the other, and the gap is the asset or liability that should be deducted from the wider equity value of the sponsoring business? This is likely to be the accounting treatment anyway, but it also seems right to us for real markets. In other words, pension underfunding today is like a debt.
– Pragmatism ‘But’, cry the pragmatists, ‘this is surely too harsh’. These liabilities mature over an extended period, and in the meantime equities in the schemes should produce superior returns that bridge any gap today. The capital asset-pricing model tells you so.
The approach this group uses is to look at the additional cash contributions companies must make, or they make their own adjustments to annual income to reflect an effective amortisation of deficits. While we understand the approach, we think equity markets remain (rightly) cynical of accounting and adjustments need to be clear and justifiable. Arbitrary assumptions will not help.
A framework for these adjustments may come eventually, but we should probably not expect FRS17 to provide an immediate answer. The effect this new standard will have on the annual profit of companies is going to be as open to manipulation as ever. As we are now seeing in the US, companies with the flexibility to choose their own discount rates and rate of return assumptions are going to be free to alter earnings in a way that may have a limited reflection on reality and could reduce comparability across companies. More work for equity analysts.

The future effects of FRS17
Looking beyond equity market valuation, what else can be said about FRS17 in the ‘real’ world? Well, for a start, we believe we are already beginning to see the impact of the required disclosure on the sponsoring companies. We see more and more companies moving away from defined benefit schemes, as FRS17 is already highlighting to the world the effects of the most recent market downturn. In fact, I would not be surprised to see these schemes disappear completely in the long term as shareholders increasingly demand that employees, not owners, bear the risk of providing for retirement. Remember, shareholders generally base their investment decisions on a company’s ability to make money in its core business, not on its management of pension schemes.
For those schemes that remain, finance directors are beginning to argue the merits of at least a somewhat more conservative funding strategy. We have not yet seen wholesale support of the Boots approach to funding (100% bonds), but it is clear from our conversations with companies that they would rather not be exposed to as much volatility in the future as they have seen in the past few years. I can tell them, they are not alone!
If we stand back from the current situation, however, it is important to understand the importance of timing. If FRS17 had come along three years ago who would have noticed? Just another accounting standard change. Pension schemes would have shown healthy surpluses backed by record highs in equity markets across the world. But now? Equity markets are down almost everywhere and all FRS17 does is simply show how much things have changed. Add to this the increasing financial scrutiny in capital markets post-Enron, and a new accounting standard becomes a minefield for companies.
So where are we today? Frankly, it is not clear. There is no track record of seeing how equity markets will deal with this new information, and our view from talking to institutional investors is that no one thinks the tools are yet ready to provide an accepted common framework. Surely we must get there, though, as (unless equity markets bounce in a way that we can but hope for) the cat is now out of the bag.

No going back
In other words, FRS17-type disclosures are important, and there is no turning back. There are big pension deficits out there, on both sides of the Atlantic, and someone is going to have to use real cash to pay. We know for certain that it will be shareholders.
Will equity markets bounce and rescue us all? As we all know, there is an industry out there paid to answer this question (of which I am a part) and some might persuade you that they will. Talk to a market trader, though, and they will tell you that today’s prices reflect today’s information, and that the assets are worth what they are worth (try selling your house for more than someone will pay for it!). But then they probably said that when the FTSE was close to 7,000