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The Actuary The magazine of the Institute & Faculty of Actuaries

Soapbox: Pensions pile-up

People often say that corporate defined benefit (DB) schemes in the UK are an accident waiting to happen. That is wrong. The accident has already happened. It is just that we are only now beginning to see the effects. The cost of well-intentioned government actions over the years has gone unnoticed because the accounting standards we had gave no indication of the true risks that were involved in a DB promise, and so did not show the significant increases in pension liabilities that resulted from these rule changes.

Current accounting regime
Even now the accounting is not working well. DB pension liabilities are longerterm, more complex, and more uncertain than any other liability on a company’s balance sheet, apart from nuclear decommissioning costs. Accounting standards require a spot valuation at the end of each period, and an estimated allocation of the costs of making the pension promise to the period in which it accrues. These requirements are built into the fabric of our current accounting regime — they worked well when we were prepared to wait until the ship returned from the voyage before counting the contents, but things have become much more difficult ever since we have demanded that the score be calculated en route.

Actuaries are clearly involved in this process, but all too often have ended up joining in the fruitless debate about which discount rate to use instead of seeking better ways to ensure investors and employees understand the costs of what is promised and the risks to which it exposes the business and the benefits to recipients. We have ended up with the current IAS 19 approach, which uses an AA corporate bond yield to calculate the accounting liability, resulting in companies declaring a present value that is useless in terms of forecasting cash flows from the company into the scheme.

Meanwhile, somewhere else in the same building, an actuary will be advising the finance director about the actuarial view of the pension liability and the scheme’s funded status, and another actuary will be sitting in reception, preparing to explain how his insurance company values the pension liability and prices a pension buyout. Three very different views, founded upon potentially the same data set, but only the one with the least informational content and least impact on corporate decision-making is required disclosure under IAS 19.

Some companies, and some pension schemes, are leading the way in terms of disclosure, publishing their actuarial and buyout liabilities, and setting these figures in the context of the expected cash payment profile of the scheme; but in far too many cases this information remains hidden from the financial markets, leaving schemes and their sponsors subject to rumour and guesswork. Imagine you are a finance director. If you started providing pension benefits today, would you open a DB scheme? If you did, would you fill a trust fund with equities and property and appoint a mixture of shop-floor workers, management and external worthies, with unfettered discretion to play with shareholders’ money and the right to demand more if their bets do not work out, without any obligation to return any surplus?

Same concept, different pile
Putting it another way, if the majority of the pension scheme members do not work for you, and the majority of your employees are not scheme members, what benefit does the business get from running off an existing scheme over 80 years?

Fudging the numbers has not worked — what can be done? Pension schemes could start by publishing their latest funding statement and a cash flow profile on the internet. The government could raise the retirement age and disclose the value of the pensions it has promised. The reality is that we will all have to work harder and for longer than we thought.

Peter Elwin is head of accounting and valuation research at Cazenove Equities. He is also a member of the UK Accounting Standards Board and a pension trustee