ASB pension accounting changes recognise reality
by Dr. Ros Altmann
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The Accounting Standards Board has today issued a consultation on pension accounting. This bravely attempts to inject more reality into reporting the true costs of employer defined benefit pension promises. There is likely to be strong resistance, from both industry and government, to many of the proposals, which would, if adopted, cause reported pension scheme deficits, and perhaps funding costs, to rise. Indeed, if such measures were adopted for public sector pensions too (as they should be!) the increases in public debt would be enormous. Taxpayers are facing staggering burdens in future pension payments to former public workers, but there is no money building up to pay for this. In my view, despite the likely criticisms, it is about time that we recognized reality now, rather than trying to keep pushing pension costs into the indefinite future.
Historically, employers were allowed to take credit for future investment returns that had not yet been earned, meaning that finance directors and investors did not properly recognize the future costs that were building up. It almost seemed as if pension funds were used by company management as a kind of ‘financial toy’, as if pensions were not really a ‘proper’ liability. For years, companies continued making pension promises to their workforce, but were not putting in the money to fund them. Quite simply, employers and trustees were relying on future equity returns to be high enough to pay these pensions in the long-term and actuarial and accounting standards allowed them to do so. There is no economic rationale for this – it really was a fools’ paradise.
Once the current FRS17/IAS19 accounting standards came in a few years ago there was enormous criticism of the use of a corporate bond discount rate to value the liabilities. But the fact that accounting standards started to use mark to market valuations is not the problem. The problem is that pension accounting was previously so opaque that pension obligations were not taken seriously as a ‘real’ liability and not enough money was being put aside to meet the future costs.
The ASB is correct to highlight the need to recognize the funding position of schemes as accurately as possible in future. Even the current pension accounting standards with a ‘double A’ bond discount rate are not robust enough. Schemes with a so-called ‘surplus’ on FRS17/IAS19 measures still contain much less money than is actually required to pay the pension liabilities that have accrued to date. This lulls employers and scheme members into a false sense of security.
The particular problem with final salary pension schemes is that they are not just another liability, like a bank loan or rental payments – they have members’ lives attached to them. Receipt of a company pension often makes the difference between a ‘decent’ retirement and an old age in penury. If the money is not put in to pay the pensions, then there will be serious consequences some time down the line.
The bottom line is that final salary pension schemes are a hugely expensive, open-ended commitment by employers to pay a promised level of pension to former workers, for as long as they live. Employers do not know how much this will cost, but have signed a blank cheque to keep on paying, often with yearly increases, for the indefinite future. This applies to public sector pensions too, except that many of these schemes have not even built up any fund to pay from in future!
The traditional employer thinking (or lack of it) on pensions accounting has now been exposed to the chill winds of modern reality. Defined benefit pensions are a significant burden for today’s employers. No doubt many will argue that more stringent accounting valuation standards will hasten the demise of final salary schemes. But if they are unaffordable, why keep pretending the costs can be met in the future? UK final salary pension schemes saddle employers with huge additional labour costs (well over 20% of current salary and well over 30% in public sector schemes) which can damage competitiveness and profits. But it is not just the level of cost, it is also the uncertainty of the cost which probably makes final salary pensions so troublesome to modern-day capitalism. Increasing longevity, falling interest rates and uncertain investment returns make it impossible to budget properly for future pension expenses.
Employers and shareholders – as well as taxpayers for public sector schemes – must recognize the true implications of these commitments. This is long overdue and I think it is commendable that the ASB is tackling the problem head-on, despite the likely criticism it will generate.