27 May 2016

What’s behind a pension deficit?

By Peter Walton

What with BHS and Tata Steel in the business headlines, there has been much talk of pension deficits. However, these are usually treated as known quantities, rather than what they are: estimates based on a large number of assumptions and the plaything of both history and market returns.

The ‘pension deficit’ reported in a balance sheet is a residual of a calculation where four different factors interplay, and can swing the scheme from deficit to surplus back to deficit again on a regular basis. The deficit number is indicative only, and it should not be a surprise that managements do not respond instantly to every change.

The first element is the pension liability for the current year for people in work. A fundamental of financial reporting is matching costs to the revenues that have been earned. This means for final salary pension schemes (once the norm) that the employer must estimate how long the employee will work, what their final salary will be, and how many years they will draw a pension, and then recognise a portion of that as a cost for the current year.

However, this already highly uncertain number is compounded, especially for long-lived companies with a large number of pensioners, by the second factor: the problem that people are living longer. This means the provision made many years ago for current pensioners is not enough and the cost of making good falls on the company today, even if it is the result of a mis-estimate from decades earlier.

The traditional scheme involves the company recognising a pension liability and then putting assets into a fund to meet that liability. The difference between the fund assets and the liability is the deficit we all hear so much about. This gives the other two factors, which are a function of the market.

The value of the assets for accounting purposes is their current market value, and how robust this is depends on the mix of assets held and the state of the economy. If the fund holds fixed income securities, their value goes up as interest rates fall. However, if they hold equities or investment properties, their market value moves according to different stimuli. In the wake of the financial crisis, these markets have not been strong.

The final element is the liability. The numbers which make up the liability are estimates, but then this amount is discounted by the current rate for corporate bonds. In the current low interest environment, the liability is very high. The liability grows as interest rates decline, so a company whose pension was in surplus in 2008 could find itself with a deficit in today’s low interest rate market.

Discounting reflects that if the company has to pay £100 in ten years’ time, that is worth much less than £100 to be paid now. If you could earn 10% interest, you only need set aside £62 and compound interest will take this to £100 in ten years. However, if the market rate drops to 5%, you would need to set aside £77 – you would now have a deficit of £15, without anything changing except the market interest rates.

The financial crisis has had the effect of holding down most classes of investment asset, while, through low interest rates, the pension liability has grown, and at the same time life expectancy has been steadily extending. No wonder that managements see the final salary pension scheme as a nightmare. No wonder also that it is tempting to wait for market conditions to reduce that deficit residual.

Peter Walton is Editor of World Accounting Report