Putting a value on an employer’s defined benefit pension scheme is a complicated matter and figures can vary widely according to the measure used and its intended purpose, says Katrina McKeever.
An employer which wants to know how much its defined benefit (DB) pension scheme is worth on any given day will not find an easy answer. That is because the actual value of the pension fund – the amount it needs to pay out to pensioners and meet its running costs – can only be estimated. Stock market fluctuations and pensioners’ longevity are just two of the constantly-changing factors that make it almost impossible to determine a value.
Therefore a number of measures have been developed to “account” the value of a fund, each with a different purpose. One measure enables accountants to put a figure in their annual accounts, while another is used by trustees to check the fund will meet its liabilities. A third measure is adopted by the Pensions Protection Fund (PPF), and a fourth is used by insurance firms looking to buy out employers’ pension funds. Brian Peters, pensions partner at PricewaterhouseCoopers, says: “One of the problems we see is that companies find it quite hard to understand why you have so many different measures of what is, ultimately, the same thing – the cost of a pension fund.”
The figures drawn up for annual company reporting accounts and financial statements are worked out using an accounting standard called IAS19 – an international standard used for UK listed public and international companies – and FRS17, a UK standard. Jerome Melcer, partner at Lane Clark & Peacock, says: “The main objective is to make accounts easily comparable to the previous year’s.”
The funding calculations used by trustees apply more cautious assumptions because they want to ensure members’ pensions will be paid. For example, assumptions on pensioners’ longevity are often a year or two higher than those used for the accounting figures. Funding figures also take into account the strength of a scheme’s sponsoring employer, because a financially-strong organisation will be better placed to provide extra funds if needed.
There can be a big difference between accounting figures and funding figures. For example, in a fund with assets valued at £100m, the accounting figures could value the liabilities (the amount it needs to pay out in the future) at £100m, leaving a neutral balance. But the funding figures could value the same scheme’s liabilities at between £110m and £130m, leaving a funding gap of between £10m and £30m.
“Trustees are asking for fairly cautious assumptions at the moment because they are worried about the future returns they can achieve,” says Peters. “That means the company needs to put more money in than the accounting standard suggests it should. The problem for a financial director is to stand in front of investors and explain why the accounts say they have a surplus but you are putting more cash into the pension fund.”
If an employer is looking to remove the risk of running a final salary pension scheme, one option is to get an insurance company to take it on through a buyout deal. The insurance firm will then work out its own value of the scheme, based on the assumption that it must maintain solvency margins and try to turn a profit. Typically, these figures will be 30% to 40% above those that the employer would disclose in its annual accounts.
Pension schemes must also produce accounts for the PPF, the insurance fund that pays members’ pensions if a scheme collapses. The PPF charges all DB schemes a levy, which varies according to the scheme’s risk rating. The Pensions Regulator issues a standard equation to determine the value of each pension scheme. It allows no subjectivity, and focuses on the chances of the scheme becoming insolvent and the size of the deficit. The PPF figure is likely to be lower than the insurance buyout figure because the PPF pays only 90% of benefits. The difference between these figures varies greatly, depending on the scheme, and can be around 90% value.
The PPF figure and the insurance buyout figure can also vary widely from the accounting and funding points of view. Using the same £100m example as above, the insurance company might value the employer’s liabilities at £125m – a deficit of £25m – whereas the PPF might put the figure at between £110m and £120m, a funding gap of £10m to £20m.
If you read nothing else, read this…
- There are four main accounting methods used to work out the value of a pension fund.
- Accounting figures are drawn up for company reports to a set standard, aiming to fit in with its accounting methods.
- Funding figures are drawn up for trustees to ensure the pension has sufficient funds to pay all members’ benefits.
- Figures drawn up in the event of a pension scheme buyout by an insurance company are 30% to 40% above the employer’s traditional valuation.
- PPF figures are worked out using standard assumptions. Generally, schemes deemed to be riskier are charged more.