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The final countdown

Hardly a day passes without the media predicting the death throes of the traditional final-salary pension scheme – with good reason as the evidence of the acceleration of scheme closures is overwhelming.

There are a number of factors driving this change but the single factor standing at the head of the list is the innocuous-sounding Financial Reporting Standard 17.

The National Association of Pension Funds&#39 27th annual survey records that 77 per cent of schemes say that FRS17, as published, will make it less attractive for employers to offer a final-salary pension scheme.

What is FRS17 and who does it affect? It is a new accounting standard introduced by the Accounting Standards Board in November 2000 to replace the earlier standard, SSAP24. It is being phased in over a transitional period starting with accounting periods ending after June 21, 2001. Full adoption is required for accounting periods ending after June 21, 2003 although the ASB states that earlier adoption is encouraged.

The stated objectives of the standard are threefold. It aims to ensure that:

Financial statements reflect at fair value the assets and liabilities arising from an employer&#39s retirement benefit obligations and related funding.

The operating costs of providing retirement benefits to employees are recognised in the accounting period(s) in which the benefits are earned by the employees.

The financial statements contain adequate disclosure of the cost of providing retirement benefits and related gains, losses, assets and liabilities.

It applies only to company accounts and not to pension scheme accounts themselves. Nor does it directly affect the costs or funding plans for occupational schemes.

The scope of FRS17 is wide, however. It covers all company accounts except those for companies that have applied the Financial Reporting Standard for Smaller Entities. In short, all public limited companies must adopt FRS17. The only companies that can be considered to be smaller entities, and therefore exempt, are those that meet at least two of the following conditions:

Annual turnover must be £2.8m or less.

The balance sheet must total £1.4m or less.

The average number of employees must be 50 or fewer.

The standard covers all forms of retirement benefits including both defined-benefit and defined-contribution pension schemes, whether funded or unfunded. It also extends to other forms of retirement benefits such as post-retirement medical plans. This article is concerned only with defined-benefit pension schemes. We need not consider defined-contribution schemes here because, as long as contributions are up to date, costs will equal contributions paid and the balance sheet will be neutral.

What are the main effects of FRS17? It will impinge on three areas within the accounts, apart from a whole host of extra information and background data being required under the disclosure requirements of the standard. The three areas affected are the balance sheet, profit and loss account and statement of total recognised gains and losses.

The standard starts from the premise that the assets and liabilities of a pension scheme are, in effect, assets and liabilities of the sponsoring employer. Key, therefore, to the effect of the standard is the method used to value assets and liabilities of the scheme.

Assets will be measured at their fair value on the balance sheet date. For quoted securities, this means the mid-market value, while an estimate of fair value is to be used for unquoted securities. This contrasts with the SSAP24 approach whereby assets were valued using long-term actuarial assumptions designed to smooth volatility.

Unfortunately, there is no market in pension scheme liabilities. The use of a market value approach is not therefore possible. Instead, liabilities will be valued using a traditional actuarial method and a discount rate reflecting the market yield available on high-grade (AA-rated) corporate bonds. Hitherto, actuaries in the UK have tended to use a discount rate more appropriate to the actual assets held by the scheme. The new basis is also in line with IAS19.

Any difference between the values of the assets and liabilities will be considered to be a surplus or a deficit and will be recognised in the balance sheet for the accounting period. In fact, the only part of any surplus that will be reflected in the balance sheet is that part which can be recovered by the employer either by refund or reduced future contributions. Any deficit should be assumed to be borne by the employer, unless the scheme rules specifically require members&#39 contributions to be increased to help fund a deficit.

The cost of providing pension benefits for the year in question is to be shown in the profit and loss account. Although the contributions actually paid by the employer will be disclosed, the amount is almost entirely irrelevant. The standard is concerned about the true cost of the benefit promise and it would be inappropriate for the cost to appear different if, for example, the employer is enjoying a contribution holiday or the promise is unfunded.

Two major contributors to the cost of the scheme are current service costs and past service costs. The current service cost is the cost of benefits accrued during the period under review after allowing for expected salary increases up to retirement.

It must be calculated, in the context of the company&#39s accounts, using the AA-rated corporate bond yield at the beginning of the review period. This conservative assumption will drive up the reported cost of pensions.

This increased reported cost will, to some extent, be mitigated by another part of the cost assessment, the expected return on assets. This will be based on the actual assets held by the scheme and is, therefore, open to some flexibility. The assumptions are made by the company directors, having taken advice from an actuary, and could reasonably be higher than the specified discount rate, reflecting the equity content of the scheme investment portfolio.

There is a big change in the treatment of past service costs. These are normally associated with a benefit enhancement. In SSAP24, the cost of such an augmentation has been spread over the remaining service life of the members. , However, FRS17 insists that these costs are recognised when the benefit vests. Most improvements in past service benefits vest immediately.

Another component of cost is to be actuarial gains and losses. These will not appear in either the profit and loss account or the balance sheet but in the statement total of recognised gains and losses. The STRGL is a part of the accounts that covers issues that do not relate to the company&#39s normal trading activities and is needed to reconcile balance sheet changes.

Gains and losses in this context would include the difference between actual and expected returns on assets and the difference between actuarial assumptions about scheme liabilities and actual experience.

What effects might FRS17 have on businesses? It must be emphasised that FRS17 applies only to the methodology to be used when accounting for pension costs. It has no direct impact on the methods or assumptions used by trustees and actuaries when deciding how to value schemes or meet the costs of benefits. Equally, it has no direct effect on pension scheme investment. Good investment returns will continue to lead to lower future contributions but the costs in the accounts will always be based on the prescriptive assumptions in the standard.

Indirectly, however, there may be some impact on scheme investment. Given the market value approach, any scheme that is invested heavily in equities will be subject to some volatility and this will carry straight through to the balance sheet.

Should companies be concerned about the effect that volatility in their accounts will have on shareholders? Not according to the ASB, which feels that investors are sufficiently sophisticated to view the figures in their proper context.

If FRS17 worries mean that there is a move away from equity investment towards fixed interest, then actual scheme costs will be likely to increase in the longer term if you accept the standard view that equities will outperform bonds over the longer term. If any shift is towards corporate bonds, then the price of such assets will be expected to rise and the yields, therefore, to fall. This will result in lower discount rates under FRS17, with a resulting increase in the reported value of pension scheme liabilities.

There may also be a fall in the price of equities, which would have wider implications potentially impacting, for example, on the actual value of defined-contribution pension arrangements that are largely invested in equities.

However, it should be remembered that, although the company may be worried about the effect of FRS17 on the accounts, it is the trustees who decide on the investment strategy. If they alter their investment approach simply to meet the company&#39s short-term accounting needs, they could well be in breach of Pensions Act requirements.

It is recognised by the ASB that the new standard could have a direct effect on distributable profits. Such a problem could arise where the company accounts show a defined-benefit liability so large that it reduces distributable reserves to below those needed to cover any intended distribution. If the liability is large enough for the accounts to show that the company is technically insolvent, then the Companies Act will prevent a public company from paying any dividend.

The standard will exaggerate the financial risks attached to providing a definedbenefit pension scheme by focusing attention on the volatility of the assets. However, it is almost certain to lead to an overall review of pension schemes by their sponsoring employers. As a result of this, it is difficult to imagine that the trend from defined-benefit to defined-contribution schemes will slow down.

This is likely to lead to lower pension provision from company pension schemes and the Government is unlikely to make up the difference.

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