Accounting for Pensions Survey 2000 
Appendix 3 - Changes to pension cost accounting Proposed Financial Reporting Standard for Retirement Benefits


  1. Introduction

    The UK Accounting Standards Board ("ASB") issued in November 1999 an exposure draft of a very different Financial Reporting Standard for pension accounting, "FRED 20".
    The main intention of the proposed new standard is that pension surpluses or deficits for defined benefit schemes should be reflected in the balance sheet on a market value basis, and that the pension cost shown should be the regular cost ignoring any surplus or deficit. Liabilities will be valued on a nearly "risk-free" discount rate, being that on AA corporate bonds. This is currently a lower rate than actuaries tend to use and will exaggerate cost. On the other hand, an offsetting allowance can be made for the expected return on assets, including an expected equity return.
    Other very important features of the FRED include:

    • actuarial gains and losses on the market value basis will go through the Statement of Total Recognised Gains and Losses ("STRGL") and so will not affect reported profits;
    • greatly increased disclosure requirements; and
    • the value of one-off improvements to past service benefits will be charged to the profit and loss account in the year they are granted even if financed by surplus.
    Comment:   FRED 20 therefore proposes that companies should disclose a pension cost which, ignoring any surplus or deficit, is very different from the expected true cost. The true cost will reflect the higher return expected from equities, which the proposals ignore in setting regular cost. This is a major change from SSAP 24. However, allowance for an "interest" offset based on the expected return on assets leaves a surprising degree of choice available in setting overall pension cost. Since gains and losses do not affect profits, it will be important to use an expected return on assets that is not conservative. The proposed treatment of past service costs is unfair and will have the effect of cutting back on future improvements. For smaller companies in particular the considerable extra calculations required and the corresponding disclosure requirements will be seen as an unreasonable imposition.
    The FRED is a complex document and proposes wide-ranging changes to reporting and disclosure requirements. This Briefing Note highlights only certain important areas of general significance.

  2. Proposed calculation method

    For defined contribution schemes the pension cost will continue to be calculated as contributions paid during the period. The proposed pension cost for defined benefit schemes is very different from the current UK standard. Three regular elements will affect the profit and loss account:

    • service cost (shown under the statutory heading for pension costs); plus
    • interest cost less expected return on assets (shown with interest costs).

    The service cost will be the cost of one year's accrual of benefit allowing for projected salary increases to retirement, and is therefore similar in concept to the "regular cost" under SSAP 24. The service cost will be based on the discount rate at the beginning of the accounting period. The discount rate should be the yield on "an AA corporate bond of equivalent currency and term to the scheme liability".
    Comment:   Calculating the service cost using bond rates is a more conservative approach than is currently used for both funding and accounting purposes. The effect could be to increase the service cost dramatically. For example a standard "60ths" final salary scheme where members contribute 5% might now give rise to a service cost of 12% of salary; using current corporate bond ratescould increase this to 19% of salary.

    The expected return on assets should reflect the actual split between the various asset classes and the actuary's expected rate of return on each asset class at the start of the period.
    Comment:   The expected return on assets will be a vital assumption, which the actuary has to set. The expected additional return from equities, above that from corporate bonds, must be disclosed and the ASB expect extreme values to be questioned. As market values change the expected rate of return on assets may change also, but the ASBexpect the total amount of the expected return to be reasonably stable. We are not convinced that this is a realistic expectation. Suppose that the assets and liabilities are each valued at £1 million and the service cost is £50,000.

    Suppose also that the actuary assumes an overall expected return of 8% pa compared to a corporate bond rate of, say, 6% pa. Then the interest cost less expected return on assets will be £60,000 less £80,000 ie a credit of £20,000, which is a material reduction of cost relative to the £50,000 service cost. (NB this reduction will be shown in the interest cost section of a company's accounts, not the pension cost section.)

    The balance sheet should include the pension surplus or deficit allowing for:

    • assets at market value; and
    • liabilities calculated on the appropriate AA corporate bond discount rate at the year end.

    Surplus in the pension scheme should be recognised in the balance sheet, but only to the extent that the employer can benefit from that surplus, for example by reduced future contributions. Similarly, a deficit should be recognised to the extent that the employer is obliged to meet that deficit. There will be an offsetting deferred tax reserve to the gross balance sheet items.

  3. Recognition of gains and loses

    In its July 1998 discussion paper the ASB put forward four options for the recognition of gains and losses. It now proposes just one option, namely immediate recognition in the STRGL. This is very different to the current treatment, whereby gains and losses are recognised gradually over the remaining service of the current employees.

    The rationale behind the ASB's proposal is that actuarial gains and losses are incidental to the main operating role of the employer and are therefore best reported within the STRGL, rather than in the profit and loss account. This is consistent with the Board's proposed "components" approach to reporting financial performance, under which characteristics not typical of operating profit should not distort the profit and loss account but be recognised separately.
    Comment:   Most users of accounts are not well acquainted with the STRGL. It is essentially a link between successive balance sheets that includes most of the items that by-pass the P&L. At best it will take time to get used to the importance of the STRGL.

    Under the ASB's proposals the gains and losses escape the P&L forever.

    One element of the actuarial gains and losses is the difference between actual and expected returns on assets. Since the difference is not reflected in the profit and loss account, it will be important that the actuary does not adopt a conservative estimate of expected returns.

  4. Treatment of benefit improvements

    Under SSAP 24, the cost of a benefit improvement is allowed as a first charge on surplus and so is, effectively, spread over the remaining service of the current employees. However, it is proposed that such a cost should be now recognised immediately in the profit and loss account.

    Despite the fact that benefit improvements tend to be provided when there is surplus in the pension scheme, surplus (unless non-recoverable) should not be offset from the cost of the improvement - the entire cost is recognised immediately in the profit and loss account.

    Improvements such as discretionary pension increases or early retirements on favourable terms may not fall under this treatment if they can be justified as a normal variation of the actuarial assumptions. Such items would be reflected in actuarial gains and losses within the STRGL and would not affect reported profit.
    Comment:   Very often an employer will make a benefit improvement by allocating part of surplus to the members. If the full cost is nevertheless a direct hit to P&L this is bound to deter employers from making the improvement. The ASB explain that if the employer uses surplus for members' benefits when he could alternatively use it to reduce contributions, the full cost of that decision should be reflected in that year's profits. We believe this is an unfair approach because the ASB are at the same time not allowing surpluses to affect profits. The proposals will certainly reduce future benefit improvements.

  5. Disclosure requirements

    FRED 20 suggests elaborate disclosures of pension costs. The example disclosure in the FRED itself extends to five pages. For example, the accounts will have to include an analysis of sources of surplus and deficit over the year and a summary of the last five years' experience gains and losses.

    Comment:   LCP has long advocated better disclosure of pension costs. We nevertheless feel that the new disclosure requirements proposed by the ASB go too far and will be especially onerous for smaller companies.
    There may also be practical difficulties as it appears that the only allowable measurement date for the calculation of the balance sheet items is the year end, giving very little time for the necessary actuarial work to be completed before publication of the accounts.

  6. Small company exemptions

    Only entities applying the FRS for Smaller Entities will be exempt - meaning in practice that most employers with over 50 staff will need to comply.

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