Accounting for Pensions Survey 2002
Detailed analysis of FRS17 disclosures


  FRS17 and balance sheet risk
What is risk? Some companies’ balance sheets are more exposed than others’ to the volatility of FRS17.

Currently, there are only two ways of reducing the volatility effect of FRS17 on the balance sheet:

  • by investing a significant proportion of the pension scheme assets in high grade corporate debt, which would “match” the FRS17 liability so that the assets and liabilities would move broadly in line with each other; or
  • by reducing the company’s exposure to defined benefit pension provision.
Boots Boots notably took the step of investing all their pension scheme assets in bonds. One might think that Boots effectively “locked in” their FRS17 surplus with this investment strategy, but they maintain that the move was not made for accounting reasons and it is certainly not the case that their FRS17 position is fully protected.

For Boots, FRS17 overstates the true value of the pension scheme surplus. According to their recently published 2002 FRS17 disclosure, Boots expect to achieve an investment return of just 5.4% pa from their pension scheme assets, whereas their liabilities have, quite correctly, been discounted under FRS17 at 6.1% pa. This higher discount rate places a lower value on the liabilities and hence gives a flattering FRS17 position.

This demonstrates that an FRS17 surplus can not be regarded as a true surplus and that the full disclosure is fundamental to putting the surplus figure into context.

If this investment strategy continues, Boots’ assets will fail to keep pace with the FRS17 liability and the surplus will reduce, unless, of course, they pay contributions into the scheme in excess of the operating cost disclosed in their accounts.

For the majority of companies with pension schemes that remain invested largely in equities, the converse logic applies. The extra return that they expect to receive in the long-term should, if the assumptions under FRS17 are borne out, improve the ratio of assets to liabilities by around 1% pa on average. In other words, an FRS17 deficit of 10% would be expected to be eliminated within around 10 years if the FRS17 assumptions are borne out in practice. Whilst this looks like a long time, it should be compared to the average point of future payments for a typical pension scheme, which can be 20 years or more.

We conclude that FRS17 disclosures need very careful consideration as the headline surplus or deficit can be very misleading.
Increased
cost		 Many of today’s defined benefit pension arrangements have evolved because the sponsoring employer, quite justifiably, felt that the short-term volatility of equities was irrelevant where the liabilities become due a long time into the future. If these companies had restricted themselves to investment in bonds from the outset, many would never have set up defined benefit schemes with the current level of benefits, as such schemes would have been deemed simply too expensive.
Measuring
the risk		 Significant balance sheet risks from FRS17 occur where
  • the pension scheme is large relative to the size of the business; or
  • the pension scheme is heavily invested in equities.
In Appendix 3 we list the size of each company’s pension schemes relative to the company’s net asset value. The higher this ratio, the greater the effect of a volatile FRS17 position on the company’s balance sheet.
ICI ICI have a very large pension scheme and disclosed negative Group shareholder funds. Their pension scheme is in deficit. However, they have significantly reduced the scheme’s exposure to equities, which should limit their downwards exposure to FRS17.
Rentokil
Initial		 Rentokil Initial have a very large pension scheme and disclosed negative Group shareholder funds. Their scheme was in surplus at 31st December 2001. However, they have invested nearly 80% of the pension scheme assets in equities, making that surplus very fragile.
Rolls Royce Rolls Royce disclose a deficit of £580m, over 25% of the net assets of the company. Furthermore, the pension scheme remains over two-thirds invested in equities.
BG, P&O At the other end of the scale BG (British Gas) and P&O Princess Cruises both have seemingly worryingly low ratios of assets to liabilities (both 83%). However, their pension schemes are, relative to reported net asset value, very small.