mast image

Special Report

Impact investing

Sections

Volatility generator

SSAP 24’s successor FRS17 has various implications for pension fund professionals, be they investment managers, accountants or actuaries. From whichever perspective though, the main implication is volatility in the balance sheet and profit and loss account and, although this may sound anodyne enough, there are practical implications and potential side effects, most of which were covered by a recent gathering organised by the Irish Association of Pension Funds.
In short, the new standard forces corporates to include market valuations of their pension scheme’s surplus or deficit in their annual statements. Una Curtis of the Institute of Chartered Accountants in Ireland, started by welcoming FRS 17 as a departure from SSAP 24, a measure she said was renowned for a lack of transparency and a tendency to confuse. There was, she says, a need for internationalisation and under the new system publicly listed companies in the EU have to report according to international standards.
DC schemes are unaffected as they will report in the same way as under SSAP 24 since cost equals contributions and the latter are considered operating profit in the profit and loss account. All DC schemes need to disclose is the nature of the scheme and the outstanding pre-priced contributions costs for the period. DB schemes in contrast will feel the brunt of the changes and will be subject to fuller disclosure including the change in the surplus year on year.
Under FRS 17 assets will be measured at fair values (mid-market price at the date of the balance sheet) while liabilities will be measured on an actuarial basis using a projected unit method. In addition, surpluses are to be included counted as pensions assets while deficits are classified as liabilities. “Under FRS 17, the actuarial assumptions are far more prescriptive,” said Curtis.
Paul McMahon of Mercer in Ireland took the actuary’s perspective saying SSAP 24 had been relatively flexible and that, as such, it had been possible to ‘smooth’ out results. He agreed that the new approach is more prescriptive in that the actuary is no longer responsible for the funding. “The link between what you put in to the pension funds and what is reported on the profit and loss account is broken,” he said.
Under SSAP 24 it was possible for the actuary to select the actuarial methodology and the accompanying assumptions. Generally speaking the pension expense in the profit and loss account equalled the contribution paid and consequently a scheme’s expense tended to be reasonably smooth and predictable.
Under the new system, the actuary faces a specified methodology and the range of assumptions available are limited. Unlike SSAP 24, pension expense in the profit and loss account will not necessarily equal the contribution and there is the possibility of large assets and liabilities on the balance sheet. Assets are priced according to market value, liabilities are valued according to an AA bond yield and there is now the potential for sharp fluctuations in either assets or liabilities. “The result could be a very large swing in balance sheet assets,” said McMahon.
As illustrations, McMahon gave two hypothetical situations where a 20% fall in the market could potentially lead to a 70% fall in assets while a 1% drop in yield could potentially lead to a 57% increase in the cost of the pension. In addition, under extreme circumstances a company who has to move substantial deficits to its balance sheet may face the prospect of a credit review. While this is feasible, McMahon stressed it is too early to make predictions.
Tim Walsh, chief economist at AIB, looked at the implications of the new standard from an investment analyst’s perspective and welcomed FRS 17 for producing greater transparency. Although volatility in the profit and loss account will invariably increase thanks to market fluctuations, in practice a scheme’s vulnerability will depend on its maturity.
Walsh compared British Airways’ scheme with that of Vodafone. As of April 1998, BA has a market cap of £3bn, just over a third of the pension fund’s £8.8bn assets. Vodafone in contrast was valued by the market at £170bn while its fund is worth £1bn and therefore its balance sheet is far less susceptible to volatility.
In practice increased volatility has possible implications for loan covenants, the ability to raise new finance and for valuations based on the balance sheet. One scenario is the new accounting standards putting pension funds off investing in volatile equities. This fall in, in turn, has the potential to drop the price, increase volatility and exacerbate the situation. This is unlikely to be a major problem in that domestic funds are not the only purchasers of equity. Life funds and overseas investors have provided significant demand but Walsh nevertheless said the scenario was worth noting.

Have your say

You must sign in to make a comment

IPE QUEST

Your first step in manager selection...

IPE Quest is a manager search facility that connects institutional investors and asset managers.

  • QN-2559

    Asset class: Multi Assets.
    Asset region: -.
    Size: EUR 15m (may be split into two mandates EUR 7.5m).
    Closing date: 2019-09-06.

  • QN-2560

    Asset class: Private Equity.
    Asset region: Global.
    Size: $40m.
    Closing date: 2019-08-30.

  • QN-2561

    Asset class: Infrastructure.
    Asset region: Global.
    Size: $40m.
    Closing date: 2019-08-30.

Begin Your Search Here
<