The standardisation of Europe
One of more comforting features of pension funds around Europe is their national differences but with the forthcoming adoption of International Accounting Standards this is likely to change. This change will arise as the European Union has adopted a regulation requiring publicly traded companies in the European Union to apply International Accounting Standards when preparing financial statements. This requirement will apply from 2005, with a few exceptions allowed until 2007.
For pensions (and other post employment benefit plans) the applicable standard is IAS 19. This says that publicly traded companies must be required to apply a single set of high-quality international accounting standards.
Whilst in theory this standard only affects the way sponsoring companies account for pension expenses it is bound to have an effect on the way pension funds are run by the corporates in the future. In addition this effect will probably spread to industry wide schemes and even local and national government schemes.
It has been a long road since the US adopted the APB Opinion 8 in 1966 and then FAS 87 in 1985 and the UK adopted SSAP 24 in 1988, and now we have FRS 17 in the UK and even the potential adoption of IAS 19 by the US.
But what do FRS 17 and IAS 19 offer that other standards have not? Basically real transparency and potential efficiency. It is quite clear that an actual cash contributions may not reflect the real cost of providing pensions in any given year and therefore IAS 19 requires that companies account for their defined benefit obligation as the present value of expected future payments resulting from employee service in current and prior periods.
In the new standards companies will have to project cash flows for both liabilities and assets but use single discount rate for assets and liabilities. The expense is determined by adding service cost to interest cost and deducting the expected return on assets.
This ties in with the theory increasingly gaining currency that pension liabilities are simply bond like obligations – that is, future streams of known payments and should be recognised as such in company accounts.
IAS will have an impact on a company’s balance sheet as the cumulative difference between the IAS 19 expense and the actual employer cash contributions. We will also see an effect on the income statement.
As a result, in the future, companies will want to actively manage their pension plans to address IAS 19 compliance and their overall business objectives? Most will want certainty as to future contribution policy. To get this, companies will want their pension funds to adopt an investment policy which gives them what they want rather than what trustees have hitherto provided.
Plan sponsors will probably have a different definition of risk than trustees. But will all companies and their shareholders be willing to accept, what could easily be, a higher pension expense than hitherto, or will companies be willing to accept a more volatile pension expense?
But I suspect the real problem for a lot of companies could be the possibility of having to contribute unbudgeted cash to their pension funds.
Some employers do not have the choice but to support their final salary schemes. Others do have a choice and in the UK and are already voting en masse to close final salary schemes in order to start defined contribution schemes.
Where companies do not have the choice to close their scheme you can be sure that heavy influence will be brought on trustees to establish an investment policy totally acceptable to the company. The strategies will depend on the nature of the plan, the maturity of the liabilities, the current state of funding as well as the covenant or financial position of the plan sponsor.
But the end result is likely to be a realisation that equities are not risk free. This would have happened even if the markets had not fallen for the third consecutive year. However, I suspect the reduction in equity exposure will be permanent even if the actual level of equity markets increases substantially over the next few years. Most companies will simply not be able to take the risk of underperforming. The result will be a very short- term investment policy when what most pension funds want is long-term time horizons.
Currently most pension funds rely on their actuary to smooth contribution requirements so that funds and corporate balance sheets are rarely hit with immediate cash calls when the market falls. In the future if a corporate’s profits or balance sheet are hit immediately the market falls there really will be little incentive to hold stocks – the risks will simply be too great for most employers to bear. Maybe the dream of a Europe-wide pension fund is closer than you realise. But will you like the product?