UK – Investment bank UBS has suggested an alternative to the FRS17 accounting standard as a way of measuring pension scheme funding.

It reckons the FRS17 ‘AA’ bond yield is “too high a discount rate” in most situations - particularly where the obligation is funded.

The bank says in a research report on UK pensions that it is “too crude a calculation that fails to take account of the degree of collateralisation (funding) of the debt and the credit risk of the sponsor”.

It proposes an alternative uses a risk-free rate for the collateralised portion of pension deficits. This approach reveals “significant increases in liabilities for many companies”.

“An alternative to FRS17 is to measure the funded portion by discounting at the risk free bond yield the unfunded portion at a discount rate that reflects the entity’s credit rating,” writes analyst Stephen Cooper.

“In our view this better reflects the true value of the obligation and is therefore more likely to represent an appropriate amount to include in equity valuation.

“The method is certainly not perfect since arguably one should also take into account the nature of the collateral such that equity investment in the fund would lead to a lower valuation of the liability.

“However, we believe that this alternative calculation is a useful addition to the FRS 17 figure.”

Cooper also says there are problems with current accounting practice in that it artificially rewards equity investment by recognising the higher expected return from stocks. But this method gives “far less prominence to the additional risk arising for the sponsor”.

He suggests removing the ‘equity spread’ component of the expected pension asset return, something that would materially impact the profits and valuation metrics of several companies.