UK - Existing pension accounting rules can be ‘misleading’ about the funded status of a defined benefit scheme, research from the Pensions Institute has suggested.
The report ’An Unreal Number: How Company Pension Accounting Fosters an Illusion of Certainty’ highlighted that while accounting standards have improved, the requirement of reporting a single number to value a deficit or liability can mislead investment analysts and shareholders.
Findings from the research, funded by the Institute of Chartered Accountants in England and Wales (ICAEW) charitable trusts, revealed existing reporting requirements mean companies have to forecast the stream of future payments required to fund the scheme; discount these payments to a present value and then subtract that from the value of the pension assets.
Professor David Blake, co-author of the report and director of the Pensions Institute at Cass Business School, argues this methodology does not allow for the potentially-wide range of possible future outcomes and is an “unreal” figure.
“The single number which is required on balance sheets is a hypothetical construct reliant on forecasting and discounting. It creates an aura of precision but, in reality, the ability of the assets to fund the future payments is highly uncertain,” he added.
Instead, the report urged standard setters for pensions accounting give priority to developing new tools, such as fan charts used by the Bank of England for inflation, and actuaries for longevity assumptions, which can “measure and communicate the uncertainties inherent in the pension promise”.
In addition, the report noted pension forecasting is made more difficult by a “lack of consensus” over the discount rate that should be used, including the yield from ‘risk-free’ government bonds, the yield from high-quality AA corporate bonds, or the expected return on pension fund assets.
Blake said: “Given this range of views, we should not be surprised to learn from the Pensions Regulator that an overwhelming majority of its respondents think that a single-figure measure of DB pension liabilities is meaningless.”
Research findings did reveal standard setters have started to recommend the disclosure of the risks and rewards of pension plans, implicitly acknowledging the limitations of a single number, with the Accounting Standards Board (ASB) suggesting the use of ’sensitivity analysis”.
But Blake warned while the use of sensitivity analysis will display how much a number will change if the underlying assumptions are changes, he pointed out it does not reveal how much confidence analysts can have in the single number.
“The current pension accounting standards are better than their predecessors because they seek to provide information about the amounts and timing of the projected pension payments and the value of the pension fund assets,” said Blake.
But he warned: “As our research shows, they over-reach themselves by allowing this useful information to be reduced to a single number.”
The report from the Pensions Institute has been published at the same time as a discussion paper by the ASB, in which it calls for a “fundamental review” of pension accounting standards, including changes to the discount rates, and the time frame over which surpluses and deficits are recorded.