The UK’s biggest 100 companies enjoyed rare good news about their defined benefit (DB) pension schemes in the summer of 2017.

Research from Lane Clark & Peacock (LCP), a pension consultant, showed FTSE 100 pension schemes were in surplus at the end of 2017 for the first time since 2007. According to LCP’s Accounting for pensions 2018 spring update, the overall funding level for the country’s largest schemes had improved from 95% to 101% in the space of the year. Using the average of the 100 companies’ IAS19 accounting assumptions, this equates to a £4bn surplus at year end 2017 – a jump of £35bn since 2016. 

Then, in autumn 2018, LCP delivered further good news to the FTSE 100’s finance directors when it revealed a £30bn aggregate surplus.

However, LCP’s head of corporate consulting and the report’s co-author, Phil Cuddeford, describes this positive landscape as a rarity and adds: “It remains to be seen if the current surplus is here to stay.”
Getting the measureLCP analysed FTSE 100 companies that use the IAS19 accounting measure to report funding status. IAS19 uses AA-rated corporate bonds to discount future liabilities and includes mortality assumptions and expectations for inflation. 

Marian Elliott, from the Pensions Board at the Institute and Faculty of Actuaries, says: “The accounting basis is designed to be a best estimate and therefore should not contain a margin for prudence. On that basis, there is an equal chance that the actual cost of funding the benefits will be greater or lower than has been estimated on the accounting basis.”

This differs from actuarial assumptions that the discount rate includes prudent assumptions about returns from the scheme’s assets. If a scheme is invested in equities, the actuary might assume a discount rate of the return from gilts plus 3% to allow for assumed stock market performance. A more prudent actuary might assume gilts plus 2%, which would result in higher projected liabilities than in the gilts plus 3% discount rate.

Neither actuarial nor IAS19 measures are ‘accurate’ since they assume future returns. However, IAS19 is meant to give a consistent snapshot of DB health across the FTSE 100, while actuarial assumptions provide scheme-specific figures.
Smoke and mirrorsIAS19 is prescriptive in demanding companies use a discount rate based on AA corporate bond yields, yet it allows some room for manoeuvre. Examples of this include excluding certain bonds from the AA corporate bond universe and using multiple rating agencies to decide what constitutes an AA-rated bond. 

John Ralfe, an independent pension consultant, notes that such activity is legitimate, but may mean the improvements in funding levels reflect different discount rates rather than a tangible improvement in schemes’ financial health.

John says: “There have been various nips and tucks which, when taken together, take scheme funding a long way in the right direction. None of this is illegitimate, but nothing has changed in underlying economics; it’s just been cut and pasted in a different way.”

Companies can also value future payable benefits differently under IAS19. LCP found a 40% difference, as at 31 December 2017, between the most prudent and most generous assumptions made by FTSE 100 companies in valuing the future worth of £1 pa of pension payable from age 65 for a 45-year-old man (see chart overleaf). Using those figures, LCP reports that if all FTSE 100 companies switched to the lowest possible valuation, the surplus would jump from £4bn to £75bn overnight.
Cash injectionsSpecial sponsor contributions played a significant factor in bolstering DB funding levels in 2017, with FTSE 100 scheme sponsors injecting £13bn through the year. Employer contributions are critical to removing deficits, because they instantly improve the funding figures and allow trustees to derisk the scheme. For example, with a healthier funding status, trustees can buy out liabilities with a third-party insurer in the form of bulk annuities. They can also use contributions to hedge longevity risk or simply disinvest from risky assets. This creates a virtuous circle since derisking strategies can lock in surpluses and make the likelihood of continued funding improvements more realistic.

Trying to understand the financial health of the UK’s DB schemes based on a widely interpreted accounting measure taken as a snapshot is unreliable. A surplus can switch to a deficit simply by changing the discount rate by a few percentage points. 

The motivation to make an occupational pension scheme look as healthy as possible is obvious; shareholders do not want to compete with plan members for a share of the company’s cash. Company accounts need to reflect a positive funding position to attract investors. 

However, creative accounting can only achieve so much. When rules change, markets shift or expectations adjust, the whole landscape can shift from black to red in an instant.

This is particularly relevant for financial planners whose clients may be considering a transfer out of their DB scheme. Typically, DB members will be advised to remain in their DB scheme and take the ‘guaranteed’ benefits at retirement. But planners must be sure that the sponsor covenant – the employer’s ability to honour the DB scheme – is robust. If the surplus is a result of creative accounting rather than true funding improvements, and the sponsor is unable to support the plan for the foreseeable future, a transfer out may well be the right course of action.

What matters most – to investors, members, sponsors and planners alike – is that the pension fund is truly healthy, which requires strong governance, investment and, ultimately, time.
This article was originally published in the Q1 2019 print edition of The Review. All members, excluding student members, are eligible to receive the quarterly print edition of the magazine. Members can opt in to receive the print edition by logging in to MyCISI, clicking on My account, then clicking the Communications tab and selecting ‘Yes’.

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