The right assumptions

THE END of December 2011 will mark the end of a turbulent year in the world of defined benefit pensions. If your company year-end also comes at this time of year, then your thoughts will soon be turning to the FRS 17 pension disclosure.

Falling bonds yields have pushed up scheme liabilities while falling markets have pushed down schemes’ asset values, a real double-whammy especially for pension schemes predominantly invested in the equity market. What can you do to minimise the damage to the balance sheet and avoid problems for next year’s profit and loss charge?

Firstly, and perhaps most importantly, it is the company directors (subject to the agreement of the auditor), not the actuary who are responsible for setting the assumptions which determine the FRS 17 calculations. Directors should seek to proactively challenge their actuary’s advice and assumptions to ensure that the disclosures are appropriate for their company and the profile of their scheme.

Looking firstly at the balance sheet, there are several steps you really should be taking:

1. Ensure the discount rate is appropriately adjusted for the term of the scheme’s liabilities – using a longer term rate which is higher results in a lower present value being placed on the liabilities. Taking appropriate action here could reduce the value of liabilities by 10%;

2. FRS 17 calculations are predicated on realistic/best estimate assumptions – the prudence required by the Pensions Regulator is not needed for these so it’s important that life expectancy assumptions are not too great and that member options (eg – taking cash lump sums at retirement) are appropriately allowed for. This could reduce liabilities values by up to a further 10%;

3. Proper allowance should be made for the change in inflation measure from the Retail Price Index (RPI) to the Consumer Price Index (CPI) if applicable to your scheme. Typically this change has reduced scheme liabilities values by six or seven per cent but in some cases it’s substantially higher.

If you are part of a multi-employer scheme (such as the Local Government Pension Scheme) it is vital to ensure future salary assumptions are appropriate to your organisation. I have seen countless examples with growth assumptions set at least 1.5% a year above inflation which seems totally inappropriate for most organisations in the current climate. Moving the salary growth closer to inflation will result in a significant reduction in the reported liability.

Turning to the effect of the pension scheme on the profit & loss (P&L) charge, it is important to note that the year-end assumptions only impact in the following year. You should ensure that the actuary confirms the impact on next year’s profit & loss charge before you agree the assumptions. The main drivers of this are interest cost, which creates a charge to the P&L, and the expected return on assets, resulting in a P&L credit.

The interest cost is generally lower when the liabilities are lower, so following the above steps will help minimise the P&L charge. Overall, the expected return on assets credit for next year is likely to be depressed with falling markets resulting in by lower asset values. I’d recommend that you therefore establish whether higher future returns can be allowed for to compensate for lower current values.

Alan Collins is head of corporate advisory services at Spence & Partners