In my last post, I discussed how the introduction of new accounting standards at the start of the millennium cemented the fate of the private sector defined benefit pension scheme. This post continues this discussion explaining how to value future liabilities and why the new rules caused conniption fits among finance directors and shareholders.
I explained in the previous article how an actuary would forecast the total likely value of the benefits due to be paid to members, making assumptions about their longevity. But a current value of these future benefits need to be found.
How can you asses what, for example, annual payments of £30,000 to a member retiring in 2040 would be worth today?
To understand how actuaries and accountants carry out this valuation, first you need wrap your mind about one of the key concepts which makes it possible to build up a pension pot – the power of compounding.
Compounding works because every year the amount of capital to be invested is getting bigger.
For example, an investment of £100 today with annual returns of 3% will be worth £103 by the end of the year. If you reinvest that £103 for another year with the same returns, it will be worth £106 at the end of the second year. After five years, by reinvesting both the capital and returns of 3%, the initial £100 will have become £116.
When an actuary wants to determine the value of, for example, an annual benefit of £30,000 in 2040 they are carrying out the compounding calculation in reverse. This is known as a discounted cash flow. They know how much they will have to pay in the future; they need to determine what it is worth today.
To use our compounding example, if you wanted to have £116 in five years, what would you have to invest today? To be able to carry out this calculation, you need to estimate what returns you likely to earn over this period.
FRS 17 specified this rate of return – or more accurately, the discount rate – as an AA corporate bond rate. This is the value of the interest a well-financed company would have to pay to anyone owning its bonds.
Now the actuary can carry out the calculation and determine the present value of the future liabilities. This is when things can start to get scary.
Remember I said a balance sheet was supposed to balance? What happen when assets are worth less than the value of the pension liabilities? Then the pension has a deficit.
This freaks out the finance director of a company because this shortfall needs to be remedied. As the company provides a guarantee to the pension scheme, it will have to stump up the cash if the assets are insufficient to pay the benefits.
But this is not the only way the new accounting regulation caused conniption fits among both finance directors and shareholders.
As the liabilities are valued using an AA corporate bond rate and assets are marked to market, the two sides of the balance sheet now used different valuation metrics. If, for example, the principle assets of the pension scheme are held in equities, it’s likely this value will move in a different way to the liabilities.
This introduced significant volatility into the pension scheme valuations – one year the scheme might in surplus, the next it could be in deficit.
Finance directors crave predictability. The biggest nightmare for a FD is large liability which fluctuates according to movements in bond rates and equity prices – over which he or she has no control. Shareholders also prefer companies with strong and stable balance sheets.
This volatility was compounded in the early 2000s with a synchronised fall in the value of equities coupled with falling bond yields.
And so the introduction of FRS 17 produced a radical change. The liabilities of a pension became too much of a liability and defined benefit schemes were closed not only to new members but also to existing members.
This caused the number of active members of private sector occupational pension to rapidly decline from the start of the millennium. This sparked government concern and created the momentum for an in-depth review of the UK pensions system – which I’ll discuss next.