In the last post, I discussed how changes during the 1990s turned defined benefit pension from a useful recruiting tool into an expensive liability. By the end of the decade many companies chose to close these schemes to new members.
At the start of the millennium, however, changes to national accounting standards made many choose to close these schemes to accruals as well. In other words, a member of defined benefit pension would no longer receive any future benefits.
The accounting standard which drove this change was FRS 17. It was gradually phased in from 2000 to 2005 and replaced the earlier accounting standard SSAP 24. This new standard made a significant difference to how pension schemes were treated in a company set of report and accounts. FRS 17 has since been replaced by FRS 102.
According to the Office for National Statistics, the number of active members of private sector schemes declined from 5.7 million in 2000 to 2.9 million in 2011.
It may come as a surprise to learn a change in an accounting standard could have such an impact on the long-term viability of private sector defined benefit schemes. But so great was this effect that many companies closed down their defined benefit schemes.
To gain a better understanding of why this was the case, an insight is needed into how pension schemes are now valued and why that caused so much distress to finance directors and shareholders.
How to value a pension scheme
The overall impact of the introduction of FRS 17 was to magnify the importance of the pension scheme in the annual report and accounts. In particular, the pension scheme became an important item in the balance sheet.
When a company includes an item on the balance sheet both the value of this asset and its liabilities are included. A balance sheet is so-called because it must operate in equilibrium – the assets should be equal to the liabilities plus the shareholders’ equity.
For example, if a company owns an office building, it will list the value of this asset along with the value of any debt incurred in its purchase on the balance sheet.
While the earlier accounting standard has enabled the impact of the pension scheme to be recorded principally on the profit and loss account, FRS 17 required the key impact of the pension scheme to be on the company’s balance sheet.
In other words, the pension scheme had to be treated in the same way as a building owned by a company rather than how sales and marketing costs are recorded.
FRS 17 also specified how companies should value their pension schemes. The assets were to be assessed according to their market value. This was a change to how these assets had been valued in the past − actuaries had used a dividend-discount model to value equity portfolios.
Assigning a value to liabilities is less straightforward. The liabilities of a pension scheme are the benefits you have promised to pay to employees.
First you need to forecast the benefits promised to employees yet to retire as well as those already collecting income from you. Then you need to assess how long all those employees are likely to live. As most pensions will increase with inflation, you need to take a view on this too.
This assessment is made by an actuary. But once this analysis has been completed, it will tell you the likely amount of benefits to be paid many years into the future. FRS 17 is not interested in these future valuations – it wants to know what those liabilities would be worth today.
In our final chapter of the rise and fall of the gold standard pension scheme we will discuss how you determine the value of the liabilities today as well as why these accounting changes made so many companies turn their back on this workplace benefit.