Increase or Decrease in the Service Costs or Contributions - Essay Example

?Pension Risk Disclosure by FTSE 100 companies: Introduction: In the report “ Pension Risk Disclosures by FTSE 100 companies”, published for the Institute of Chartered Accountants of Scotland ( ICAS ), Christopher O’ Brien ( Nottingham University Business School), Margaret Woods ( Aston Business School) and Mark Billings ( Nottingham University Business School) make a case for tighter disclosure requirements for risks of the Defined Benefit Pension schemes ( DBPS ) of FTSE 100 companies. The other documents that I have analyzed in this discussion are: 1) Accounting for Pensions written by Chris O’ Brien and Margaret Woods (two of the authors of the ICAS report on pension disclosures) that appeared in Financial Management Journal in April 2006. The arguments made in this article form the basis of the recommendations that the authors have later made in their report for ICAS. 2) ICAS wants better disclosure of pension risk reporting, by Pat Sweet that appeared in September 2010 in Accountancy Magazine. 3) The FTSE 100 and their pension disclosures: Pension Capital Strategies quarterly report of February 2010. Discussion: The key risks associated with Defined Benefit Pension Schemes (DBPS) highlighted in the ICAS report are: the asset-price volatility caused by market driven factors, a mismatch in the duration of the assets relative to the liabilities and increase in the life expectancies of the individuals covered under these schemes. The increase in pension liabilities is directly proportional to the increase in life expectancies of those covered. There is also the risk to cash flows in cases where the company has to provide cash to fill or reduce the deficits in their DBPS. The report as part of its research surveyed the information relating to DBPS in the annual reports of FTSE 100 companies. The research survey covered all 88 companies, as on 31st December 1999, that had a Defined Benefits Pension Scheme for their employees. 80 of these companies had UK based DBPS schemes. The research of the report revealed that the total aggregate deficit faced by the DBPS schemed of FTSE 100 companies was GBP 53.5 billion. This deficit of GBP 53.5 billion was caused because the total liabilities of GBP 409 billion were backed by assets of only GBP 356.3 billion. There was widespread variation in the size of the schemes of the different companies and in the extent to which they were funded by the companies. Only ten companies disclosed the sensitivity of DBPS’ liabilities to all four actuarial assumptions. These four actuarial assumptions are: a) Future price inflation rates. b) Salary inflation. c) Mortality rates or life expectancy. d) The discount rate used to compute the present value of the liabilities. These actuarial assumptions have been recommended by the UK Accounting Standard Board’s suggested guidelines on best practices ( 2007 ). Thirty five companies disclosed no sensitivities to changes in actuarial assumptions. Disclosures of the companies increased with the size and strength of the schemes. The different industry sectors were compared and it was found that the banking sector had the highest level of risk disclosure of their DBPS. As far as assumption of future rates of price inflation were concerned, there were limited variations in the assumptions of the different companies. Salary growth assumptions ranged from 1.8% per year to 5.9% per year.There was significant variation in the time frame covered by the life expectancy forecasts of the different companies. These forecasts ranged from 5 years to 25 years in future. The recommendations of this report have caused some debate. One of those recommendations is that the companies should disclose the time estimation risks for those assets (in which the DBPS has invested) for which there are no quoted market prices. The second recommendation is that companies should do a sensitivity analysis of the pension liabilities vis-a-vis the four actuarial assumptions that have been mentioned above. The writers of the report justify this recommendation on the ground that UK companies have experience in conducting such sensitivity analysis and tests. A number of these companies are already following the Accounting Standards Board’s (ASB ) best practices in regard to the sensitivity analysis. The report also recommends that the FTSE 100 companies should disclose the concentration of risk, if any. The asset-liability matching strategies of the DBPS should also be disclosed. Some of the common asset-liability matching strategies that are currently being used by DBPS of the companies include the use of annuities, longevity swaps etc. The report also requires the companies to disclose any factor that could cause the contributions over the next five years to differ significantly from the current level of the contributions. Another major recommendation of this report is that the companies should also reveal all enterprise risks that can arise out of the pension obligations and how these risks will be managed. The report has also recommended a tabular format that the companies should follow in conducting sensitivity analysis for the risks associated with their DBPS. The risk variables included in this recommended format are: Price inflation & salary growth (companies need to conduct sensitivity analysis for a .5% change in price inflation & salary growth); real Salary growth (companies need to conduct sensitivity analysis for a .5% change in real salary growth); interest rates (companies need to conduct sensitivity analysis for .5% change in equity prices); equity prices (companies need to conduct sensitivity analysis for a 20% change in the equity prices); and life expectancy (companies need to conduct sensitivity for a change in 1 year in the life expectancy). In a September 2010 article in Accountancy Magazine, Pat Sweet , writes that the recommendations of this report, when implemented, will end the secrecy and vagueness surrounding pension liabilities of the companies ( Pat Sweet, 2010). How sensitive are pension fund liabilities to risk variables can be seen from the fact that one FTSE 100 company reported that a one year increase in life expectancy will cause its pension liabilities to shoot by a massive GBP 1.3 billion ( Pat Sweet, 2010) . The February 2010 Quarterly report of Pension Capital Strategies also points out that there has been a noticeable growth in FTSE 100 companies where the pension schemes now represents a material risk to the business (FTSE 100 and their pension disclosures, 2010). According to this report, seven FTSE 100 companies have pension liabilities that are greater than their market value of equity. Companies like British Airways and BT had pension liabilities that were twice the market value of their equity (FTSE 100 and their pension disclosures, 2010). In such a scenario the increased disclosure of risks relating to the Defined Benefits Pension Schemes (DBPS ) of the companies becomes even more relevant. The increased disclosure of risks, as recommended by this report, will not only benefit the investors but the sensitivity analysis will help the companies greatly in the risk management of the pension liabilities. In a 2006 article of Financial Management journal (titled Accounting for Pensions) two of the writers of this report, Chris O’Brien and Margaret Woods, argue that pension funds are like any other investment portfolio. Knowledge of mortality/life expectancy assumption and other risk variables will help the boards of the companies to make better risk management decisions (Chris O’ Brien, Margaret Woods, 2006). The sensitivity analysis recommended in this report will make the risk management of the pension liabilities of the companies more effective. The pension liabilities of many FTSE 100 companies have become so much that management of the risks of their DBPS is of prime importance. The variables put in the recommended sensitivity analysis are interest rates, equity prices, life expectancy, inflation and salary growth. All these factors are sources of risks for the DBPS schemes of any company. The argument that these recommendations will have the effect of increasing the reporting complications of the companies is also not justified. The recommended sensitivity analysis and other recommendations are simple to conduct. For instance, the sensitivity analysis is to be done on the following three parameters only: Increase or decrease in the value of the assets of the DBPS; increase or decrease in the value of the liabilities of the DBPS and increase or decrease in the service costs or contributions. Conclusion: The recommendations of the report, when implemented, will bring many benefits. It will considerably bring down the vagueness and secrecy surrounding the Defined Benefit Pension Schemes and pension liabilities of many FTSE 100 companies. The increased transparency will benefit the investors, shareholders, employees and other relevant stakeholders. It will greatly help the companies in the management of the risks of their pension funds. The biggest benefit will come from more effective risk management of their pension portfolio. This will benefit all the stakeholders of the companies. It will also be in line with the best practices of accounting and corporate governance. References: Christopher O’ Brien, Margaret Woods, Mark Billings, 2010, Pension Risk Disclosures by FTSE 100 companies, The Institute of Chartered Accountants of Scotland. Chirstopher O’ Brien, Margaret Woods, 2006 , Accounting For Pensions, Financial Management, London. Pat Sweet, 2010, ICAS wants better disclosure of pension risk reporting: call for end to ‘secrecy’ surrounding pension liabilities, Accountancy Magazine. The FTSE 100 and their pension disclosures , 2010, Quarterly report from Pension Capital Strategies. Read More