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FRS17 - Accounting for Retirement Benefits

Barnett Waddingham's detailed commentary on the new UK accounting standard - FRS17.

FRS17 - Accounting for Retirement Benefits  

  1. Introduction
  2. Financial Reporting Standard (FRS) 17 sets out the treatment of pensions and other forms of retirement benefits in a company's statutory accounts.
  3. The main features of FRS17 are summarised in the following sections of this note:
    • Valuation of assets and liabilities;
    • Recognition in the financial statements;
    • Transitional arrangements and disclosure;
      In each case Barnett Waddingham's comments are shown in italics.
  4. FRS17 is largely unchanged from FRED 20 and will be phased in over a transitional period starting with accounting periods ending on or after 22 June 2001. Full adoption will be required for accounting periods ending on or after 22 June 2003.
  5. Broadly speaking FRS17 requires the assets and liabilities of the pension scheme to be valued by reference to current market conditions. This is consistent with the approach adopted under  FAS87
  6. Valuation of assets and liabilities
  7. Assets are taken at market value.
  8. Liabilities are valued using a discount rate based on the return available on AA corporate bonds at the balance sheet date.

    This is a major change from SSAP24 which required the assets and liabilities of a pension scheme to be valued on the basis of long-term actuarial assumptions. However the Accounting Standards Board (ASB) was concerned that smoothed figures are more difficult to interpret and so recommended an approach based on market values which also reflects the trend internationally towards the use of market values for pension cost accounting.

    Although the UK corporate bond market is growing fast, an element of subjective judgement will still be required in order to choose the most appropriate discount rate. Even in the US where the corporate bond market is much more developed, there is considerable variation in the level of the discount rate used for FAS87 purposes. It will be important to remember that just ¼ % change in the discount rate could have a significant effect on the value of the liabilities and hence the reported pension costs.

    The difference between the value of the assets and the value of the liabilities is likely to be very volatile using this method especially for those schemes with significant levels of equity investment.
  9. All other financial assumptions should also reflect market conditions at the balance sheet date.
  10. All actuarial assumptions should be the actuary's "best estimate" and be mutually compatible. FRS17 notes that the assumptions are ultimately the responsibility of the directors but should be set upon the advice of the actuary.
  11. FRS17 also requires that discretionary pension increases "awarded under an established practice that creates among the employees a valid expectation of receiving them" should be included in the actuarial assumptions.

    We are disappointed that this wording is unchanged from FRED20 as, in many cases, it may not be clear whether to include discretionary pension increases in the actuarial assumptions.
  12. The expected rate of return on assets which forms part of the calculation of the pension cost in future years is based on the pension scheme's current investment strategy. FRS17 requires the expected rate of return to be separately disclosed for each main asset class, namely; domestic bonds, domestic equities, overseas investments and other investments. The expected rate of return on these asset classes should be based on the actuary's long-term expectations.

    FRS17 acknowledges that the expected rate of return on equities is a difficult figure to assess which means that there is likely to be a wide variation in the choice of this particular assumption.
  13. Recognition in the financial statements

    Profit and loss Account

  14. The profit and loss account will include the following items:
    • current service cost;
    • any past service costs;
    • gains and losses on any settlements and curtailments;
  15. The current service cost is the cost to the Employer of benefits arising in the future and will be calculated using the "Projected Unit Method".

    This is the cost of benefits arising in the year following the valuation date, after allowing for projected earnings up to retirement. However we do not think this method is appropriate for schemes which are closed to new entrants; SSAP24 currently allows alternative methods to be used in these circumstances.
  16. The past service cost refers to the cost of any benefit improvements.
  17. FRS17 requires any past service costs to be recognised in the profit and loss account over the period in which the increase in benefit vests.

    Therefore the total capital cost of an immediate improvement to benefits should be recognised immediately in the profit and loss account. This will include the capital cost of discretionary pension increases awarded if allowance for these discretionary increases is not already included in the actuarial assumptions.
  18. Similarly FRS17 requires any gains or losses arising from settlements and curtailments not allowed for in the actuarial assumptions to be recognised immediately in the profit and loss account.

    Examples of settlements and curtailments include a bulk transfer or a major redundancy exercise.
  19. In addition to the above the interest cost and the expected return on assets should be included as a net financial item adjacent to interest in the profit and loss account.

    The interest cost is calculated as the value of the liabilities multiplied by the discount rate; the expected return on assets is calculated as the value of the assets multiplied by the expected rate of return on assets.

    Given that any past service costs or settlements and curtailments are unusual events the ASB hopes that the pension costs shown in the profit and loss account will be reasonably stable from year to year.

    However we believe that the net effect of the interest cost and the expected return on assets could still be a volatile item especially for mature pension schemes where the current service cost is a very small proportion of the total size of the fund.

    Statement of Total Recognised Gains and Losses (STRGL)
  20. FRS17 requires any actuarial gains or losses arising during the year to be recognised immediately in the statement of total recognised gains and losses (STRGL).
  21. The STRGL is intended to show those gains and losses which are incidental to the main operating business of the Employer. Examples of such items include revaluation of fixed assets and exchange rate gains and losses on overseas investments. These items are deemed to be incidental to the Company's main activities and are therefore not appropriate for disclosure in the profit and loss account.

    This approach is significantly different to SSAP24, FAS87 and IAS19 where actuarial gains and losses are spread forward over a number of years and recognised through the profit and loss account.

    Although the amounts of these gains and losses will be volatile from year to year, the ASB believes the "users of accounts are sufficiently sophisticated to view them in their proper context."
  22. The actuarial gains and losses shown in the STRGL will not be recycled through the profit and loss account (this was considered as a possibility in earlier consultation papers).

    Balance sheet
  23. FRS17 requires the total surplus or deficit in the pension scheme to be recognised as an asset or a liability on the balance sheet.
  24. An asset is recognised to the extent that an employer can recover a surplus through reduced contributions or a refund. The amount that can be recovered through reduced contributions is based on the total saving in future contributions for existing employees.

    FRS17 states that no growth in the number of active members should be assumed but a declining membership should be reflected if appropriate. Therefore, it will be possible to assume a stable membership unless, for example, the pension scheme is closed to new entrants.
  25. FRS17 requires any recognised surplus or deficit to be presented separately on the face of the balance sheet after other net assets.

    We are concerned that this approach implies that employers have absolute control over final salary pension schemes both in terms of the level of benefits and the use of surplus. Final salary pension schemes are set up under trust and trustees are heavily involved in the financial management of the scheme. The balance of power between the trustees and the employer varies between pension schemes, but we believe it is unrealistic for a company's financial statements to completely "look through" the trust regime and treat pension scheme surpluses as being wholly an asset of the company.
  26. Transitional arrangements and disclosure
  27. FRS17 will be subject to a lengthy transition period to give all parties time to get used to these new requirements. This will be achieved by a gradual increase in disclosure over this period until FRS17 is fully operational, although early adoption is encouraged.
  28. Broadly speaking the transition period will operate as follows:
    • year ends on or after 22 June 2001 - disclosure of the FRS17 balance sheet figures;
    • year ends on or after 22 June 2002 - disclosure of the FRS17 balance sheet, profit and loss, and STRGL figures;
    • year ends on or after 22 June 2003 - full adoption of FRS17.
  29. The disclosure requirements under FRS17 are considerable. As well as the balance sheet, profit and loss, and STRGL figures referred to above a five year history of actuarial gains and losses in the STRGL will be required together with a significant amount of explanatory and background information.

    30. Barnett Waddingham, February 2001.