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Accounting for Pension Costs under FRS17 - 2001 Survey
Nigel Hacking sets out the key assumptions adopted by FTSE100 companies in determining the value of their pension liabilities under the Financial Reporting Standard, FRS17.
Introduction
In this note, we set out the key assumptions adopted by FTSE100 companies in determining the value of their pension liabilities under the Financial Reporting Standard, FRS17. Our analysis is based on the data in the published accounts of 45 FTSE100 companies with financial years ending on 31 December 2001.
Discount Rate
The discount rate is the rate of interest used to discount the expected future pension payments back to the balance sheet date and so put a current capitalised value on the pension liabilities. The higher the discount rate assumed, the lower the value of the pension liabilities.
FRS17 states that the discount rate should be the yield as at the balance sheet date on a AA-rated corporate bond of equivalent currency and term to the pension scheme liabilities.
Unfortunately (or fortunately, for those looking for flexibility), there is a wide spread of yields on AA bonds. At 31 December 2001, yields on long-dated Sterling-denominated AA bonds lay predominantly in the range 5.5% to 6.5% per annum and so the choice of any discount rate in this range may comply with FRS17. To resolve the difficulty of deciding which individual AA bond to use, many companies seem to be using a discount rate equal to, or close to, the yield on one of the published indices (representing an average yield on those AA bonds in the index). At 31 December 2001, the annualised yield on an index of over 15 year AA bonds was approximately 5.8%.
The actual discount rates used by the companies in our survey are set out below.
As anticipated, some of the companies in our analysis appear to have used a discount rate derived from one of the AA bond indices although many (18 companies) have used a discount rate of 6% per annum.
Inflation Rate
The rate of price inflation influences the assumed rate of future salary increases (see below) and the assumed rate of pension increases and is therefore another key assumption for determining the value of the pension liabilities.
FRS17 states that the yields on index-linked bonds relative to those on fixed interest bonds of similar credit standing will give an indication of the expected rate of general inflation.
At 31 December 2001, the yield on long-dated index-linked gilts was around 2.4% per annum and the yield on equivalent fixed interest gilts was around 4.9% per annum. Hence, one would expect an assumed annualised inflation rate of about 2.5% (= 4.9% less 2.4%).
The majority of FTSE 100 companies in our survey did indeed use an assumption for inflation of 2.5% per annum as shown below.
A few companies used a rate of price inflation of less than 2.5% per annum, perhaps by reasoning that the yield on fixed interest gilts includes an "inflation risk premium" and so a truer measure of inflation should be somewhat less than the difference between fixed interest and index-linked yields.
Salary Increases
The reporting company will have its own opinion as to the likely future rate of salary increases for its employees. Some companies may use a scale for promotional salary increases in addition to an assumption for general salary inflation and therefore a comparison of the disclosed salary increase rates may not be a like-for-like comparison in all cases. Nevertheless we have shown below the disclosed salary increase assumption relative to the assumed rate of price inflation (i.e. the real rate of salary increases assumed).
Surplus/Deficit
Of the companies in our analysis, almost one-half disclosed a surplus on the FRS17 basis and would therefore have recognised a pension asset on the balance sheet had FRS17 been fully in force at 31 December 2001.
The following chart shows the funding level (i.e. the ratio of assets to liabilities) plotted against the discount rate. We were interested to see if there is any relationship between the assumed discount rate and the funding level, for example whether those companies using a high discount rate tend to disclose a better funding level (and vice versa). This indicates the extent to which differences in funding levels are genuine as opposed to being the result of more or less aggressive assumptions. However, the chart shows no discernible pattern and therefore suggests that there are significant genuine differentials in funding levels and the financial strength of pension schemes.
Expected Investment Returns
The expected investment returns are not relevant to the calculation of the FRS17 surplus or deficit at the balance sheet date. However, the expected returns are used in the calculation of the pension cost for the next year's P&L account. (Under the transitional provisions of FRS17 only a disclosure note is needed for 2002 accounts but, in future years, the actual P&L entry will be on the FRS17 basis.)
FRS17 states that the expected investment returns should be based on long-term market expectations as at the balance sheet date and should be net of the scheme expenses. The higher the rate of expected investment returns, the lower the FRS17 pension cost charged to the P&L and the more likely that "experience losses" (or reduced gains) will need to go through "below the line" in the Statement of Total Recognised Gains and Losses. Companies are likely to be more concerned about the headline profit figure (and less concerned about losses appearing "below the line") and so will want to ensure that their expected returns assumptions are not understated.
The ranges of expected investment returns disclosed for equities are represented in the chart below.
The expected return from equity investments is a very subjective assumption and opinions clearly differ significantly as to likely future returns. The assumptions disclosed as at 31 December 2001 varied between 6.5% and 9% per annum. This difference of 2.5% per annum may have a significant impact on the employer's P&L profit. As a result, this item is likely to receive much closer attention when FRS17 is fully adopted and the assumption impacts directly on the actual charge to the P&L account.
As one would expect, the assumed expected return from bonds is less variable between companies as the chart below demonstrates.
Summary
It is very interesting to see both the areas of consistency between companies and, perhaps even more so, the extent to which companies have chosen different assumptions for reporting under FRS17, given that it was intended to be a fairly prescriptive accounting standard.
We hope that this analysis is helpful to companies in formulating their own assumptions to use for reporting under FRS17.
Please contact your usual Barnett Waddingham consultant to discuss any of the above.
Nigel Hacking, June 2002.