Jack Nicholson in 'A Few Good Men' famously said of Tom Cruise, 'you can't handle the truth'. Nicholson might not have had FRS17 in mind at the time, but his accusation could be made against those many companies, trade unions and pension advisers who clamoured to give voice to their disgruntlement over the recent introduction of accounting standard FRS17 - they detest it because they can't handle the truth. FRS17 was borne out of a need to address the predicament created by the then prevalent discounting of pension scheme liabilities, based on the erroneous assumption that equities would continue to deliver a healthy level of return for years ahead. Of course, as we now know, recent years have seen interest rates continue to fall while, simultaneously, the equity market suffered a marked slump.
As a result of the introduction of FRS17 there has been a definite shift towards valuing liabilities in a more transparent manner by relating them directly to yields on secure assets, such as government bonds. As bond rates have subsequently fallen, the value placed on liabilities has increased substantially, with the result that we have seen the value of assets fall at the same time as the liability, for the first time, is valued correctly, courtesy of FRS17. Whilst FRS17 has been subject to some heavy criticism, the fact is that it is succeeding in forcing companies to confront the true value of their pension scheme liabilities - and many companies can't handle the truth. Likewise, many trade unions dislike FRS17 because, when companies do face up to the value of their liabilities, they're then forced to do something about it. More often than not that means cutting back on future pension provision. Furthermore, some pensions advisers also dislike FRS17 for the same reason, namely that, by forcing companies to face up to their responsibilities and liabilities, some clients are switching over to lower cost, lower risk pension arrangements. Whilst by no means perfect, from the perspective of shareholders, analysts and financiers, FRS17 is valuable because by placing a realistic value on pension liabilities, it provides a benchmark against which one company can be consistently compared against another. Its use could be further enhanced by the requirement to disclose all assumptions. It seems quite ludicrous to even attempt to defend the alternative approach whereby a pension cost would be valued according to the preferred assumptions of the actuary concerned. This could mean that company A and company B might have identical pensions arrangements but with entirely different pension scheme costs.
The shift towards a more transparent method of valuing pension liabilities coupled with more onerous requirements on winding-up a pension scheme will undoubtedly make it more difficult for shareholders to realise value whether they own a large quoted or small privately owned company. Potential purchasers will be much more wary of taking over the burden of an existing pension scheme and deals are unravelling as a result. Pension scheme funding was a major consideration in potential suitor Permira, the private equity firm, reconsidering its interest in WH Smith and was also a contributing issue in Peter Green's failed bid to acquire M&S. Many responsible pension schemes sponsors are now hoping that a recovery in the equity markets will pull them out of the mess within which they have become mired, though such a recovery is by no means certain. Worryingly for scheme sponsors, there is also a great deal of uncertainty in relation to future life expectancy, with all the evidence appearing to suggest that, until now, likely future improvements in life expectancy have not been fully incorporated. Over the next few years, new mortality tables will be introduced factoring in improved life expectancy which will push up the value of the company's pension liabilities.
Whilst the downside of uncertainties in equity markets can be reduced or removed by investing in bonds, companies are completely exposed to the risk of current employees enjoying a much longer retirement than had previously been assumed. The suspicion lingers that some companies are simply hoping that further gains in equity markets are inevitable rather than there being any convincing reason to believe why this should be so. Meanwhile, many companies that have learned, from bitter experience, the risks associated with equity investments, have subsequently sought a degree of protection by investing in bonds, which clearly reduces the potential for upside gain. Ultimately, though, FRS17 is a good thing for the simple reason that it forces companies, trade unions and some pensions advisers to confront the truth about the extent of pension scheme liabilities. The truth may hurt at times, but surely it's preferable to self-deception?
Published in the Scotsman 26 th June 2004 and Edinburgh Evening News on 20 th July 2004