Article by Giles P. Elliott, John J. Papadakis, John R. Phillips, Hilary A. Winter and Rosalind J. Connor

Liability relating to company pension schemes has increased substantially over recent years and has become much more visible in corporate finance. In particular, pension scheme deficits now appear in company accounts and it has become common for pension scheme liabilities to be discussed in the front end of circulars and offer documents. This article explains some of the concepts of pension scheme liabilities to allow corporate finance professionals to better interpret information relating to their clients’ pension schemes.

What are pension scheme liabilities?

Most companies have obligations to make some contribution to pension schemes for the benefit of their employees and these costs are part of the general payroll costs. However, the substantial pension scheme liabilities which are affecting the profitability of companies usually relate to defined benefit occupational schemes (also known as final salary schemes) set up by the company. Under these schemes, individual employees are promised a specified level of pension when they retire, usually based on a formula relating to their years of service and their salary at retirement. The company makes whatever contributions are necessary to ensure that, as employees retire, there is enough money in the scheme to pay these pensions.

A valuation of a defined benefit scheme seeks to establish whether the amount of money in the scheme, together with the returns on investment that are expected to be earned in the future, will be sufficient to buy, as they fall due, the benefits that have been earned up to the date of that valuation. To the extent that the money in the scheme is insufficient to do this, the scheme is said to be in deficit.

Calculating deficits

The calculation of a deficit in a pension scheme is made by the pension scheme’s actuary using a number of assumptions. These relate, for instance, to future wage inflation, return on investment and mortality rates. As a result, calculating a scheme deficit is an art and not a science and no calculation will give a definitive "true" figure. The use of different but perfectly reasonable assumptions will result in very different figures for the scheme deficit or even show the scheme to be in surplus.

There are a number of different valuation methods which are applied including:

  • MFR (the minimum funding requirement) - this is the present statutory funding level and is based on fixed assumptions so that no two calculations would differ by more than 1% for the same scheme. This usually gives a very small deficit in comparison with other methods;
  • FRS17 - this is the basis used in company accounts. The assumptions used for this basis are generally market based assumptions and will conform with the assumptions used elsewhere in the company’s accounts. Therefore, the deficit will vary with the accounting policies of the company's auditors. A valuation on this basis usually gives a much larger deficit than under the MFR; and
  • Full BUY-OUT basis - this basis assumes that no more benefits will be earned in the scheme but that the existing benefits will all be secured immediately by deferred annuities provided by insurers. Deferred annuities are extremely expensive and there are presently only two providers in the market, neither of which quotes prices. As a result, buy-out estimates may vary, but the deficit will always be very substantial and much higher than on any other basis.

Liabilities of the company

A company with a defined benefit scheme has an obligation to make contributions to the scheme to ensure that it is fully funded on the MFR basis. However, the MFR is being replaced this year (expected September) by a "scheme specific" funding requirement which is expected to be much harsher. As a result, much more substantial contributions are likely to be required from companies in the future.

If a company decides to close down its pension scheme, it will be liable to ensure that any deficit is paid into the scheme immediately. In the case of closure of a scheme, the deficit must be calculated on the BUY-OUT basis. The result is that most companies are not willing or able to close their pension schemes.

Liabilities of group companies

Pension liabilities usually fall on the employing company. However, new powers under the Pensions Act 2004 give the Pensions Regulator the right to demand contributions from any other group company or any company with at least a one-third shareholding, including non-UK companies, in the following circumstances:

  • if that party has acted to reduce the liability of any group company to the pension scheme at any time since 27 April 2004; or
  • the Regulator believes that the company with the pension scheme does not have sufficient assets to service the pension scheme liabilities.

Accounting for pensions

Under FRS17, all accounts with an accounting date on or after 1 January 2005 must show in the balance sheet any pension scheme deficit or surplus. In this case, the calculation must be done on an FRS17 basis. Changes in this amount on a year-on-year basis will show through the profit and loss and the statement of recognised gains and losses.

Listed companies also have to comply with IAS19, the international accounting standard for pensions. This differs from FRS17 in allowing companies to spread certain losses over the working life of the employees who are members of the scheme. However, IAS19 has been varied to allow the immediate statement of all losses in the balance sheet to comply and conform with FRS17.

The effect of FRS17 and IAS19 is that pension scheme liabilities are clearly disclosed to the public by way of company accounts and also have substantial effects on financial ratios, such as earnings per share and gearing levels. Because FRS17 gives the value of pension scheme liabilities on a set of market led assumptions, the level of FRS17 may be very volatile and not truly representative of the company’s liability to the pension scheme, which is a contingent and changing liability. Therefore, it may be appropriate for the purpose of financial analysis to calculate ratios both with and without the FRS17 element to give a clearer indication of the status of a company.

That bad news one more time. . . .

The different methods of calculating pension scheme deficits result in very different liability amounts, none of which could be said to be the true deficit but all of which have implications for the financial health of the company. In particular:

  • The FRS17 deficit will now appear in company balance sheets. Because of the market based assumptions, this valuation can be very volatile and, depending on market movements, can have a very substantial effect on the company’s net assets on a year-by-year basis.
  • MFR is the basis on which companies are obliged to keep ongoing schemes funded. However, when the scheme specific basis is introduced, companies will need to increase their contributions to an ongoing scheme.
  • If a scheme winds up or a company comes out of the scheme, a debt will be due on the BUY-OUT basis. This is very expensive and companies which close their schemes are at risk of this liability. Many acquisitions are being restructured to ensure that this debt does not arise.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.