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Commercial Angles' Newsletter - March 2002

FRS17

There has been much comment in the national press recently about:

the number of defined benefits pension schemes which are being closed to new employees or in several cases closed to existing members, and
the effect of Financial Reporting Standard 17 (FRS17) on the future reported profits of PLCs, and
the possible link between FRS17 and the demise of the defined benefits pensions schemes.

So what is FRS17 about and why is the demise of defined benefits pension schemes of importance?

Types of pension scheme

There are several types of pension schemes but the principal ones are listed below:

a defined contributions scheme is one where the employee and employer both pay fixed amounts or percentages of the employee's salary into a fund created for that employee. The employee owns his pension fund and can (theoretically) ask a new employer to contribute to it when he/she changes jobs. The value of the pension when the employee retires depends on the level of contributions and the performance of the investments making up the fund. So all the risk of poor investment returns lies with the employee.
a defined benefits scheme, sometimes called a final salary scheme, normally requires an employee to contribute an agreed percentage of his pay into the scheme and the employer will then pay in sufficient to provide the defined retirements benefits. Unlike a defined contributions scheme, the pension fund is not divided into individual pots for each employee. When the employee changes jobs he/she may be able to transfer his pension rights from his old employer to his new employer's scheme but frequently that is either not possible or not economic. The amount that the employer pays into the scheme depends on the investment performance of the underlying pension fund assets. The employer bears all the risk of poor investment performance and usually gains most of the benefit of good performance.
Stakeholder pensions were introduced in 2001 and are designed to provide a low cost pension scheme for people on middle to low earnings who frequently had had no access to pension benefits in the past. Like a defined contributions scheme each employee has an ear-marked investment fund which is portable when the employee changes jobs. Unlike a defined contributions scheme, however, the employer is not obliged to contribute to the employees' funds.

Problems encountered with defined benefits schemes

Over the last twenty years many of the employers with these schemes have considerably reduced the sizes of their workforces. The redundant employees often left their pension benefits in their old employers' schemes and the underlying funds in these schemes grew faster than the overall pension benefits payable. All was well and good whilst investment returns were strong. After the Maxwell affair, the government introduced much stricter controls over the pension schemes. This was good, but the review of pensions concentrated on how to measure pension scheme assets and liabilities and to determine whether schemes were under/over funded. The Treasury did not want to give tax relief on company pension scheme contributions to an overfunded scheme. The test of a scheme's solvency was the Minimum Funding Requirement, which basically took a long-term discounted view of the liabilities of the scheme and compared this with the current realisable value of the present assets of the scheme. Also the Chancellor altered the taxation of dividends and, overnight, pension scheme earnings were significantly reduced. Thus companies were squeezed - their schemes could not be overfunded or they would be forced to award higher pension benefits and their fund income was reduced. Then interest rates were reduced, which increased the pensions liabilities, and then stockmarkets started to decline, which reduced pension fund assets. But worse; experts forecast lower investment returns in the next decades and longer lives for pensioners. These factors created projections of severely underfunded defined benefits pension schemes. As all the risk lies with the employers, for the last few years they have been closing their defined benefits schemes to new entrants. This trickle has now changed to a torrent and pundits foresee the end of the defined benefits scheme.

Pension scheme funds and the company accounts

SSAP24 is the current standard covering the presentation of defined benefits pension schemes in the company accounts. However SSAP 24 is being replaced with FRS17 with full implementation being compulsory in accounts for periods ending on or after 22 June 2003. There is to be a phased introduction of FRS17 but early adoption is encouraged. Under SSAP24 the cost of pension scheme contributions is averaged over the remaining working lives of members of the scheme. This average cost is charged against profits in the published accounts and the difference between the actual pension costs and the SSAP24 charge is held in the balance sheet as a separately disclosed item. SSAP24 can give rise to anomalous results: a company on a pensions holiday due to an overfunded scheme would report a charge against profits in its published accounts although no contributions had been made. In the view of the Accounting Standards Board, SSAP24 did not adequately reflect a company's potential liability arising from its defined benefits pension scheme. Hence FRS17 was introduced, under which:

pension scheme assets are measured using market values,
pension scheme liabilities are measured using a projected unit method and discounted at an AA corporate bond rate,
the pension scheme surplus or deficit is recognised in full on the balance sheet, and
the movement in the scheme surplus or deficit is analysed into:
- current and past service costs which are recognised in operating profit,
- the interest cost and expected return on assets which are recognised as other finance costs, and
- actuarial gains and losses which are recognised in the statement of total recognised gains and losses.

Putting all a defined benefits scheme's deficit on the balance sheet will initially reduce a company's profits and possibly restrict its ability to pay dividends. But in stable conditions the future effect of the pension scheme on the company accounts would be small. If, however, stockmarket conditions or interest rates fluctuate during an accounting period, a company's reported results could be grossly affected by its defined benefits pension schemes. Hence this type of pension scheme is being discontinued by a number of companies.

Does it matter if defined benefits schemes are closed?

The short answer is that it wouldn't matter if suitable alternatives such as defined contributions or stakeholder schemes were in place. However the level of funding required to give a two-thirds pension on retirement at age 65 can be 15-20% of salary over 40 years. Few employees pay in more than 5% of earnings and employers frequently reduced their contributions to 5-8% when changing from a defined benefits pension scheme to a defined contributions scheme. Thus there is a significant funding gap. Employees will have to choose between paying in greater contributions themselves, continuing in employment to age 70-72 or being considerably poorer in retirement. But that is not the only effect. If less money is invested in pensions, the upward pressure on share prices will be reduced and stock markets will be affected - there is little doubt that some of the rise in the US stock market over the last ten years was caused by people investing in their personal pension plans. If people have to work 5-7 years longer then the jobs market will need to increase by 10% or 2 million positions over the next twenty or thirty years. Is that possible or is unemployment going to rise? The real problem is that no-one can forecast more than a short while ahead yet pensions decisions are best made early in one's working life.

All these questions remain to be answered in the future but one question can be answered now.

Is FRS17 responsible for killing the defined benefits pension scheme?

No. The death knell was rung a long time before FRS17 - but the new standard may just be the last nail in the coffin.

Articles from previous newsletters