FRS 17 & IAS 19 – Who cares about pension scheme deficits
by Roderick Ramage, solicitor, www.law-office.co.uk
not previously published – first posted on this website 26 September 2010
This article is not advice to any person and may not be taken as a definitive statement of the law in general or in any particular case. The author does not accept any responsibility for anything that any person does or does not do as a result of reading it.
Who cares about pension scheme deficits?
The answer, while the employer continues to pay contributions, is no one. That is to say, no one except accountants.
The directors of a company (or an LLP) must not approve its annual accounts unless they are satisfied that they give a true and fair view of the assets, liabilities, financial position and profit or loss of the company: Companies Act 2006, s 393. The Accounting Standards Board (ASB) has defined a true and fair view of an employer’s pension liability in Financial Reporting Standard 17 (FRS 171); and auditors will not state in their reports that annual accounts give a true and fair view of the state of the employer’s business and its profits or losses, unless the pension scheme is accounted for in accordance with FRS 17. The objective of FRS 17 is copied in the box below. If the pension scheme is a final salary scheme FRS 17 requires the deficit or, rare at present, the surplus and changes in them to be recognised in the accounts. Broadly similar principles apply under the International Accounting Standards (IAS 192), which companies may use as an alternative to FRS 17.
“True and fair view” has a technical meaning in the context of a company’s audited accounts, which is very different from that expression’s meaning in everyday usage, when the technically true and fair view may seem far from an everyday view of what is true or fair. Owners of companies carrying on business, people dealing with them and pension scheme members need the following information about a company and its pension scheme:
first whether the company, as long as it continues in business, can afford to fund the scheme sufficiently to enable it to meet its liabilities as and when they become payable and to continue to do so for the whole, or at least the foreseeable, life of the scheme; and
secondly whether, if a debt under s75 of the Pensions Act 1995, becomes payable, typically when the company becomes insolvent and the pension scheme must be wound up or one employer in a multi-employer scheme ceases to be an employer in relation to the scheme, when, in both cases, members’ benefits must be fully secured with an insurance company.
first – ongoing business
The information for this purpose is not and is not intended to be provided by FRS 17. The only information which FRS 17 gives is the market value of the scheme’s assets at the company’s accounting reference date and the result of a mathematical calculation of its liabilities at the same date, showing capital values for both, and therefore the scheme’s surplus or deficit, as at that date: there is a touch of apples and pears in the comparison of a market value for assets and a calculated value of liabilities. These amounts must be reflected in the company’s accounts, have no direct relevance to its business, but have a major influence on how the company and its business are perceived.
The contributions which an employer pays to the scheme are in accordance with the contribution schedule produced as a result of its so-called “recovery plan”, on the basis of its triennial actuarial valuation. The basis of the recovery plan is that the deficit (as calculated by the actuary) at the valuation date will be reduced to zero at the end of an agreed period, commonly up to ten years from the valuation date, but increasingly for longer periods. This is a prudent approach given that the life of the scheme can be longer than half a century. Normally the contribution rate is more than adequate to enable the scheme to meet it liabilities to members as and when they fall due.
Therefore all that a company, people dealing with it and the members of the pension scheme need to know are the amount of the contributions and that the company has and is likely to continue to have the income to pay them. The capitalised values of the scheme’s liabilities and the calculated deficit or surplus figures in neither the actuarial valuation nor under FRS 17 have any bearing at all on the scheme’s needs and the company’s resources while the scheme is on-going. A more useful tool for both company and trustees is a long term (at least 25 years) cash flow projection of the scheme’s assumed annual liabilities and investment returns and hence its annual funding needs to be met by the employer and, if still open, members.
secondly – wind up and other s75 debts
Here too FRS 17 does not and is not intended to give the necessary information. In these circumstances the basis for calculating the liabilities is the cost of buying annuity and deferred annuity contracts for each member, ie a market value, which is higher, possibly by a factor of two or more, than their values calculated under FRS 17. Therefore the scheme’s deficit on a winding up would be greater, often very much greater than is shown in the accounts.
It is possible but rare at the present for a pension scheme to be in surplus when it is wound up, in which case, although FRS 17 would show the surplus to be an asset of the company, it could be paid to the company only if the trustees thought fit after securing members’ benefits in full, increasing them and complying with the statutory procedures for payments to employers: and it is quite possible for an FRS 17 surplus to be a deficit on a winding up basis.
the untrue and unfair view
Not only does FRS 17 not tell anyone what they actually need to know about the impact of a pension scheme on a company, but it misleads them by what on one interpretation, is a wholly false statement in the accounts
A difference between a lawyer’s and an accountant’s view of the world is illustrated in para 3.4.1 of “The Financial Reporting of Pensions – Feedback and Redeliberations” published in November 2009 by Pro-Active Accounting Activities in Europe (PAAinE)3 (evidently no pun or irony intended). What para 3.4.1 says is: “The ASB affirms its views that recognition should be based on the principles of reflecting only present obligations as liabilities.”
The lawyer’s view of this statement is that, if a liability is shown in the accounts, one can assume that it represents a liability that the company is or might be required to pay. There is no circumstance whatsoever in which a company can be required to pay the FRS 17 pension scheme deficit shown in its accounts. Only the trustees of the scheme can demand payments, and all that they can demand, unless and until a s75 debt become payment, are contributions in accordance with the schedule of contributions. No one is able to demand payment of an FRS 17 deficit, and therefore it is misleading and neither fair nor true to include it in the balance sheet as a liability.
Similar, although some accountants appear to argue to the contrary (on the basis of IFRIC 144, which, to be fair, would have only limited application), it should be inconceivable that a company could argue that a reported pension scheme surplus could be treated as a basis to justify the payment of a dividend or a larger divided than would otherwise be justifiable.
Whilst is useful as a conceptual tool to convert income streams into present values. and to show and explain them in notes to accounts, it is misleading to incorporate them in balance sheets and P & L accounts.
As a final (and not wholly frivolous) suggestion, ought not the accountants, if they are to be consistent, tell us not just the date but also the time of the day at which the pension scheme is to be valued, so that we know whether their snapshot of the pension scheme was taken before or after, say, the close of the Hang Seng market or the announcement of the collapse of Lehmann Brother?
It is undeniable that one needs a means of comparing and valuing future cash flows and discounting them to present values. My complaint in this article is that such a useful economic tool as discounted cash flow has been turned into an accounting fetish to the detriment of businesses and pension schemes. The realistic, as opposed to the accounting, “true and fair” view of a pension scheme in a company’s accounts consists of (first) the contributions payable under the scheme’s recovery plan and (secondly), to show what would happened if a s75 were to become payable, the deficit if any on the winding up basis. The inclusion in accordance with FRS 17 of the pension scheme’s assets and liabilities in the company’s balance sheet and P&L account shows neither of these, nor anything of any practical use, but it does enable the accountants to show consistency in their treatment of pensions in different companies’ accounts. Everyone else remembers, as Emerson said, but in rather more words, that a foolish consistency is the hobgoblin of little minds5.
Financial Reporting Standard 17 published November 2000
The objective of this FRS is to ensure that:
(a) financial statements reflect at fair value the assets and liabilities arising from an employer's retirement benefit obligations and any related funding;
(b) the operating costs of providing retirement benefits to employees are recognised in the accounting periods in which the benefits are earned by the employees, and the related finance costs and any other changes in value of the assets and liabilities are recognised in the accounting periods in which they arise; and
(c) the financial statements contain adequate disclosure of the cost of providing retirement benefits and the related gains, losses, assets and liabilities.
1 www.frc.org.uk/asb/technical/standards/pub0206.html (accessed 26/09/10).
2 www.iasplus.com/standard/ias19.htm (accessed 26/09/10).
3 www.frc.org.uk/inages/uploaded/documents/Pensions Redeliberations Report.pdf (accessed 26/09/10).
4 http://www.ifrs.org/Current+Projects/IFRIC+Projects/IFRIC+14+IAS+19%e2%80%94The+Limit+on+a+Defined+Benefit+Asset+Minimum+Funding+Requirements+and+their+Interact/IFRIC+14+IAS+19%e2%80%94The+Limit+on+a+Defined+Benefit+Asset+Minimum+Funding+Requirements+and+their+Interact.htm (accessed 26/09/10).
5 Ralph Waldo Emerson, Essays First Series (1841), Essay II Self-Reliance.
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