Pension accounting: getting in a tangle

Pension scheme accounting standards rarely make the top ten list of favourite
standards. They are hard to understand and seemingly illogical to finance
professionals, analysts and shareholders alike. Now they have also become a
meaningless mess.

Pension surpluses and deficits are often artificial and measuring long-term
pension obligations using short-term measures is always going to end in
difficulties. At the same time, global accounting standard setters have an
impossible job to balance the competing virtues of transparency and accuracy.

In normal times, the current approach of measuring pension scheme liabilities
using a high quality (often AA) corporate bond yield attracts criticism. It
doesn’t reflect the price of debt, it doesn’t reflect the scheme’s actual
investments, it doesn’t reflect the actual expected cost to the company, nor
does it even reflect expected economic value. Nevertheless, as any replacement
would be equally flawed, a begrudging acceptance of the status quo had settled
in – until now.

A crisis of confidence caused credit spreads to widen. The yields on AA
corporate bonds started to rise and kept rising; so the value placed on pension
scheme liabilities fell and fell. AA corporate bond yields stand at over 7% (at
the time of writing), higher than it has been since standards adopted the
measure as their benchmark. The effect has been to reduce dramatically the
artificial value on the scheme liabilities.

On the asset side, however, this has been one of the most difficult years in
economic history. At one stage, UK defined benefit pension scheme asset values
had dropped by over £225 billion. This figure seems remarkable, but in the
context of what has happened to the wider financial markets, pension schemes are
only sharing the wider pain.

December is the year-end for around half of UK companies, and many companies
would be forgiven for expecting to disclose significantly worse pension scheme
deficits. Since 31 December 2007, however, the Aon200 index of pension scheme
accounting positions has actually improved from a £2bn deficit to – wait for it
– an £18bn surplus.

During the one of the worst periods for pension scheme finances, pensions
accounting disclosures are actually revealing gains. Don’t be fooled though, the
gains are only the result of a meaningless mess.

Marcus Hurd is head of corporate solutions at Aon

Related reading

Fiona Westwood of Smith and Williamson.