Paul Boyle, chief executive of the Financial Reporting Council (FRC), the UK’s independent regulator for corporate reporting and governance, has called on trustees of final salary pension schemes and the directors of sponsoring companies to recognise the limitations of accounting and actuarial information related to pensions and to develop a better understanding of the cash flows in pension schemes. Speaking at the Association of Corporate Treasurers’ (ACT) Pensions Conference, he explored the potentially misleading impression created by discounting future cash flows.
He said: “The pensions accounting challenge is how to compare a long-term flow of benefits with a current stock of assets. We can use discounting to convert the long-term flow into a present value, which dramatically shrinks the reported value of liabilities. However, discounting is a practical technique with a theoretical conceptual underpinning. The theory is only valid in the real world if two critical assumptions hold good. These theoretical assumptions are, of course, rebuttable in the real world.”
Boyle used the cash flows from a real pension scheme to illustrate the effect of long-term investment returns that are less than the discount rate applied to the liabilities. He also illustrated the effect on future investment returns of a modest level of underfunding. In both cases apparently small differences would, if not addressed on a timely basis, lead to very large shortfalls in the scheme’s ability to meet its liabilities.
He suggested a number of conclusions from the analysis, including:
- There is a high probability of further shortfalls emerging in cases where there is already a deficit in the pension scheme because the liabilities have been reduced to take credit for the returns on non-existent assets.
- The higher the rate used to discount pensions liabilities the greater the risk of shortfalls emerging at a later date.
- The greater the delay in addressing pensions deficits the greater the amount, which will ultimately be required to address them.
- Companies should consider whether the disclosures which they are currently making about the likely future cash flows associated with their pension obligations, even if those disclosures fully comply with existing accounting standards, are adequate to convey a balanced and realistic view of the risks which they face.
He noted that a draft new Actuarial Standard issued for consultation by the Board for Actuarial Standards would require actuaries to give greater prominence to the timing and nature of cash flows on which their reports are based and to the likely results of similar future reports.
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