When sizing up a new investment opportunity the FRS17 or IAS19 pension accounting figures disclosed in a company’s published accounts are generally taken as a reasonable first estimate of the pension liability exposure.

But what might they be hiding

1.Are the figures out of date? Accounts might be a year or more out of date.  For many schemes the long term investment strategy creates huge deficit volatility in pension accounting owing to the mark-to-market nature of current accounting standards.

2. What was influencing the Directors setting the assumptions?  Directors setting company accounts are not trying to ascertain fair value for a future transaction.  They have other interests and pressures when setting the assumptions for pensions accounting.  Often this will include objectives such as minimising deficits within the allowed margins of the accounting rules or perhaps to try to reduce volatility in deficits disclosed from year to year.

3. Are the mortality assumptions appropriate and up to date?  This assumption is not disclosed currently and the difference between mortality tables can have a very significant impact of the pension liabilities calculated.  Resistance in the Board room to adopting new mortality tables can be strong and in some cases justified as much uncertainty exists.  But when making a new investment a margin for prudence on this “unhedgeable” risk is more appropriate.  However, the ASB has recently proposed changes to FRS17 including introducing the requirement  to disclose the mortality assumption and this is likely to increase pressure on companies to use more up-to-date mortality assumptions than they may have done in the past.

4. Which other key assumptions are not shown in the accounts?  Allowances for members to commute pension for cash at retirement, scheme expenses, early retirement allowances and early leaver assumptions are not usually disclosed and might have been used to flatter pension liabilities and hide additional costs.

As an example, we pick a large UK plc and their 31 December 2005 accounts.  The graph below shows their pension liabilities, assets and deficit as disclosed at the year end.  We then show the same information but using the median key disclosure assumptions for that year end highlighting the contributing factors.

Further to illustrate the volatility of the result we have then projected forward on the publicly available information to estimate the position as at 30 April 2006.

This shows a disclosed deficit of £195m compared to an expected deficit of say £400m on typical disclosure assumptions but this then reduces to £290m in the first quarter of the year even retaining typical disclosure assumptions.

This illustrates clearly the dangers highlighted in the bullet points above.  Even from publicly available information we are able to produce approximate roll-forwards of pension scheme accounting positions to give a feel for the current position using market median assumptions and highlight the volatility.  However, where assumptions are hidden from disclosure the true position can only be revealed by obtaining the information from the target to fill in the blanks.

Please contact Paul Geeson (020 7533 1872) or Richard Jones (020 7533 6967) for further information or assistance on clearance or funding target issues.