Pension accounting can produce some odd results, such as companies that report a pension surplus but which still make ‘deficit reduction’ cash contributions. This illustrates an underlying problem in financial reporting where pension assets and liabilities may not reflect the true economic position of the sponsoring company.
We think the increasing closure of defined benefit schemes to new accrual, and the growing trend to de-risk, including the use of pension buy-ins and buy-outs, makes the flaws in pension accounting increasingly obvious. We explain the problem and what amount you should include instead in an equity valuation.
A subscriber to The Footnotes Analyst recently sent us an interesting question about pension assets and liabilities in equity valuation. It specifically concerns a situation at IFRS reporting media company ITV Plc, although the question is relevant to any company with a material defined benefit pension scheme.
ITV has significant pension schemes where the most recently reported scheme assets of £2,835m are about 91% of the company’s current market capitalisation. In aggregate, the schemes show a healthy net surplus of £352m at the most recent balance sheet date of June 30, 2022. The pension fund surplus is measured using the IFRS standard (IAS 19) and is reported as an asset in the balance sheet. The pension schemes are closed both to new members and future accrual, which means that no further pension rights are being accumulated by employees1The company now operates defined contribution schemes, the expense for which is separately reported in profit and loss. and therefore there is no reported defined benefit pension service cost in profit and loss.
The fact that there is an aggregate surplus and no future service cost, suggests there should not be any negative effect of these pension schemes on the valuation of the company. Indeed, if the surplus can be ‘recovered’2A recoverable surplus is one where the sponsoring company can achieve a commensurate economic benefit. This may be due to reduced future outflows if the scheme is still open to future accrual, or through cash payments from the fund – effectively repayments of past contributions. This is the explanation given by ITV … “The Group has determined that it has an unconditional right to a refund of any surplus if the Schemes are run off until the last member dies. On this basis the Group has recognised an accounting surplus on the ITV Pension Scheme and the UTV Scheme as at 30 June 2022.” (which the company says it can) the schemes would seem to have a positive valuation impact. However, what concerns our reader is that the company continues to pay “deficit reduction” contributions, despite the schemes having an aggregate surplus. In the first half of 2022 the payment was £137m (which is already included in the balance sheet funding position shown below), and the company discloses that further contributions of £176m are planned from 2023 to 2025.
The question our reader asked is how should the pension funding situation be included in a valuation of ITV? Do the schemes have a positive effect on value due to the aggregate surplus and the resulting balance sheet asset? Or is there a negative impact due to the expected future “deficit reduction” cash outflows? Furthermore, why are contributions being made anyway considering a surplus is being reported and there is no future accrual of pension rights?
Here are extracts from the 2022 interim report of ITV, which include the figures we quote above.
ITV pension funding disclosure extracts
ITV interim report 30 June 2022
One possible explanation for the apparent contradiction of there being both a scheme surplus and future deficit reduction contributions is that the group operates several schemes, some of which are in surplus and some in deficit. Because there is generally no right to offset surpluses and deficits, the schemes in deficit may require further funding, even though the aggregate position is a net surplus. While this may, in part, explain the ITV situation, it is not the primary cause.
The real explanation is that the funding of the schemes is based on a different measurement of scheme liabilities compared with that applied in the IFRS balance sheet.
Actuarial funding valuation for pension liabilities
In planning how to accumulate sufficient assets that can fully pay benefits to members in retirement, companies and the scheme actuaries use what is commonly referred to as an actuarial funding valuation. This may be higher or lower than the amount used for financial reporting. The difference is the measurement of the gross pension liability and specifically the choice of discount rate.
In an actuarial funding valuation, the expected future pension payments to scheme members are discounted to a present value using the expected return on the scheme assets. The rationale is that if an amount of cash equal to this present value were invested today, and the asset returns are as expected, the fund will grow sufficiently to fully pay all future pension payments to scheme members for the remainder of the scheme life.
Of course, expected asset returns are not necessarily guaranteed and, if the scheme invests in ‘risk assets’ such as equities, hedge funds or real estate, there may be a significant difference between the actual and expected return. In fact, if a true expected return is used, there will be, by definition, only a 50% probability of the scheme assets being sufficient to pay all benefits. As a result, pension actuaries may use conservative expected return assumptions when planning funding payments. Nevertheless, investment in higher risk (and hence higher expected return) assets tend to result in a higher funding valuation discount rate and therefore a lower (funding) liability.
In financial reporting, the composition of the asset portfolio does not impact the measurement of the pension liability. The expected future cash flows are essentially the same, but the discount rate used to measure the accounting obligation must equal the yield of high-quality corporate bonds (usually interpreted as ‘AA’ bonds). As a result, the asset allocation of the fund and the expected asset return is irrelevant. The logic for this approach is that changing the pension fund assets does not impact the economic nature of the liability and that therefore the discount rate should reflect the characteristics of the liability, not the funding assets.3 Only if the liability cash flows are themselves linked to the underlying assets should a discount rate be linked to asset returns. This can happen for some pension schemes, including those commonly called cash-balance plans. While this linkage is recognised in insurance accounting, unfortunately this is not the case in IAS 19 and as a result the accounting for cash-balance plans is problematic, with the liability potentially overstated.
Depending on the composition of the scheme assets, the IAS 19 discount rate can be higher or lower than the rate used for the funding valuation, which is why the IAS 19 accounting valuation may be lower or higher than the actuarial funding valuation.
In the case of ITV, the company aims to closely match assets and liabilities to minimise the risk to the company, and therefore maximise the security of the schemes for members. Consequently, the scheme assets are invested conservatively with few risk assets. The asset allocation of the schemes is not disclosed in the 2022 interim financial statements – the footnote below is from the previous annual report.
ITV pension scheme asset allocation
ITV annual report 31 December 2021
The scheme assets above include a 44% share for risk-free bonds and related derivatives, which are classified as “liability hedging”. However, it seems to us that other assets have a similar effect. For example, the ‘insurance policies’ represent a bulk annuity purchased to achieve a partial buy-in and will fully match a portion of the pension payment outflows. In addition, ‘other bonds’ are likely to be low risk and with a duration that will probably, at least in part, match the liability profile. In our view, all these assets are low risk and largely geared towards matching the liability cash flows.
Only 8% of the asset portfolio is identified as riskier “return seeking investments” and even these seem to be less risky compared with the return seeking assets of other schemes – notably there is a complete absence of equity investments.
The net result of this low risk and largely liability matching approach to asset allocation is that the average expected return on the asset portfolio, and consequently the rate applied in the actuarial funding valuation to determine cash contributions, will likely be lower than the ‘AA’ bond rate used for the IAS 19 accounting measurement. This explains the higher liability (and scheme deficit) based on the funding valuation, and therefore the continued payments of “deficit reducing” contributions, even though the IAS 19 valuation results in a surplus.
Here is the company’s explanation of the difference between the two valuations:
ITV pension liability measurement explanation
ITV annual report 31 December 2021
Unfortunately, the footnote disclosures are insufficient to be more precise about the differences between the two valuations. ITV, like most companies, does not disclose the discount rate used for the funding valuation in any financial statements, and the IAS 19 discount rate is only disclosed in the annual report and not in the interims. Nor are the two valuations done at the same time – the accounting IAS 19 measurement takes place, and is presented in the balance sheet, at every half-year reporting date, whereas the funding valuation is only done every 3 years and on different dates for individual schemes.
Not all funding valuations of pension liabilities will be higher than the measurement for financial reporting purposes. For companies that have not de-risked their defined benefit pension schemes, the expected asset return may well be higher than the IAS 19 high-quality corporate bond discount rate.
We discussed exactly this situation in one of our early Footnotes Analyst articles, which was based on the accounting of BAE Systems.
BAE Systems takes a very different approach from ITV. Its pension fund asset allocation includes a significantly higher investment in equities, pooled investment funds (which also appear to be predominantly return seeking investments) and properties. We estimate the proportion of risk assets is 51% of the aggregate pension fund portfolio, which compares with just 8% for ITV. This difference may be due to a different attitude to risk in the pension scheme, but could also be because the BAE Systems scheme is still open to new accrual of pension benefits by current employees. The orthodox actuarial thinking is that as schemes mature, and particularly when in run-off, a greater importance is attached to liability matching.
BAE Systems pension fund asset allocation
BAE Systems annual report 31 December 2021
Irrespective of the motive behind the asset allocation, the consequence of the greater exposure to risk assets is that the funding valuation discount rate (even though based on “prudent” expected asset returns) will exceed the IAS 19 discount rate. Consequently, the actuarial funding valuation of the BAE Systems pension scheme obligations is lower than the IAS 19 amount (the opposite of ITV).
BAE Systems explanation of their funding valuation
BAE Systems annual report 31 December 2021
Which pension valuation is most relevant for investors?
When we previously wrote about pensions in the context of BAE Systems, we argued that investors should not use the actuarial funding valuation in their analysis if this has been reduced by using a discount rate that includes a premium due to risky investment. This is because we do not believe that the benefit from a higher expected return for the pension fund assets adds any value, after allowing for the higher risk. Switching a pension fund from low-risk matching bonds to higher risk equities may well reduce expected future contributions, but it does not add value – $100 of bonds and their expected future return are worth the same as $100 of equities and their higher but riskier return, as shown by the market pricing of equity swaps.
More Footnotes Analyst articles on pension asset allocation and pension leverage …
For a more detailed explanation about how higher risk pension assets may reduce an actuarial funding liability, but not add any economic value, see ‘Pension liabilities: Not so prudent actuarial values’.
Further explanation and a downloadable spreadsheet about pension leverage and the impact on discount rates and DCF valuations can be found in ‘DCF and pensions: Enterprise or equity cash flow’.
For a description of how pension leverage is reported differently in IFRS and US GAAP see ‘Pension leverage under IFRS and US GAAP’.
However, there are also challenges with the accounting IAS 19 measure. The problem is that the ‘AA’ rate still includes a premium for investment risk, which makes the accounting liability, in effect, the same as a funding valuation, albeit with a standardised rather than scheme specific investment risk premium.
Whether credit risk should be included in liability measurement is an ongoing debate in financial reporting. We think that (ideally) all liabilities should be measured using a discount rate that reflects the credit risk applicable to that liability. However, an ‘AA’ rate is almost certainly too high for pension obligations that generally have little credit or non-performance risk, particularly those schemes that are closed, well-funded and invested in liability matching assets (as for ITV).
Accordingly, we think that (most) pension liabilities should be measured by discounting expected future pension payments at a risk-free rate.
Comparing pensions with insurance
The new IFRS standard for insurance accounting, IFRS 17, uses a risk-free rate to determine the best estimate component of an insurance liability.4An insurance liability also includes an unearned profit component. Although the discount rate is adjusted to reflect the illiquidity characteristics of insurance contracts, no spread for credit or investment risk is included.
Insurance and pension liabilities have essentially the same characteristics, so why are they measured differently?
In the case of ITV, the pension asset allocation at the end of 2021 included insurance policies purchased from an insurance company that provided cash flows to match some of the pension payments. In 2022 the company went further and actually transferred these obligations to the insurer in the form of a pension buy-out. When the insurer measures their new liability, it will use the (illiquid) risk-free rate and not the ‘AA’ rate previously used by ITV for their pension liability in the balance sheet. This change in measurement, for what is effectively the same obligation, makes little sense.
In our view the new IFRS 17 measurement basis for insurance liabilities would provide a better basis for the measurement of pension obligations. Not only would it remove the illogical credit spread from the discount rate, but it would also solve other problems in pensions accounting, notably how to measure so-called cash balance plans.
A note on IAS 19 and pension buy-ins
One interesting feature of IAS 19 is how the standard deals with pension buy-ins. A buy-in arises when a pension fund acquires a bulk annuity that provides matching cash inflows for all or a portion of a scheme’s liabilities. The responsibility for paying pensions remains with the sponsor, which is why the liability remains on the balance sheet, but the annuity provides an exact offset. The insurance contract annuity itself is regarded as a scheme asset.
Considering that the purchased bulk annuity insurance contract exactly matches the liability, you would assume that the two would be measured at the same amount with there being a zero surplus or deficit for this portion of the overall pension. However, an exception to the general measurement approach is required in IAS 19 to achieve this. Without this exception the liability that the insurance policy offsets would be measured using the usual ‘AA’ discount rate; but the annuity asset is stated at fair value, which effectively involves discounting at a risk-free rate. The application of the IAS 19 principles would therefore show a surplus for this part of the scheme, although a surplus does not exist given the exactly matched position.
IAS 19 deals with this anomaly by overriding the normal measurement basis for the asset and instead requiring that the annuity contract asset be measured at the same amount as the related liability (as measured using IAS 19 principles). This achieves the right outcome but only through two offsetting errors – both the asset and the liability are understated.
Here is what it says in IAS 19:
Where plan assets include qualifying insurance policies that exactly match the amount and timing of some or all of the benefits payable under the plan, the fair value of those insurance policies is deemed to be the present value of the related obligations (subject to any reduction required if the amounts receivable under the insurance policies are not recoverable in full). IAS 19 paragraph 11
We think this exception in IAS 19 is further evidence that the measurement approach based on the ‘AA’ bond yield is flawed. If measurement of the pension obligation correctly reflected the characteristics of the liability, it would be the same as a matching insurance contract asset, with no exception required.
Returning to the question from our reader …
Generally, we do not think funding valuations are a good basis for measurement because they typically include a spread for investment risk. However, in the case of ITV, the investments are low risk, and the funding valuation would have used a discount rate equal, or at least close, to the risk-free rate. In effect the ITV funding valuation is how we think the accounting measurement should be for all companies. On this basis, we think that the ITV pension position at 30 June 2022 has a negative impact on value and that the expected future funding payments disclosed by ITV are more relevant than the reported accounting surplus.
The apparent contradiction of an accounting surplus being reported, even though ‘deficit reduction’ payments continue, is likely to become increasingly common. Many companies are de-risking their pension schemes by investing in matching assets, or through buy-ins or buy outs with insurance companies. This means that companies will increasingly seek to fund pension schemes to a level higher than the accounting liability.
We think de-risking of pensions is positive for investors in sponsoring companies. In fact, we can claim to have advocated pension de-risking way back in 2003 when the strategy was far from mainstream thinking. This is the cover picture from the 2003 report. Interestingly the ‘biased accounting’ that we highlighted at the time has indeed now changed in IFRS (although not US GAAP).
Cover illustration from the UBS investment research report – Pension fund asset allocation
This old 2003 UBS report can still be found on the internet. Inevitably much of the analysis of the accounting is out of date but we think it is still an interesting read.
Adjusting the accounting liability
The pension asset or liability reported in financial statements can be adjusted to approximate what it would be with a risk-free discount rate. The impact of a lower rate can be estimated by simply multiplying the difference in rate by the duration of the liabilities. This should be applied to the gross pension liability before deducting the scheme assets.
In the case of ITV, we cannot do this calculation at the most recent balance sheet date because the discount rate applied in the IAS 19 measurement is not disclosed. On 31 December 2021, the previous year-end, the disclosed discount rate was 1.8% and the average term of the liabilities was 15 years. On this date the yield on 15-year UK government bonds was 1.15% which implies a yield spread of 0.65%.5If the discount rate used in the accounting is not disclosed, just use the average yield spread for AA bonds. The difference in liability measurement based on a duration of 15 years is therefore 15 x 0.65% = 9.75% and the revised liability is £3,943m x 1.0975 = £4,327m
ITV Plc – reported and adjusted pension funding position at 31 December 2021
ITV financial statements 31 December 2021 and The Footnotes Analyst estimates
* The adjusted scheme liabilities represent an approximation of the present value of pension payments discounted at the prevailing risk-free rate. The calculation ignores any convexity effect and assumes that the disclosed average term of the liability is the same as the ‘duration’ of the obligation.
** This excludes the “other pension asset” disclosed in the note shown above.
In a valuation of ITV at 31 December 2021, we think the adjusted (approximate) deficit of £454m, with a commensurate adjustment to deferred tax, is more relevant than the disclosed balance sheet position.
Insights for investors
- We do not generally recommend using actual funding valuations as a basis for including pension obligations in equity valuation. If fund assets are ‘return seeking’ the risk premium included in the funding valuation artificially reduces the liability.
- The actuarial valuation will be more realistic and a better reflection of the future cashflows if pension assets are low risk and ‘liability matching’.
- We think the IAS 19 balance sheet measurement of pensions is skewed by including the ‘AA’ bond spread in the discount rate. A risk-free rate is usually more appropriate.
- Applying the new IFRS 17 measurement basis for insurance liabilities to defined benefit pensions would improve financial reporting.
- You can approximate the economic pension liability if you increase the reported gross accounting liability by the credit spread used in IAS 19 multiplied by the duration of the obligation.