Pension liabilities

A pension accounting asset may be an economic liability

Published

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.

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Pension leverage under IFRS and US GAAP

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US GAAP and IFRS present the effects of pension leverage differently in financial statements, notably leverage arising from pension fund asset allocation. This complicates the comparison and interpretation of performance measures and valuation multiples.

We use Delta Air Lines to illustrate the positive impact of the US GAAP ‘expected return’ approach on reported profit, including the effect of optimistic return assumptions. If Delta had applied the IFRS ‘net interest’ approach we estimate that a ‘gain’ of $594m would have been excluded from profit and loss and instead reported in OCI.

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DCF and pensions: Enterprise or equity cash flow?

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Defined benefit pension schemes create two leverage effects – financial leverage due to the debt-like nature of pension deficits, and asset allocation leverage if pension assets are not matched with pension liabilities. In DCF valuation these effects must be correctly, and consistently, included in both the discount rate and free cash flow.

We use an interactive model to demonstrate four possible DCF approaches based on enterprise and equity cash flows. Our preferred approach uses enterprise free cash flow with the effects of asset allocation leverage excluded from the discount rate.

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Multi-employer pensions: Liability missing, expense unhelpful

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Defined benefit pension liabilities arising from participation in multi-employer plans may not be recognised on the balance sheet. Under IFRS, companies can avoid recognition by simply asserting that “information is not available”. Disclosures in the footnotes help, but these may be measured on an ‘actuarial’ basis which is not relevant for investors.

We use retailer Ahold-Delhaize to illustrate the challenge for investors. It participates in several US multi-employer schemes and discloses an unrecognised actuarial liability of €1.1bn as per year end 2018. We estimate the more relevant IAS 19 liability, which we think should be recognised on-balance sheet, to be €2.2bn.

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Pension liabilities: Not so ‘prudent’ actuarial values

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The valuation of pension obligations can be an important component in determining the value of an equity investment. But should you include in your analysis the pension surplus or deficit based on the accounting liability or, as some argue, the lower actuarial ‘funding’ valuation?

It is all about the discount rate. The problem is that there are very different opinions about the appropriate rate for pension obligations and what measurement approach is most relevant for investors. We examine a view expressed by many, including BAE Systems.

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