The decision to measure pension deficits under Financial Reporting Standard 17 could be driving companies and trustees into a more conservative investment strategy which could prove costly in the long term, claims the Association of British Insurers.
In its latest research report: ‘Understanding Companies’ Pension Deficits’ the ABI points out although FRS17 – which requires companies to disclose pension liabilities on balance sheets – was introduced as a way to reduce subjectivity in the valuation of pension assets and liabilities, there is “ample room for improvement”.
The 52-page document warns the problem with “balance sheet disclosure in general and FRS17 in particular” is that the information is condensed into a single number on a standardised basis, and they provide a “static” picture of a scheme at a given point in time, but fail to address the risks of changing assets and liabilities.
As a result, the ABI says better information on pension deficits is needed as one of the problems with relying on a ‘headline’ deficit value is the negative impact it may have on asset allocation decisions.
It warns ‘headline’ figures, such as the FRS17 deficit, are very volatile and effectively assume funds are going to sell the assets in the market and turn them into cash - the marked-to-market approach.
And it says there has been a concern schemes have been concentrating on reducing volatility, rather than optimising investment strategies, as recent evidence suggests pension funds are still selling equities, although it admits not all of the “run down in equity allocation is due to a switch into bonds”.
Instead, it says some of it reflects a shift into other asset classes such as private equity and hedge funds, although the research paper warns liability-driven investment is increasing, and predicts the switch to long-dated bonds would have been even stronger if bond yields had not fallen so sharply during 2005-2006.
The ABI claims the “full extent of the shift in investment strategy may not be known” but warns a move into bonds may be premature for some schemes and particularly costly given that long-term gilts are currently in short supply.
The ABI suggests, while the FRS17 figures are “useful”, the challenge is to create a new “measurement system”, which “remains reasonably objective, but also embeds the cash flow characteristics of the scheme.”
As the document suggests cash-flow forecasting may provide useful information, “with potential gains in terms of efficient asset allocations”, compared to one-line accounting measures such as FRS17.
Stephen Haddrill, director general of the ABI, says the industry needs to understand deficits better, to be able to devise investment strategies which really deliver the best value for beneficiaries and sponsoring companies.
He adds: “If trustees and sponsors do not have a complete picture, pensioners could lose out badly. We encourage international standard setters to draw on its findings in setting a new accounting standard, and trustees to use it in assessing the health of their pension fund”.
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