The decline of the defined benefit pension is a complex process. There has been a range of factors that have contributed to the current situation where the vast majority of private sector defined benefit schemes are now closed to new members and/or future accrual. Successive amounts of statutory overlay increased the cost of pension provision and rapid increases in life expectancy increased the ultimate liability faced by corporate sponsors. As such there is no one factor that can be solely blamed for the loss of the defined benefit scheme in the private sector. The current situation therefore has a number of key drivers and one of these is the way in which pensions are accounted for.
The International Accounting Standards Board (IASB) sets accounting standards within a conceptual framework of Understandability, Relevance, Reliability, Comparability and Timeliness. As part of this approach there is a strong emphasis on the use of market prices, whether they are actual market prices or derived market prices. Current pension accounting, under IAS 19, applies a mixed accounting model and can be viewed as a hybrid between financial economics and traditional actuarial methods as it applies discounted cash flow valuation via a market determined discount rate to estimate pension liabilities, and market prices to value pension assets. The application of this approach has been detrimental to the sustainability of the defined benefit pension scheme as it removes the interaction that occurs between pension assets and pension liabilities and asset/liability cash flows when both are valued using discounted cash flows.
Consequently, this has led to greater volatility in Comprehensive Income (CI) and the recognition of substantial and often volatile pension deficits in the statement of financial position. The application of fair value accounting to defined benefit pension obligations has, therefore, expedited the decline of such schemes as corporate managers have increased the pace at which these schemes are closed to new members and to future accrual by existing members.
At a macroeconomic level, mandating the use of AA rated bond yields to discount the present value of pension liabilities has resulted in schemes purchasing greater amounts of financial investments which better match the estimated present value of their pension accounting liabilities. Pension schemes have been divesting real asset investments, such as equities, and investing in financial investments, such as long‐dated index linked gilts and corporate bonds, that are a better match for the estimated accounting liability. The systemic effect of this has been to exacerbate the bubble in long‐dated bonds and, in particular, index linked gilts.
Crucially, this move into financial assets feeds back into the long‐term operations of the firm. If the assets held to meet the pension obligation are solely or predominantly bonds this will, in all likelihood, increase the cost of pension provision over the life of the scheme, as bonds have been consistently shown to generate lower longterm returns than equities. Consequently, any shortfall in pension plan funding that occurs over the long‐term as a result of lower asset returns on bonds compared to equities will, all other things being equal, have to be met from corporate earnings.
In looking at how pension accounting can be improved, there are a number of potential solutions. First, pension accounting needs to apply a consistent model for pension valuation. As such, pension liabilities should be valued as the discounted present value of future net asset/liability cash flows, thereby correctly allowing for the asset/liability interaction that occurs over the life of a pension scheme. In doing so, corporate accounts would recognise amounts that better reflect the long‐term nature of a defined benefit pension obligation. Second, pension disclosures should include the actual cash contributions that a corporate sponsor is committed to as a result of negotiation with scheme trustees and/or the Pensions Regulator. Current disclosures with regards to the cash contributions firms have committed to pay to a scheme in the short to medium term are vague. To improve this, accounts should be required to present a schedule of past contributions and future contributions. Enabling users of financial accounts to understand these cash commitments would allow for a better assessment of the profitability of a firm, thereby increasing the decision usefulness of financial accounts, which is a key objective of the IASB.
Finally, the recognition of a discounted cash flow model of pension accounting through the accounts of the firm can be viewed as the long‐term position of the scheme. To make this number useful, company accounts should also disclose the market value of scheme assets relative to a discounted pension liability. This will provide users of financial accounts with information about where the pension scheme stands today in relation to the expected long‐term position that is recognised in the company accounts. Users of financial accounts will therefore be able to make some assessment of the probability of achieving the long‐term target of fully discharging the pension obligation through time, and so financial accounts would be more relevant. This would improve pension accounting beyond where it stands today as corporate accounts would recognise the ‘best’ estimate of the long‐term position of the scheme while allowing for an understanding of where the scheme is today relative to long‐run expectations.