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David Hillier: Reassuring realities behind the headlines over deficits
IN recent weeks, the significant increase in deficits of large defined benefit corporate pension schemes has led to a raft of panic headlines heralding the demise of such vehicles. On the penultimate day of July, BT announced that its deficit had doubled in only three months from £2.9bn to £5.8bn and BAE systems stated that, in the first half of 2009, its deficit had tripled from £1bn to £3.1bn.
What do these figures actually mean and should they worry employees and investors?
Most people, when they think of a deficit or surplus, believe that what is being reported is actual cash. That is, if a fund is in deficit it doesn't have enough money to pay out to its members.
Conversely, many believe that a fund must always be in surplus so it has enough cash to meet its pension payments. If only life (and pension accounting) was so simple. Pension funds invest in financial assets and these assets provide cash flow streams that can go on for an exceptionally long time. Moreover, the cash flow streams are not known today with certainty and actuaries and accountants must predict how they will grow in the future.
The main assumption concerning pension fund assets relates to the return that can be made on the different asset classes the fund holds. Using BT and BAE systems as examples, they predicted that UK equities would grow by 8.5 per cent and 8.25 per cent per annum respectively. On the basis of these figures, a notional value for the pension fund assets can be calculated.
Defined benefit pension fund liabilities are even more complex to value because the actuary must consider how long individuals are going to stay alive (how long the payments will last), the present day valuation of all future pension payments (how risky the payments are), the rate of growth in employee salaries (the value of future payments), and future inflation. Furthermore, these estimates can vary a lot across companies.
For example, although BT and BAE systems predicted a similar life expectancy of approximately 84 years for their employees and a future inflation rate of 2.9 per cent at the end of 2008, their estimates of the discount rate on bonds (riskiness of payments) was 6.85 per cent and 6.3 per cent, respectively. For salary growth, it was 2.9 per cent versus 3.9 per cent respectively. Using these forecasts, the actuary can arrive at a valuation for the pension fund liabilities.This all seems very scientific and precise but what happens when the estimates are wrong or the assumptions are revised? This is what happened to BT when they announced their quarterly results on July 30. Looking back, forecasting an 8.5 per cent return on equities was hopelessly unrealistic given the economic conditions companies have been facing in 2009.
Although the markets have performed reasonably well in the last few months, they definitely haven't done as well as predicted.
BT's pension deficit took an even bigger hit when the firm decided to change two of its main assumptions. First, they increased the estimate of future inflation from 2.9 per cent to 3.25 per cent, which meant that predicted future pension payments are now valued significantly higher.
In addition, they reduced the discount rate used to value the future pension payments from 6.85 per cent to 6.2 per cent causing a further increase in the value of their pension fund liabilities. The combined effect of these accounting changes was a net worsening of the BT deficit by 2.9bn, even though the pension fund assets grew by 1bn. Crucially, the increase in deficit did not mean that the fund lost 2.9bn in three months, only that its accounting value had fallen by
this amount.
BT's recent quarterly results illustrate the dangers that the media and public can face when interpreting simple pension surplus and deficit figures. The newspaper headlines can scream, "Imminent pensions crisis!", but in reality the increase in BT's deficit had no real impact on the cash flows of the company, the risk of its operations, or the funding of its pension scheme. It was simply an accounting adjustment – nothing more and nothing less.
So is there an imminent pension crisis? At the moment, the answer is no. The deficits that have been reported are notional values that represent the totality of inflows and outflows in the future.
The total actual cost of defined benefit pension payments in 2008 for BT was 47m, significantly less than the 5.8bn reported as a pension deficit, and the 478m paid out as dividends to shareholders. Although
deficits make news headlines, the reality is, fortunately, much less worrisome.
Professor David Hillier is head of accounting and finance at Leeds University Business School.
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