Matthew Craig asks whether old age could be the death of pensions, as widly varying longevity scales muddy the accounts.
For finance directors with a defined benefit (DB) pension scheme to think about, rapid increases in longevity are causing scheme costs to skyrocket.
It is estimated that each extra year of life expectancy adds 3% to scheme liabilities. Even worse, many organisations have been using outdated mortality tables, and moving to more realistic assumptions can steer the figures towards the 20% mark.
Many of those that study mortality rates say that increases in longevity are accelerating. Life expectancy in the UK population has risen as much in the last 20 years as in the previous 150 years. Watson Wyatt’s consulting actuary Mike Stoaling says: “The big unknown is whether that will continue - we simply don’t know.”
At present, mortality or longevity projections are based on the generation born between 1926 and 1935, as there is enough data here for valid conclusions to be drawn. One view is that this golden generation are enjoying an exceptional longevity due to special circumstances. Firstly, their parents were the hardy survivors of the Spanish influenza epidemic of 1919. Then, in their youth, this generation benefited from rationing and abundant outdoor exercise. As they grew older, they had better health care and better housing than previous generations. Financially, they benefited from huge increases in property prices and are often recipients of good workplace pensions.
Subsequent generations, some argue, will be less healthy and less financially blessed. Driving the debate is higher obesity rates as we choose virtual activities over physical ones and as adults accompany this with a culture of binge drinking. Mark Wood, chief executive of pensions buy out specialist Paternoster, assumes the rapid acceleration in longevity will continue, based on factors such as the public smoking ban, the increased use of blood-thinning statins to prevent heart attacks, and non-invasive surgery which reduces post-operative trauma. “Medical care is extending life; men are no longer dying in significant numbers in their early sixties. It was quite common in the past not to make it to retirement,” says Wood.
Actuarial research on the 1926-35 generation has been sub-divided into three groupings, the first is a demographic with ‘short’ life expectancy, reaching terminal age in their early 80s, a medium cohort whose demise is anticipated in their mid-80s and a longer lasting group that will make it to at least their late 80s. Wood says: “In general, pension schemes reserve at a lower level of life expectancy than we would consider reflective of current trends, using the short cohort. Insurance companies are somewhere between the short and medium cohorts and in Paternoster’s case, we [adopt] a long cohort [view].”
Orlando Harvey Wood, a partner in the pensions actuarial team at Deloitte, says: “It is not unreasonable to say that updating mortality assumptions could add 10%-20% to pension liabilities. Organisations need to reveal what they are doing, and auditors are starting to challenge it.”
Can insurance products assuage worry?
For FDs worried about the impact of longevity on scheme liabilities and their financial statements, one option is to buy out liabilities with an insurance product. This can be expensive, but new entrants in the market have made it more competitive.
Products have also been developed that can hedge against longevity. Professor David Blake, director of the Pensions Institute at London’s Cass Business School, says, “At the moment the reinsurance companies are having the greatest success, but some investment banks are investing a lot of capital and won’t let the insurance industry take all the business.”
In 2004, the European Investment Bank and BNP Paribas issued a longevity bond, with coupon payments based on a mortality index of 65 year olds. Other developments include mortality catastrophe bonds, which protect against extreme mortality event risk, and longevity swaps, where payments are exchanged between counterparties depending on actual mortality versus a benchmark. PricewaterhouseCoopers pension partner Brian Peters says: “For organisations with a large pension scheme, longevity could represent one of their biggest corporate risks.”
If longevity is a concern for FDs, one issue that could then turn the screw is the recent International Accounting Standards Board’s guidance, IFRIC 14, on the treatment of accounting surpluses under international accounting standard IAS 19.
This guidance comes into effect in January and its exact implications are still the subject of debate. But it could mean that additional funds paid into a pension plan, perhaps because of increases in longevity, could be trapped, or could create an additional liability on the balance sheet.
“If you have a deficit, that’s a liability that a company must disclose. But if you have a surplus, is it an asset that can be disclosed? IFRIC 14 is trying to answer that question,” says Peters.
In the past, companies could take advantage of a surplus by reducing contributions or obtaining a refund, but IFRIC 14 states that a surplus can only be considered an asset when a company has an “unconditional right” to it, or “sufficient scope to reduce future contributions”. As the Pensions Act 2004 gave scheme trustees and the pensions regulator greater powers over scheme funding, it may now be harder for companies to show that either of these conditions exists.
One interpretation of IFRIC 14 is that if a surplus is available to a company when the last pensioner in the scheme dies, then that could show that an unconditional right exists. “Companies should investigate how the scheme rules work. Is there something that the trustees can do before the scheme finishes as an entity? If yes, that may impact on whether the surplus can be recovered,” comments Peters.
IFRIC 14 also raises issues over the interaction of accounting and funding rules, which could cause FDs a real headache. Basically, where a company does not have an unconditional right to a surplus and has an existing deficit, if a funding plan has been agreed that creates a surplus under IAS 19, this will create an additional balance sheet liability in addition to a current IAS 19 deficit.
Deloitte’s Orlando Wood says this is a real issue for some companies. “FDs need to think what they are signing up to before making a commitment to repair deficits in the pension scheme. Under IFRIC 14 there is a real chance that if a company is committed to future payments to repair a deficit then it could be recognised immediately on the balance sheet.”
The use of contingent liabilities, according to Grant Thornton’s Cook, is one option where companies don’t want to commit capital. “A few years ago contingent assets were comparatively rare, but this is changing,” he says. Charges over property or other assets, parent company guarantees and letters of credit are all possible options.
Aon Consulting senior consultant and actuary Paul Dooley says there is still some dispute over how IFRIC 14 will be interpreted. “What we can say is that when companies are looking to agree contribution plans with trustees, they should make sure that they understand any potentially negative impact on company accounts before making an agreement,” he says
IFRIC 14 guidance on pension fund accounting
- IFRIC 14 is guidance on pensions accounting standard IAS 19 and is effective for financial periods beginning on or after 1 January 2008. If it is not adopted for the 2007 accounts, its impact must be disclosed, as if it had been used.
- Under IFRIC 14, companies must have an ‘unconditional right’ to a refund, or ‘sufficient scope to reduce future contributions’ for a surplus to be included on the balance sheet.
- An ‘unconditional right’ means that the company does not need third party agreement to a refund, for example from the trustees or pension regulator.
- Where companies do not have an unconditional right, they may need to make an additional provision due to the interaction of funding and accounting rules. Where companies are funding for a surplus under IAS 19, it is possible under IFRIC 14 that an additional liability should be shown in addition to the current IAS 19 deficit.
- For companies accounting under FRS 17, different rules apply; surpluses are restricted to reductions in future contribution and refunds already agreed with the trustees.
- IAS 19 applies to listed companies and FRS 17 to unlisted companies, including subsidiaries within a group structure.
Executive summary
- Many organisations have been using outdated mortality tables, with projections based on the 1926-1935 generation.
- Each extra year of life expectancy adds an estimated 3% to scheme liabilities, and moving to more realistic assumptions can increase liabilities to between 10%-20%.
- An option is to buy out liabilities with an insurance company. And reinsurers and banks are working on products that can hedge against longevity.
- Other developments include mortality catastrophe bonds, which protect against extreme mortality event risk, and longevity swaps, where payments are exchanged between counterparties depending on actual mortality versus a defined benchmark.
- IFRIC 14, which comes into effect in January 2008 could mean that additional funds paid into a pension scheme, perhaps because of increases in longevity, could be trapped, or could even create an additional liability on the balance sheet.
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