Pension schemes are complex. We help to clarify how they are affected by interest rate changes and how you can recognise a surplus when it arises.
Throughout 2022, we saw the vast majority of defined benefit schemes improve their solvency position. This was largely driven by rising discount rates.
But a common misconception among companies and users of financial statements is that these pension surpluses are a full asset of the company.
The balance sheet can appear to show them as an asset, and indeed it does show a much better position for companies than previous deficits. But it’s important to make clear in the financial statements that this surplus is only on the basis that the pension scheme continues until final payment is made to the final member in the scheme – and the length of these schemes can differ and sometimes extend far out into the future.
It’s also vital to note that the scheme liabilities represent a ‘best estimate’ of the cost, at a certain point in time, to provide the benefits due to the members of the pension scheme. This usually assumes that investment returns are in line with corporate bond yields, estimated at around 1% per annum above gilts.
There is always a possibility that in the future; the ongoing time, costs and risk of the scheme will exceed the potential cost of passing the pension scheme on to an insurer. Companies, in collaboration with pension scheme trustees, need to consider their long-term target and ensure they retain sufficient expected investment returns within their asset portfolio to bridge the gap between being fully funded and, for example, the cost of passing the scheme to an insurer without the need for additional contributions. Alternatively, companies may wish to continue to underwrite investment risk with the intention of extracting surplus from the pension scheme and potentially increasing shareholder value.
Why are interest rate increases leading to a scheme surplus?
Defined benefit pension schemes have commitments which may not be fulfilled until many years later. The pension sponsor must ensure that the fund will have sufficient assets to make benefit payments as and when they arise, up until the last member of the scheme dies or transfers out.
The scheme actuary will determine the value of its assets and liabilities at a point in time. Where the scheme’s assets exceed the value of the liabilities, it is said to be in a ‘surplus’. The actuary will discount the value of future liabilities to present value by using a rate linked to interest rates. So an increased interest rate means that the discounted liabilities will decrease.
It’s also worth noting that defined benefit schemes in recent history have been working to offset the impact of low interest rates on the value of the discounted liabilities. They have been increasing up-front contributions to meet long-term obligations and changing their investment strategy. Therefore, the increased scheme asset positions arising from the higher interest rates and as a result the reduction in the discounted liabilities have led to significant scheme surpluses.
When can you recognise a surplus on the balance sheet?
IFRIC 14 provides details of when a surplus can be recognised. It limits the recognition of a surplus to cases where the company can derive economic value from that surplus. This means it must have an unconditional right to the surplus. It all comes down to a ‘run-off argument’, based on it being within a company’s control to run the pension scheme until all benefits have been paid.
If the company does have an unconditional right to the surplus, this should be shown on the balance sheet. If not, then no surplus can be shown and IFRIC 14 requires the company to go one step further. It must recognise an additional liability on its balance sheet for all deficit contributions promised to its pension plans, but from which it cannot derive economic benefit.
What are your next steps?
Identify the risks of any trapped scheme surplus – can you demonstrate there is an unconditional right to a surplus?
Identify the scale of potential issues – considering both legal and financial aspects of a scheme surplus.
Identify any potential uses of the surplus – there will be different preferences from the employer, members and trustees.
Identify the preferred use of any surplus – ensuring there is common ground between the employer and the trustees who must act in the best interest of the members.
For more information about any of the issues raised in this article, please contact Nick Joel.