UK Pensions - Accounting Standards Board's pension reform proposals: "Horrendous"

Proposals by the UK's Accounting Standards Board (ASB) to bring the annual volatility of pension scheme assets directly onto the balance sheet and to use a risk-free, rather than corporate, bond rate to discount occupational pension liabilities have been savaged by a leading figure in the UK pensions sector.

The ASB discussion paper proposed an end to the smoothing mechanism which currently allows the expected rate of return to iron out short-term volatility and instead report the actual returns onto companies' balance sheets as they happen - an approach which John Chilman, director of pensions at UK-based transport firm, First Group, described as, "horrendous".

Chilman has calculated that the introduction of a risk-free discount rate of either gilts or the swap rate, instead of AA corporate bonds, would increase liabilities by about 25% - or £600 million in the case of the £3.1 billion scheme - which when combined with the absence of smoothing would place a "massive, massive volatility" on First Group's P&L.

"The 6.2% yield you can expect from AA corporates is a million miles away from the 4.5% gilt yield that has been suggested by the ASB - and if this is put in place it could herald the closure of the remaining UK defined benefit pension schemes (DB). And to launch this proposal at a time of such market turmoil is simply ludicrous."

The director of pensions highlighted the decline in both corporate profits and the equity markets between 2000 and 2007, and the potentially fatal impact such an accounting standard would have had at this time.

"The FTSE halved in value between 2000 and 2003. If this happened again the impact on our pension schemes could be to reduce assets by £1 billion. The three main strands in our business had a combined EBITDA of about £400 million in 2007 - those two figures just don't add up."

The ASB declined to specify whether gilts or the swap rate should form the risk-free rate - a potentially significant difference given the 30 basis points wider spread found on swap rates. David Blower, technical director at the ASB, said that this had been left "deliberately vague", an approach he conceded had, "Created some comment in the industry."

"But at this stage we were simply trying to set-down some principles, and we believe that the rate used to discount liabilities shouldn't be at a rate which takes into account a risk premium."

In Chilman's view, the use of a risk-free rate to determine pension scheme liabilities would mirror the approach of pension buyout companies, therefore adding an extra incentive to companies looking to offload their DB schemes. This view was supported by Nigel Burton, director of pensions at buyout firm AIG Life.

"Clearly changes like the one proposed by the ASB will increase the level of pension scheme reserves and narrow the gap between the buyout and ongoing cost of maintaining a pension scheme. And the narrower the gap is, the more it will encourage corporate finance departments to consider this as an option.

Of course from a purely self-interested view, I think this is a good thing, but why should pension schemes use a relatively high corporate bond rate to value the cost of fixed liabilities that they have got to buy in future."

One area of the ASB paper, which could provide relief for pension schemes, is the proposal to only include current liabilities - and not the future salary increases, a facet of the prevailing International Accounting Standards Board's (IASB) pension accounting regime that Dutch pension funds have railed against recently.

Chilman welcomed this move, but argued that while it offset some of the increase in liabilities put forward by the ASB's proposed change in discount rate, its impact would be "negligible" in the broader context of the total liabilities.

Denmark's introduction of market-based solvency in 2001 created a massive distortion in the country's bond market, as insurers and pension schemes moved wholesale into fixed income instruments to meet regulatory requirements. Chilman posited that if the ASB proposals were accepted, even a market with much greater liquidity in these instruments, such as the UK, could follow a similar pattern.

"Unless the government decided to issue a large amount of long-dated debt at the same time, the yield on gilts and swaps could be depressed further, increasing liabilities even more - which is ultimately a doomsday scenario."