[A-List] Financial regulatory crisis: pensions accounting

[Keaney Michael]

The mighty bean-counter
New standards for pensions accounting will transform Europe's financial
landscape, writes John Plender
Financial Times: Feb 20 2002

Power is not something people normally associate with accountants. Yet
the European Union's financial services action plan has given them a
great deal of it by requiring EU-listed companies to use international
accounting standards by 2005.

Among other things this means that companies may have to adopt IAS 19,
an international version of the British standard FRS 17, which will
require UK companies to incorporate pension fund surpluses and deficits
fully in their accounts. A notable consequence is that the accountancy
profession will now have a profound influence in shaping Europe's
financial structure.

The explanation for this seemingly extravagant claim lies in eurozone
governments' response to changing demographics. The ageing of the
population ensures that the return on continental Europe's mainly
pay-as-you-go state pension schemes will be dismal for today's young
people.

Governments also know that the fiscal burden of supporting a growing
population of elderly folk will increase alarmingly between now and
2050. So greater reliance will be placed on pre-funded pensions, whereby
the workforce puts aside money in advance for retirement.

Optimists in the Anglo-American financial community believe the shift to
funding will encourage Europe's fledgling equity culture and provide
fund managers with a bonanza. Thanks to the accountants, they are almost
certainly mistaken.

According to Graham Bishop, an adviser to Schroder Salomon Smith Barney,
the threat of IAS 19 will ensure that few continental companies will
adopt defined benefit pension schemes, in which retirement incomes are
related to final pay and length of service. The risks in having to mark
pension funds to market values are simply too great.

So the big continental European economies will leapfrog the US and the
UK and invest from a low base in a defined contribution model, where
workers, not companies, will shoulder the investment risk. Mr Bishop
forecasts a fivefold increase in eurozone pension assets with a bias
towards bonds.

In the US, where a shift to defined contribution has gone further than
in the UK, the workers are more inclined to invest in bonds than are the
trustees of defined benefit schemes. Actuaries argue that a culture of
reckless caution may be replacing the equity culture there.

And it is certainly true that defined contribution pensions lend
themselves less readily to unquoted investments such as venture capital
or property. Note, in passing, that Gordon Brown, the chancellor,
worries about inadequate pension fund investment in venture capital. Yet
the shift to defined contribution exacerbates the problem.

If continental Europeans did expose themselves heavily to equities, the
outcome might not be very rewarding. Despite the bear market, yields on
equities in Germany, France and Italy respectively are low at 2.0 per
cent, 2.7 per cent and 2.8 per cent. On that basis, management costs
will absorb most or all of the funds' income unless governments restrict
charges, as the UK has done with stakeholder pensions. So unless equity
yields rise, pensioners will forgo the magic that compound arithmetic
works on dividends and be largely dependent on capital gains.

It might make more sense for eurozone governments to devote less effort
to boosting funded pensions than to raising retirement ages and
increasing workforce participation rates.

In the UK, which is only now following the US in pensions accounting,
companies are closing defined benefit schemes not only to new entrants
but also for existing members. The reason, once again, is the financial
risk, which is exacerbated by having to incorporate pension fund
deficits in the balance sheet. As John Ralfe, head of corporate finance
at the UK retail group Boots, has argued in these pages, investing in
equities is a form of double leverage for pension funds. It is the
equivalent of a company issuing a long-term bond and investing the
proceeds in other companies' shares - the formula that has torpedoed
Japan's banks.

The impact that this accounting change will have on the debt-equity
ratio of UK plc scarcely bears thinking about. Many pension funds are
over-exposed to equities in that their assets and liabilities are
mismatched. According to PwC, the consultants, 41 per cent of UK pension
fund liabilities relate to current employees, while 59 per cent relate
to pensioners, for whom bonds are regarded as the appropriate matching
asset. Yet 77 per cent of pension fund assets are still in more risky
equities.

Where pension funds are large in relation to the sponsoring companies'
market capitalisation, the whole nature of the company may need
rethinking because of the accounting standard. In an extreme case such
as British Airways, with a £10bn-plus pension fund and a market
capitalisation of £2.2bn, the company has been transformed at the stroke
of an accountant's pen into a highly leveraged investment trust with a
problematic sideline in air travel. Call it the bean-counters' revenge.

Full article at:
http://news.ft.com/ft/gx.cgi/ftc?pagename=View&c=Article&cid=FT3WQN92WXC
&live=true&useoverridetemplate=FTD1OUN2DNC&tagid=FTDNE3BOBNC&SectionTag=
na/column&PageTag=2cojopl&imgID=FT3L57JCCWC&useoverridetemplate=FTD1OUN2
DNC&SectionTag=na/column&PageTag=2cojopl&imgID=FT3L57JCCWC

Michael Keaney
Mercuria Business School
Martinlaaksontie 36
01620 Vantaa
Finland

michael.keaney at mbs.fi