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How strong
is your lending covenant?
All too often lenders
are prepared to accept what they are
told about pensions but accurate and realistic assessment
is essential
When it
comes to lending money to a business or financing a corporate
transaction, it’s pretty important to be able to get a good feel for
its value to identify the risk exposure. There’s certainly a huge
amount of information available from a variety of sources, but for
most, the starting point is a set of company accounts which will
provide a reasonable picture of a company’s finances. But can you
rely on the figures where a company currently offers or has
historically offered a final salary pension scheme? All too often
lenders are prepared to accept what they are told about pensions
without further research and this can be a dangerous approach.
The audit standard FRS 17 has become increasingly accepted over
recent years, although there is still a significant divergence of
opinion about it, ranging from a necessary evil, to a pain in the
proverbials, to providing a useful measure of a potential liability.
If nothing else, at least it has given us a starting point from
which to identify the extent of any liability, how material it is
and to measure pension liabilities on a consistent basis between
companies – or has it?
There does now appear to be at least a general acceptance amongst
finance directors that it needs to be produced, possibly even in
some cases requiring some gentle persuasion from company auditors.
The question now, however, has moved from should it be produced to
just how accurate and consistent a measure of pension liabilities is
it? This question has become much more important over recent years
as FRS 17 has become more widely utilised as a measure to value
pension liabilities on everything from sales and purchase and
corporate lending, to setting scheme contributions. It has therefore
become more important than ever that an accurate and realistic
assessment is achieved.
There undoubtedly seems to be an element of blind acceptance among
finance directors and auditors that whatever they are provided with
on FRS 17 is a fait accompli without actually realising the degree
of standardisation which is employed by companies producing numerous
calculations and the potential level of variation in assumptions
which could be acceptably used. For most companies it is pretty much
a given that the assumptions used will not reflect the specific
position of the company involved.
Why is this an issue, I hear you cry? As I mentioned above, the FRS
17 figures are now used for numerous other purposes and primarily
because minor differences in the assumptions used can produce pretty
material differences in the final results.
By way of example, there are a number of key variables used in
calculating the FRS 17 figures, namely the assumed discount rate,
salary inflation and price inflation and if we look at published
sources in general, those around over the last 12 months have really
only varied by around 0.2%, 0.3% and 1% respectively. A couple of
other areas where assumptions need to be made, but in this case not
disclosed, are in relation to life expectancy and the commutation of
pension for tax free cash. There are undoubtedly very significant
differences in approach to these latter issues amongst actuaries
preparing FRS 17 figures. If we take a scheme with assets of about
£5m and liabilities pretty evenly distributed between actives,
deferreds and pensioners, we could reasonably see the scheme
deficiency vary by about £2m depending upon the assumptions used.
The assumptions used would range from a relatively weak basis to a
relatively strong basis but both sets of assumptions could certainly
be justified.
The difference in deficit of £2m for a business and its backers
could be very material, especially with results now being very
visible on the company balance sheet. This variability purely
represents movements in the liability values but there are also
potential variabilities in the calculation of the value of scheme
assets, particularly where insurance policies are involved.
It is important to recognise that it is the company directors who
have responsibility for their FRS 17 disclosures in their company
accounts and it seems wholly sensible to me that as part of the
process, the directors and financiers should be questioning their
actuary, possibly in conjunction with their auditor, over the
suitability of the assumptions used in their case and over what
flexibility, if any, is possible in their assessments.
Historically, primarily for convenience more than anything else, FRS
17 figures have tended to be carried out by the actuary advising the
pension scheme trustees, however this is not compulsory and there
may indeed be arguments in some cases for the figures either being
compiled by an independent actuary or for an independent actuary to
at least review the assumptions and make recommendations on their
suitability to the employer.
This is an area of very significant importance now for both the
company directors and lenders and needs to be given considerably
more attention going forward.
David Davison, director,
Spence & Partners,
tel: +44 (0) 141 331 1053,
e-mail: dd@spenceandpartners.co.uk, www.spenceandpartners.co.uk
