150bn to go backwards. LCP Accounting for Pensions 2017

Transcription

1 150bn to go backwards LCP Accounting for Pensions 2017

2 Over the last 10 years, FTSE 100 companies have paid around 150bn into their defined benefit pension schemes, but their accounting position has worsened. How has this happened? For further information please contact Bob Scott, Nick Bunch or the partner who normally advises you. This report may be reproduced in whole or in part, without permission, provided prominent acknowledgement of the source is given. This report is not intended to be an exhaustive analysis of company reporting under IAS19. Although every effort is made to ensure that the information in this report is accurate, Lane Clark & Peacock LLP accepts no responsibility whatsoever for any errors, or the actions of third parties. Information and conclusions are based on what an informed reader may draw from each company s annual report and accounts, and from other publicly available information. None of the companies have been contacted to provide additional explanation or further details. Lane Clark & Peacock LLP August LCP Accounting for Pensions 2017

3 Contents 4 Introduction From Bob Scott At a glance summary 8 Key findings The FTSE 100 accounting deficit How have companies been managing their pension commitments? Analysis of pension disclosures 34 Setting accounting discount rates LCP Treasury Model case study 36 Appendices FTSE 100 accounting disclosure listing FTSE 100 accounting risk measures 24 Key assumptions Life expectancy Discount rates and inflation Increases in pensionable pay LCP Accounting for Pensions

4 1. Introduction Welcome to our 24th annual survey of FTSE 100 companies pension disclosures. Since 2005, when the Pensions Regulator came into being, and particularly since 2008 in the wake of the financial crisis, companies have been pressed to pay ever higher contributions to fund their pension schemes. And FTSE 100 companies have responded to this pressure by contributing in excess of 150 billion to their pension funds over the past 10 years. IASB The International Accounting Standards Board Asset values have risen, from around 350 billion in 2007 to over 600 billion today, reflecting a healthy compound growth rate of over 6% pa, after allowance is made for net benefit payments of around 50 billion. And yet the accounts of FTSE 100 companies show that they still have a collective pensions deficit around 17 billion as at 30 June The reason for this is that liability values have grown even more quickly. And, if the IASB gets its way, IFRIC 14 could mean companies being required to disclose even larger pension liabilities on their balance sheets. For some companies, the increase in liability values has been remarkable. BT Group disclosed pension liabilities of 60 billion in its March 2017 accounts, up from 50 billion a year earlier. The same factors that have driven up liability values have also seen the cost of providing final salary pensions rise to unprecedented levels. A company that provides its employees with a traditional 1/60th scheme, with full indexation and survivors benefits, would face a current accounting cost in excess of 50% of salaries. Companies also face increased costs from other quarters, including the national living wage, the apprenticeship levy and, for those who have been paying minimum auto-enrolment contributions, an increase from 1% to 3% over the next two years in the required rate. Not to mention risks arising from the Brexit process. As a result, it is not surprising that companies are increasingly looking for ways to minimise the amount they are required to contribute in the short term to support their legacy defined benefit arrangements, and to optimise the way that their pension liabilities are presented in their accounts. To avoid over-stating their liabilities, we ve seen a number of initiatives to address this, including adopting new methods of setting accounting assumptions (see page 34), modifying assumptions about how long members will live, closing to further accrual and implementing non-cash solutions to provide security to pension schemes. 4 LCP Accounting for Pensions 2017

5 1. Introduction The debate continues as to whether people are saving enough. Whilst many companies no doubt wish to help all their employees save, some may be limited in what they can do. Meanwhile, the debate continues as to whether people are saving enough. Whilst many companies no doubt wish to help all their employees save, some may be limited in what they can do by the need to pay substantial amounts to cover the deficit in their defined benefit scheme and by the lack of an accepted middle ground pension arrangement that comes at an affordable cost. It is not only Frank Field who has expressed concern about shareholders getting a bigger slice of the cake than the pension scheme does. And, despite their persistent deficits, FTSE 100 companies were still able to pay four times as much in dividends in 2016 as they did in pension contributions. Indeed, if we exclude the 4.2 billion paid by RBS to its pension scheme as a one-off contribution, dividends were more than 5 times the pension contributions paid. Bugger the share price, what about this pension liability? Frank Field MP Looking just at companies with 31 December year-ends, 39 declared pensions deficits totalling 37 billion. Those same companies paid out 39 billion in dividends during Signs are that the Pensions Regulator will get tougher with companies that unduly prioritise their shareholders. Let's hope that any extra contributions that companies pay in future will have a bigger impact on the pensions deficit than in recent years. Bob Scott Partner Watch Bob Scott discuss the key findings of the report at vimeo.com/lcpactuaries/afp2017 LCP Accounting for Pensions

6 1. Introduction FTSE 100 pensions at a glance 150bn for funding levels to go backwards Over the last 10 years, FTSE 100 companies have paid around 150 billion into their defined benefit pension schemes bn surplus bn deficit See page 9 but the rise in liability values has meant that the net accounting position has worsened. Placing the blame on liability values Liability values rose by more than 85%. See page bn bn Deficit 2016 vs 2017 Accounting deficit in respect of UK pension liabilities Highest contribution amount ever Contributions by FTSE 100 companies into their defined benefit schemes bn 13.3bn 2017 to strong returns on bn The improvement in the net deficit is due assets and a record level of contributions. 17.3bn See page 9 See page 20 Pension schemes versus shareholders FTSE 100 companies paid four times as much in dividends in 2016 as they did in contributions to their defined benefit See page 21 pension schemes. See page 26 Assumed life expectancy falls 28 companies reduced their assumed life expectancy (on average the difference was half a year). 6 LCP Accounting for Pensions 2017

7 1. Introduction Switching from RPI to CPI The liability for FTSE 100 companies would be 30bn lower, if those using RPI for increasing benefits each year were able to switch to CPI. No traditional pensions for new employees 27 still provide traditional final salary accrual for a reducing number of their longest serving employees...but none offer this to new recruits. See page 32 See page 12 The DB vs DC savings gap The typical accounting cost of a traditional final salary pension scheme is now 55% 3% of salaries But for DC auto enrolment FTSE 100 companies will only have to pay a minimum of of salaries See page 12 Liabilities may be being overstated If the FTSE 100 were all to adopt the LCP Treasury Model to set their discount rate the combined accounting liability for pensions would reduce by 25bn See the case study on page 34 The trend to reduce investment risk The average allocation to equities has to reduce 28% 26% in 2015 to in 2016 Many of the FTSE 100 now also have significant hedging strategies in place in their pension schemes to protect against the impact of changes in bond yields. See page 15 LCP Accounting for Pensions

8 2. Key Findings In this report we have analysed 89 FTSE 100 companies reporting in companies have been excluded as they do not sponsor a material defined benefit pension scheme. A full list and summary details of the 89 companies key pension disclosures are set out in appendix 1. The information and conclusions of this report are based solely on detailed analysis of the information that companies have disclosed in their annual report and accounts and other publicly available information. We do not approach companies or their advisers for additional information or explanation. We have concentrated on the financial position of the defined benefit schemes in which the companies employees and former employees participate. Some companies offer post-retirement healthcare, which we have excluded from our analysis where possible. All of the companies analysed have reported under international accounting standards (IAS19 for pension costs) as currently required under EU regulations. It is not surprising that companies are increasingly looking for ways to minimise the amounts they are required to contribute in the short term to support their legacy defined benefit arrangements. Bob Scott Partner 8 LCP Accounting for Pensions 2017

9 2. Key findings The FTSE 100 accounting deficit We estimate that the combined FTSE 100 pension deficit in respect of UK liabilities was 17 billion at the end of June 2017, reflecting total IAS19 liabilities of 625 billion against assets of 608 billion. The chart below shows how the accounting deficit has developed over the past five years. Our figures include unfunded pension promises but exclude, where possible, the overseas pension schemes sponsored by FTSE 100 companies and any employee benefits other than pensions. We have also excluded the impact of any adjustment arising from balance sheet asset limits or funding requirements. 17bn the combined FTSE 100 pension deficit in respect of UK liabilities. Estimated IAS19 position for UK schemes of FTSE 100 companies 30 Jun 2012 Dec 2012 Jun 2013 Dec 2013 Jun 2014 Dec 2014 Jun 2015 Dec 2015 Jun 2016 Dec 2016 Jun billion Following the Brexit vote last year, the deficit increased to almost 80 billion at the end of August 2016 the highest level since 2009 before steadily reducing over the remainder of 2016 and the first half of Overall, this has resulted in the total net deficit reducing by 29 billion from the position at 31 July 2016 disclosed in last year s report. LCP Accounting for Pensions

10 2. Key findings Corporate bond yields Under IAS19, pension liabilities are valued by reference to the yield available on high quality corporate bonds all else being equal, this means that when yields fall, liability values increase and vice versa. The chart below shows how UK corporate bond yields have varied since the start of 2008, just prior to the height of the UK credit crunch. UK AA rated corporate bond yields 8% Nominal annual yield (% pa) 7% 6% 5% 4% 3% 2% 1% December December December December December December December December December December Source: iboxx In late 2008 the yield on the iboxx AA over 15 year corporate bond index peaked at more than 7.5% pa. However, since then there has been a steady fall in yields with the index hitting a low of just under 2% pa in August Although yields then rose sharply, the general downward trend began again in early bn has been paid by FTSE 100 companies into their defined benefit pension schemes over the past 10 years. This fall in bond yields has led to a sustained rise in liability values that has meant that many companies continue to disclose an IAS19 deficit despite paying significant amounts into their pension schemes. Ten years ago FTSE 100 companies had a net pension surplus of 12 billion, based on total UK accounting liabilities of 336 billion. Since then companies have paid over 150 billion into their pension schemes, but with liability values rising by more than 85%, they now find themselves with a net accounting deficit of 17 billion. 10 LCP Accounting for Pensions 2017

11 2. Key findings For individual companies, the impact could be very different depending on the level of hedging their pension schemes have in place. Most of the FTSE 100's pension schemes are now relatively well hedged against the impact of changes in bond yields on liability values, but very few will have had this hedging in place since Increasingly companies are looking for other ways to mitigate the increase in liability values when preparing their accounting disclosures for example, by adopting improved methods of setting their accounting assumptions, such as through LCP s Treasury Model for setting discount rates. See the case study on page 34 for further details. How have companies been managing their pension commitments? Reductions in defined benefit pension provision None of the companies we have analysed provide traditional final salary pensions to new employees. However, there are currently four FTSE 100 companies that provide some form of defined benefit pension provision as standard to new recruits: Croda International provides a career average revalued earrings (CARE) scheme. Diageo, Johnson Matthey and Morrisons all provide cash balance schemes. The following companies disclosed in their accounts that they had either closed their defined benefit pension schemes to future accrual, or planned to do so in the near future: ITV closed the defined benefit sections of its pension scheme to future benefit accrual with effect from 28 February Smith & Nephew closed its UK pension plan to future accrual in December 2016, resulting in a $44 million gain being disclosed in its 2016 accounts. Carnival announced that the multi-employer pension scheme it participates in was fully closed to future accrual in March In its 2017 accounts, Royal Mail has announced that it will close its pension scheme to future accrual with effect from 31 March 2018, by which point it expects its current surplus will have been fully used to meet additional benefit accrual. GKN has recently announced that it has closed its defined benefit pension scheme to future accrual. In addition, Marks & Spencer had previously announced that it would close its defined benefit scheme to future accrual during 2016 and Standard Life had announced that it would close its defined benefit pension plan to future accrual in April LCP Accounting for Pensions

12 2. Key findings After allowing for these changes, only half of the FTSE 100 continue to provide any form of ongoing defined benefit accrual to any of their UK employees, with the split of pension provision illustrated in the chart below. This shows that only 27 FTSE 100 companies continue to provide traditional final salary pensions to any of their UK employees. Number of FTSE 100 companies providing continuing defined benefit pension provision No defined benefit (DB) scheme Non-UK DB scheme only UK DB scheme closed to accrual UK DB scheme - traditional final salary UK DB scheme - final salary, with cap on salary increases UK DB scheme - non-final salary Even where companies are continuing to provide ongoing defined benefit accrual, this will be for a dwindling number of employees, as most companies closed their defined benefit pension schemes to new employees many years ago. Pension scheme closures to future accrual have been driven in part by the increasing cost of provided a defined benefit pension. The chart below illustrates how the IAS19 cost of accrual in a typical 60ths final salary scheme would have risen due to changes in yields and longevity assumptions over the last 8 years, with the cost more than doubling over this period. IAS19 cost of accrual in a typical 60ths final salary scheme 55% 50% 45% 40% 35% % of salaries 30% 25% 20% 15% 10% 5% 0% Jul 2009 Jul 2010 Jul 2011 Jul 2012 Jul 2013 Jul 2014 Jul 2015 Jul 2016 Jul LCP Accounting for Pensions 2017

13 2. Key findings We expect to see more closures of DB pension schemes in the coming years. However, as the number of employees in DB pension schemes continues to fall naturally - due to retirements and employee turnover - some employers may be willing to absorb the high cost for an increasingly small group of employees, rather than spend time and money on a formal closure exercise. Where companies have chosen not to close their pension schemes to future accrual, many have made other changes to limit the cost of the additional liabilities being built up: Babcock disclosed several changes to its pension schemes in its 2016 accounts, including a cap on pensionable salaries. In its 2017 accounts it stated that it will be consulting with employees of its two largest schemes on changes to better share costs. Centrica has introduced a reduced pensionable salary cap for two of its pension schemes resulting in an 80 million accounting gain. Member contributions have also been increased and inflationary increases for future pension accrual have been reduced to the lower of CPI inflation and 2.5% pa. Croda changed its UK pension scheme from a final salary basis to a career average revalued earnings (CARE) scheme with effect from April 2016, with pensionable earnings capped at 65,000 pa. In addition, indexation of pensions in payment for future accrual has been moved from RPI to CPI inflation. In October 2016 RBS announced that it would be increasing employee contributions in its UK defined benefit pension schemes by 2% of salary. As mentioned in previous Accounting for Pensions reports, in 2010 the Government changed the measure of inflation applying for statutory minimum increases to pensions from RPI inflation to CPI inflation. Depending on the precise wording of pension scheme rules, this resulted in an immediate one-off reduction to many companies' pension liabilities. Despite this change being announced more than seven years ago, the issue of which inflation measure to apply for pension increases continues. A number of court cases are currently in progress and International Airlines Group has recently lost legal action against the trustees of the British Airways pension scheme who granted a discretionary increase on top of the CPI inflation increase required by the rules. LCP Accounting for Pensions

14 2. Key findings Managing pension risk As well as stopping the build-up of further defined benefit pensions, FTSE 100 companies have been looking at ways of reducing the risk associated with the pensions that have already been promised to their current and former employees. Liability management exercises have been a relatively common way of achieving this in recent years. For example, under a pension increase exchange ( PIE ) exercise, pension scheme members are offered a higher level of pension in exchange for giving up some, or all, of the future increases that they would be entitled to thereby removing inflation risk from the pension scheme. These exercises can also result in a saving to the employer depending on the terms of the exercise. In 2016, two FTSE 100 companies disclosed that they had completed, or would shortly be completing, a pension increase exercise: During 2016 AstraZeneca carried out a PIE exercise which resulted in a 54 million past service credit being disclosed in its 2016 accounts. Vodafone disclosed that its main UK defined benefit scheme would be carrying out a PIE exercise between May and August As pension schemes mature and the time horizon for benefit payments decreases, companies and pension scheme trustees have typically looked to reduce the investment risks posed by the pension scheme. This is of increasing importance as schemes close to future accrual and ongoing contributions reduce because pensions and other benefits then need to be paid out of investment income or by realising assets. With increasingly complex investment strategies some of which are not fully explained in accounting disclosures it has become more difficult to split 14 LCP Accounting for Pensions 2017

15 2. Key findings FTSE 100 pension scheme assets into different asset classes. However, the general trend away from equities does appear to have with a modest movement of assets out of equities and into bonds and other asset classes during This is illustrated in the chart below. Overall asset allocation for FTSE 100 companies with December year-ends 100% 80% Other Bonds Equities 60% 40% 20% 0% Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 55% of pension scheme assets are now invested in bonds. Although this shows that around 55% of pension scheme assets are now invested in bonds, many pension schemes have used derivatives to put in place additional hedging to protect their funding position against changes in interest rates. LCP Accounting for Pensions

16 2. Key findings Pension risk disclosure Since we started our Accounting for Pensions survey 24 years ago, the reporting of pension risk in listed companies accounts has improved hugely. The revised disclosures required under the updated 2011 version of IAS19 have helped in this regard, but some companies are still not disclosing sufficient detail for informed investors to understand the level of pension risk they are running. For example Royal Dutch Shell has pension assets of over 60 billion but provides very little detail on how these assets are invested. The introduction of viability statements following updates to the Corporate Governance Code in October 2014 was expected to improve the prominence of disclosure of material pension risks in company accounts. However, in 2016 only four FTSE 100 companies referred to pensions directly in their viability statements this is despite some of these companies having a pension scheme which is larger than the size of the business. In 2016 only four FTSE 100 companies referred to pensions directly in their viability statements. 16 LCP Accounting for Pensions 2017

17 2. Key findings Analysis of pension disclosures The average pensions note runs to just under five pages, with most companies also having several paragraphs of pension commentary in the main body of their reports. The longest disclosures were made by National Grid, with 11 pages of its 2016 report dedicated to pensions, whilst BAE Systems, CRH and ITV all gave 10 pages of pensions information. Funding levels IAS19 takes a snapshot of the accounting surplus or deficit at the company s year-end and in most cases this is the number that appears on the balance sheet. However, in some cases, complex rules under IAS19 can result in a restriction on the asset recognised on the balance sheet where a pension scheme is in surplus, or a higher liability being recognised as a result of the funding agreement in place with the pension scheme's trustees. Of the companies we have analysed, 19 were affected by this issue in 2016, which is the same number as in Notably, in 2016 RBS changed its policy in this area and as a result disclosed an additional 3.0 billion liability on its balance sheet in respect of its main pension scheme. The International Accounting Standard Board is currently finalising amendments to this aspect of pensions accounting, which it expects to issue around the end of Depending on the details, this could result in material changes in the amount that companies need to disclose on their balance sheet in future. However, this complexity aside, of the 89 FTSE 100 companies with material defined benefit pension schemes: 31 disclosed that their funding level had improved since 2015; 25 disclosed an accounting surplus, compared to 27 last year; and 41 companies reported being less than 90% funded on an accounting basis at their 2016 year-end compared with 31 in FTSE 100 companies reported being less than 90% funded on an accounting basis. As was the case last year, Royal Mail disclosed the highest funding level 193% as at 27 March 2016, although this had decreased to a funding level of 164% at 26 March LCP Accounting for Pensions

18 2. Key findings Changes over 2016 The chart below shows how worldwide funding levels have changed over the year for the 52 FTSE 100 companies in our report which have December 2016 year-ends. Ratio of assets to IAS19 liabilities at end December (%) Number of companies December 2015 December under to to to to to or over The average reported IAS19 funding level for companies with December year-ends was 89% in 2016, representing a decrease from 94% in This change in funding position reflects a decrease in corporate bond yields (and an increase in liability values) for companies reporting at 31 December 2016, offset for the most part by strong investment returns. We have shown a similar chart for those companies with March year-ends below. Ratio of assets to IAS19 liabilities at end March (%) 9 8 March 2015 March 2016 March Number of companies under to to to or over 18 LCP Accounting for Pensions 2017 The average reported IAS19 funding level for these companies was 102% at March 2017 compared with 106% in 2016 and 103% in 2015.

19 2. Key findings Sources of deficits and surpluses For the 52 companies with December year-ends, worldwide deficits increased by 10.1 billion over This is illustrated in the chart below. IAS19 sources of deficits and surpluses for companies with December year-ends only ( billion) Factors incresasing deficit Factors decreasing deficit Benefits earned Contributions Net interest charged New assumptions & experience Overall movement in the deficit Investment experience & exchange rate differences Our analysis shows that contributions paid ( 13.0 billion) more than covered the net IAS19 value of benefits earned over the year ( 4.9 billion) and the total net interest charge ( 0.6 billion). However, increases in IAS19 liability values ( 74.5 billion), mainly caused by lower corporate bond yields, were only partially offset by strong investment returns ( 56.9 billion). Overall, this has led to an increase in deficits of 10.1 billion for these companies. Pension schemes in relation to their sponsoring companies The chart below shows the size of accounting liabilities relative to companies market capitalisations. The average FTSE 100 company s pension liability was 38% of its market capitalisation, which is an increase from 34% last year. Accounting liabilities as a proportion of market capitalisation (%) 38% is the average FTSE 100 company s pension liability as a percentage of its market capitalisation Number of companies under 5 5 to to to to to to to or over LCP Accounting for Pensions

20 2. Key findings Pension schemes continue to pose a very significant risk for certain companies. For example: BAE Systems had pension liabilities of more than 170% of its market capitalisation at its 2016 year-end, and the deficit in its pension scheme was 33% of the value of the company; International Airlines Group has pension liabilities of 268% of its market cap (although the deficit was only 7% of the company s value); and GKN had pension liabilities of 80% of its market cap, with the deficit representing 34% of the company s value. On average, pension scheme deficits were 4% of market capitalisation which is the same as in We have highlighted the 10 companies with largest liabilities and largest deficit compared to market capitalisation in appendix 2. What have companies done to tackle their deficits? 17bn is the level of contributions paid by FTSE 100 companies to their defined benefit schemes in the highest amount ever paid. FTSE 100 companies paid contributions totalling 17.3 billion to their defined benefit schemes in 2016 the highest amount ever paid. This follows 13.3 billion of contributions paid in 2015, 12.5 billion paid in 2014 and 14.8 billion paid in The chart below shows how company payments, including those to defined contribution pension schemes, have changed since We expect to see contributions to defined contribution schemes become a larger proportion of the total in future years, as the remaining employees with accrued defined benefit pensions retire and new employees are, in most cases, auto-enrolled into DC schemes. Employer contributions to pension schemes 25 Deficit contributions (defined benefit) Employer service cost (defined benefit) Employer defined contribution costs billion LCP Accounting for Pensions 2017

21 2. Key findings The increase in total contributions for 2016 is largely due to a 4.2 billion contribution made by RBS to its main UK pension scheme, which is the largest ever one-off pension payment made by a UK company. Overall, fewer than half of the FTSE 100 paid higher contributions during 2016 than in The 10 companies that paid the highest contributions to their defined benefit schemes are shown in appendix 2. BT Group and RBS were the only two companies to pay more than 1 billion into their DB schemes over their 2016 accounting year. These were also the only two companies to pay more than 1 billion in A comparison of how contributions to defined benefit schemes has compared to dividends is shown in the chart below. Employer contributions to DB pension schemes vs dividends 80 Contributions to DB pension schemes Dividends Dividends/pension contributions 6 billion Dividends / DB pension contributions Most companies pay contributions at a rate greater than the IAS19 value of benefits earned over the year. If IAS19 assumptions were borne out in reality, this excess would reduce the IAS19 deficit. LCP Accounting for Pensions

22 2. Key findings 19 companies paid contributions that were less than or equal to the IAS19 value of benefits promised over the year. These were: Ashtead Group, Morrisons, Next, Royal Mail, Schroders and Standard Life, which all disclosed an IAS19 surplus; and Associated British Foods, BHP Billiton, BP, ConvaTec Group, Informa, Micro Focus, Mondi Group, Royal Dutch Shell, Sage Group, Shire, Sky, Vodafone and Taylor Wimpey which all disclosed an IAS19 deficit. The chart below shows the length of time it would take for IAS19 deficits to be removed if companies paid contributions at the same rates as they did in 2016 and investments earned returns in line with the IAS19 discount rates. This is an artificial calculation as IAS19 is not a funding basis. Nevertheless it provides a way of comparing IAS19 deficits with the contributions paid. Expected time to pay off IAS19 deficits Number of companies or in surplus less than 5 years 5 to 9.9 years 10 to 14.9 years 15 to 19.9 years 20 years and over Pension schemes versus shareholders FTSE 100 companies paid four times as much in dividends in 2016 as they did in contributions to their defined benefit pension schemes. The following chart shows how pension deficits compare to dividends paid. Of the 63 FTSE 100 companies that disclosed a pension deficit in 2016, 24 disclosed a deficit that was greater than or equal to the dividends paid to their shareholders in However, in 23 cases, the 2016 dividend was more than double the deficit at the 2016 financial year-end, suggesting that these companies could pay off their pension scheme deficit relatively easily if they wanted to. The total deficit for these 63 companies was 53.4 billion, marginally lower than the total dividends paid of 54.8 billion. 22 LCP Accounting for Pensions 2017

23 2. Key findings Percentage of IAS19 deficit that could be paid off with dividends paid in accounting year (%) 20 Number of companies under to to to to to to to or over The chart below shows the company contributions paid over the 2016 and 2015 accounting years as a percentage of dividends distributed over these periods. In 2016, seven companies paid more contributions to their pension schemes than they distributed in dividends, compared to five of these companies in Contributions paid as a proportion of dividends paid (%) 45 Number of companies under to to to to to to to to to or over This is an area that has come under more scrutiny following the collapse of BHS. In its 2017 annual funding statement, The Pensions Regulator has stated that it will consider investigating schemes where there is a funding deficit and the total distribution to shareholders is higher that the level of contributions being paid to remove the deficit, unless: the deficit is expected to be removed over a relatively short period; and the scheme has a low risk investment strategy. LCP Accounting for Pensions

24 3. Key assumptions In this section we consider the various assumptions used to place a value on pension benefits under IAS19. Where a company operates pension schemes in more than one country, we have considered the assumptions used for the UK if separately given. Where a company has disclosed a range of assumptions, we have taken the mid-point. FTSE 100 companies have been modifying their assumptions about how long their pension scheme members will live, reflecting data that shows there have been more deaths in England & Wales in recent years than previously expected. Nick Bunch Partner 24 LCP Accounting for Pensions 2017

25 3. Key assumptions Life expectancy Under the IAS19 accounting standard, companies are required to disclose any significant actuarial assumptions and we would generally expect this to include mortality. 71 of 89 companies have provided sufficient information in their 2016 accounts for us to derive basic mortality statistics specifically the life expectancy for a man at age 65 in the UK. The same companies also provided this information in Of the remaining 18, all but BHP Billiton, ConvaTec, Croda, Old Mutual, Shire and Sky have provided either non-uk life expectancies, a range of life expectancies, or narrative description of their mortality assumptions. The following charts show the range of life expectancies assumed under IAS19 by FTSE 100 companies for males aged 65 on the balance sheet date. Life expectancy assumptions reported in 2016 UK males aged 65 on the accounting date 30 Number of companies or less 86 to to to to or above The average assumed age at death was 87.9 years, which is marginally lower than in these companies 2015 accounts where the average was 88.0 years. LCP Accounting for Pensions

26 3. Key assumptions In the last few years we have noted that the rate of increase in assumed life expectancy has been slowing and this trend has in To some extent this reflects UK mortality data which has shown there have been more deaths than expected in recent years. Whether this proves to be a long-term trend remains to be seen. 28 FTSE 100 companies lowered their assumed life expectancy for their scheme membership in In 2016, 28 companies disclosed lower assumed life expectancy for some or all of their scheme membership than in 2015, reducing their average assumption by 0.5 years. 30 companies disclosed higher life expectancy assumptions, adding 0.2 years on average. Research has shown that two of the main factors influencing life expectancies are socio-economic group and income. In this respect it is interesting to analyse the FTSE 100 companies assumed life expectancies by the sector in which the company operates. In the chart below the horizontal bars show the average assumed age at death for a UK male aged 65 for each sector. The vertical lines show the extent of the variation within each sector, which in most cases increases with the greater the number of companies within the sector. Life expectancy assumptions reported in 2016 split by sector UK males aged 65 on accounting date Age at death Healthcare: 3 companies Financials: 17 companies Oil & Gas: 1 company Utilities: 5 companies Basic Materials: 2 companies Telecommunications: 2 companies Consumer Services: 18 companies Consumer Goods: 10 companies Industrials: 13 companies This chart shows that the highest average assumed life expectancies are found in the healthcare and financials sectors. The lowest average assumed life expectancy was found in the industrials sector. 26 LCP Accounting for Pensions 2017

27 3. Key assumptions Future improvements in mortality As well as setting assumptions to estimate how long current pensioners will live on average, companies must also decide how life expectancies for future pensioners will change as a result of improvements in mortality. The allowance for future improvements can have a significant impact on the IAS19 value of pension scheme liabilities, and hence deficits. 69 companies disclosed enough information in their accounts to analyse how their allowance for future improvements in mortality has changed compared to The chart below shows the allowance that these companies have made for increases to life expectancy over the next 20 years. Additional life expectancy improvements reported in 2016 Improvements for UK male members aged 65 now versus aged 65 in 2036 Number of companies under 0.5 years 0.5 to 0.99 years 1 to 1.49 years 1.5 to 1.99 years 2 to 2.49 years 2.5 to 2.99 years Increase in life expectancy over next 20 years 3 to 3.49 years 3.5 years or over On average, these companies assumed that UK pensioners retiring at age 65 in 20 years time will live for 1.8 years longer than a pensioner retiring today. This is the same as for these companies in Overall, these companies decreased their average assumption for the life expectancy of a 65 year old in 2036 by 0.1 years, from an assumed age at death of 89.8 years in their 2015 accounts to 89.7 years in LCP Accounting for Pensions

28 3. Key assumptions Discount rates and inflation The discount rate is used to calculate a present value of the projected pension benefits. A lower discount rate means a higher IAS19 value of pension liabilities and vice versa. The typical FTSE 100 company has pension liabilities that are linked to price inflation. A decrease in the price inflation assumption will lead to a lower level of projected benefit payments, and hence a lower IAS19 value being placed on those benefits, all other things being equal. We have analysed the discount rates used by 43 companies and the RPI inflation assumption of 37 companies with a December year-end, together with the assumption for CPI inflation disclosed by 20 of these companies. Similarly, we have analysed the discount rates and the RPI inflation assumption of 15 companies with a March 2017 year-end, together with the assumption for CPI inflation disclosed by 9 of these companies. The results are summarised in the charts below. Discount rates Under IAS19, the discount rate should be based on high quality corporate bonds and the duration of the corporate bonds should be consistent with the estimated duration of the pension obligations. The yields on high quality corporate bonds, and hence the discount rates, will fluctuate from day to day in line with market conditions. Discount rates used in December 2015, December 2016 and March 2017 (% pa) Number of companies December 2015 December 2016 March under to 2.6 to 2.7 to 2.8 to to 3.0 to 3.1 to 3.2 to 3.3 to 3.4 to 3.5 to 3.6 to 3.7 to 3.8 to to 4.0 or 3.99 over 28 LCP Accounting for Pensions 2017

29 3. Key assumptions The average discount rate decreased markedly over the year, from 3.8% pa in December 2015 to 2.7% pa in December The average discount rate used by FTSE 100 companies with a March 2017 year-end was even lower at 2.5% pa. The spread of discount rates used by FTSE 100 companies with a December 2016 year-end has stayed the same compared to December 2015, with a 0.4% spread of rates at both dates. Hammerson disclosed the highest discount rate for a FTSE 100 company with a December year-end in their 2016 accounts (2.9% pa in 2016 compared to 3.8% pa in 2015). Aviva, HSBC, Pearson and WPP adopted the lowest discount rate of 2.5% pa. IAS19 requires companies to disclose the duration of their pensions liabilities, allowing us to compare the discount rates used against the duration of the scheme, as shown in the chart below. Discount rates used at 31 December 2016 by duration 4% Yield / discount rate 3% 2% 1% AA rated corporate bonds Discount rates 0% Duration Most companies use the same assumptions to value both past service and future service benefits. However, BP, GKN and ITV all disclosed the use of different assumptions to calculate the service cost item in their accounts, which represents the value of pension benefits accrued over the accounting year. By reflecting the longer duration of accruing benefits compared to accrued benefits, companies could assume discount rates that were, on average, higher by 0.1% pa. This meant they could disclose a lower service cost, and higher profits, than would otherwise have been the case. AstraZeneca announced in its 2016 accounts that it will be moving to a similar discounting along the curve approach from LCP Accounting for Pensions

30 3. Key assumptions In current market conditions, the use of a higher rate is arguably technically more correct on the basis that corporate bond yields generally increase as the term of the bond increases (illustrated in the chart on the previous page), and the duration of future service liabilities accruing for active members will be longer than the duration of the liabilities already accrued. Setting accounting discount rates See page 34 for our LCP Treasury Model case study. Inflation (RPI assumptions) The chart below shows long-term inflation assumptions as measured by the Retail Prices Index (RPI). The average RPI assumption of 3.3% pa in December 2016 and March 2017 was an increase from the average of 3.1% pa in December RPI inflation used in December 2015, December 2016 and March 2017 (% pa) 20 Number of companies December 2015 December 2016 March Under to to to to to to or over For December 2016 year-ends, the highest RPI inflation assumption was 3.6% pa, adopted by Reckitt Benckiser Group. At the other extreme 10 companies, AstraZeneca, BAE Systems, BP, Centrica, GlaxoSmithKline, International Airlines Group, Persimmon, Prudential, RBS and Unilever adopted assumptions of 3.2% pa. In general, the December 2016 RPI inflation assumptions had a similar spread to those used in LCP Accounting for Pensions 2017

31 3. Key assumptions The Bank of England has historically published statistics for future price inflation implied by gilt spot rates. These showed that long-term RPI inflation implied by 20 year gilt spot rates was around 3.7% pa at the end of December This suggests that, in order to justify an assumption much lower than this for future RPI inflation, companies may be allowing for a significant inflation risk premium. This represents the theoretical return that investors are willing to forgo when investing in index-linked gilts, in return for the inflation protection that these assets provide. In practice, it is the discount rate net of assumed future price inflation which is the key assumption. The chart below shows the difference between the discount rate and the assumption for RPI inflation (the net discount rate) for companies reporting as at 31 December 2015, 31 December 2016 and 31 March It shows that the net discount rate has decreased since December 2015, from an average of 0.7% pa to -0.6% pa at 31 December In March 2017 this had decreased again to -0.7% pa. Discount rates in excess of RPI inflation used in December 2015, December 2016 and March 2017 (% pa) 20 Number of companies December 2015 December 2016 March under to to to to to to to to to or over LCP Accounting for Pensions

32 3. Key assumptions Inflation (CPI) assumptions Since 2010 the statutory minimum increases that pension schemes must provide has been linked to the Consumer Prices Index ( CPI ) rather than RPI. Historically CPI has generally increased at a lower rate than RPI and is expected to do so in the future due to the different ways in which the two inflation indices are constructed. In practice the inflation measure applying in a particular pension scheme depends on the wording of the scheme rules and their interaction with the relevant legislation setting out minimum increases. Many companies have determined that some of the benefits in their pension scheme should increase in line with CPI inflation. As no significant market in CPI linked securities currently exists, market practice is to derive an assumption for future CPI inflation by deducting a margin from the assumed future level of RPI inflation. The chart below shows the range of margins used by companies in their December 2015, December 2016 and March 2017 year-end accounts, where such information was available. Difference in RPI and CPI inflation assumptions used in December 2015, December 2016 and March 2017 (% pa) 15 December 2015 December 2016 March 2017 Number of companies under to to to to or over 32 LCP Accounting for Pensions 2017

33 3. Key assumptions At 31 December 2016 the average margin was 1.0% pa which is unchanged from 31 December At 31 December 2016, Aviva, International Airlines Group, Persimmon, Provident Financial, Schroders, Rio Tinto, Rolls Royce and RSA used a long-term CPI inflation assumption of 1.1% pa below their RPI inflation assumption, the largest margin at that accounting date, whilst at 31 March 2017 BT Group has a long term assumption that CPI inflation would be 1.2% pa below RPI inflation. Increases in pensionable pay For schemes that still relate benefits to pay close to retirement, the assumed rate of growth in pensionable pay affects the disclosed IAS19 liability and the cost of benefits being earned. A lower assumption produces a lower projected pension and hence lower pension liabilities as well as a lower charge to operating income. The average assumption for increases in pensionable pay (in excess of the RPI inflation assumption) has reduced to 0% pa from 0.1% in Many companies now have caps on, or have even frozen, increases in pensionable salary and as a result disclosed a salary increase assumption lower than RPI inflation. Pensionable pay growth rates used in excess of RPI inflation (% pa) 30 Number of companies under to to to to to or over As the number of active members in final salary pension schemes has reduced, the assumption for salary growth has become less significant. LCP Accounting for Pensions

34 4. Setting accounting discount rates LCP Treasury Model case study In the current low yield environment, pension scheme figures have become increasingly material to company accounts. As a result, companies are increasingly scrutinising their pension figures to make sure that the methods and assumptions used are the most appropriate. In many cases, such a review can show that the accounts may be overly conservative, and more robust methods can lead to smaller liability values. The discount rate is the key assumption in pensions accounting and small changes in this assumption can have a huge impact on accounts. Accounting standards require that discount rate assumptions are based on the yields of high quality corporate bonds. Pension schemes are typically expecting to run for the next 80 years or so, yet there are few true corporate bonds available beyond 30 years. How this issue is resolved can lead to distorted discount rates, and make pension liabilities appear larger than they should. We have recently launched the LCP Treasury Model, an improved way to set accounting discount rates. Whereas a number of conventional models for this purpose are influenced by changes in gilt yields, the LCP Treasury Model is a robust model based solely on corporate bonds. Currently, the LCP Treasury Model reveals that typical discount rates are too prudent, by up to 0.3% pa. Whilst this may not sound much, we have already helped over 30 of our clients adopt the LCP Treasury Model with impacts relative to their original position including: reduction in value of reduction in 5% pension liabilities 10% P&L costs Each of the major auditing firms has accepted discount rates produced using the LCP Treasury Model for several of our clients (of course, as with all approaches, the situation is considered on a case by case basis and depends on each company s individual circumstances). What would change for the FTSE 100? Looking more widely at the position of the FTSE 100, if we were to assume that the FTSE 100 were all to adopt the LCP Treasury Model to set their discount rate: the combined accounting liability for pensions would reduce by around 25bn the aggregate level of surplus would move back to the levels seen in LCP Accounting for Pensions 2017

35 Progression of aggregate accounting deficit since June December June FTSE 100 deficit FTSE 100 deficit (using the LCP Treasury Model) Aggregate FTSE 100 deficit ( bn) If the FTSE 100 were all to adopt the LCP Treasury Model to set their discount rate the combined accounting liability for pensions would reduce by around 25bn. Jonathan Griffith Senior Consultant LCP Accounting for Pensions