Report: UK Needs New Pension Shortfall Measure

August 22, 2005 ( - New pension reporting mandated by a UK accounting rule may now show that many pension funds are deeply in the red, but that picture exaggerates shortages, according to a new report.

SEI Investments (Europe) Ltd said in a report written with Laurence Copeland, professor of finance at the Cardiff Business School, that an alternative measure based on firms’ cost of capital would erase deficits, Reuters reported.

Because the FRS 17 accounting standard is a too-rigid gauge of pension financial health, it should be axed, according to the report.

The rule, which became compulsory this year, uses AA-rated sterling corporate bond yields to discount future pension liabilities. When bond yields fall – as they have recently – the cost of buying bonds to offset future liabilities rises, increasing a pension plan’s deficit, the report claimed.

According to the SEI report, a key flaw with FRS 17 is that it values the pension element of a company’s balance sheet by setting it apart from all the other assets and liabilities of a firm.

SEI suggested that a better way to discount future liabilities would be to use a company’s weighted average cost of capital, which is based on the average cost of funds available to a company in the debt and equity markets. Using a WACC measure, SEI said companies listed on the FTSE 100 index would have no aggregate shortfall.