Social Housing Pension Scheme deficits and contributions explained

One of the issues with defined benefit pension schemes is that the scheme assets and scheme liabilities often do not move at the same pace or even necessarily in the same direction, despite the use of some sophisticated techniques to avoid undue volatility in some cases.

This leaves the net liability subject to unpredictable movements. So what has happened to the factors that will affect the valuation since 2014? Commentators have been forecasting an increase in the net scheme deficit, largely because of the continued fall in discount rates, which can have a significant effect on the liabilities.

“Changes in the contributions can dramatically affect operating surplus for housing associations.”

The usual approach to defined benefit accounting is to calculate a liability for the present value of the scheme liabilities and to measure the fair value of the scheme assets, giving a resultant net liability.

Net present value is a calculation applied to cashflows that occur in the future, in order to reflect the fact £1 is worth more today than £1 that is to be received in one year’s time, which is itself worth more than £1 that will be received in five years’ time, and so on.

In order to ‘discount’ future cashflows to their value right now (ie their ‘present value’), we apply what is called a ‘discount rate’. The higher the discount rate, the greater the reduction in the value of future cashflows when they are ‘discounted back’ to present value in a net present value calculation to reflect that time difference.

The movements each year are broadly split between financing costs, service costs and actuarial changes resulting from changes in assumptions (such as the discount rate and mortality rates applied to calculate the scheme liabilities).

At present, the SHPS defined benefit scheme is treated as defined contribution under Financial Reporting Standard (FRS) 102 because it is not considered that sufficient information is available to identify each employer’s share of the assets and liabilities of the scheme.

Instead, the SHPS deficit payments are discounted to a present value with movements caused by three factors: any change in planned contributions, changes in the discount rate and the unwinding of the discount.

Changes in the contributions following each triennial valuation can therefore dramatically affect operating surplus for housing associations in the year they are accounted for as a change in the liability.

Such volatility through operating surplus is quite unlikely when accounting as a defined benefit scheme.

This is an unfortunate effect of the current approach to SHPS and if the triennial valuation results in a significant increase in the required deficit payments, the implication is a charge to operating costs in the year that the new liability is accounted for.

“The effect on funders’ covenants will need to be considered.”

The discount rates used for these various calculations can have a significant effect and, despite hints of possible forthcoming interest rate rises (when has that not been suggested?), it looks likely that discount rates will be lower than in 2014 certainly.

For defined benefit schemes other than SHPS, we will have to wait and see how discount rates move up to March 2017.

The effect on funders’ covenants will need to be considered. If reserves, operating surplus or surplus for the year are involved, the definitions in the documentation will need to be considered.

Following the introduction of FRS 102, many will have been revised but previous documentation would require some subjective interpretations and discussions of what is required.

The Statement of Recommended Practice working party is trying to achieve a cost-effective solution to a move to account for SHPS as a defined benefit scheme, and this could be helpful as it will likely remove the operating surplus volatility.

The extent to which a change to defined benefit accounting would affect the liability recorded is unclear but could be significant.

If we were to look at the positive, could we argue a case for discount rates rising in future years? Maybe, but that has been predicted by economists for some time now and if we could predict the future life would be a lot simpler, if less exciting!

Steve Danby, audit manager, Mazars