contribute a set percentage of the employee’s salary. The money saved this way would be invested for the long term by the trustees of the scheme.
Under these schemes, employees could, for example, receive a pension that is equal to the number of year’s service, divided by (say) 80, multiplied by the best of the last three years’ salary. Pensions are often subject to inflationary increases year on year, subject to a set formula.
Whether the sums add up in the end is dependent upon a number of factors, including the following:
• The success or otherwise of the investments
• The longevity of the members receiving a pension
• The number of people leaving the scheme early
At any one time, it is possible to calculate the surpluses or deficits in the scheme by calculating the value of the investments on the one hand and actuarial liabilities on the other.
In the 1970s, salary-related pension schemes built up huge surpluses, because investment returns were good and people left their pension schemes to seek other jobs. In those days, if an employee had a relatively short number of year’s service, then that employee would receive only a return of his or her contributions on leaving the employment. Often, the amount returned was relatively small.
The most generous pension schemes (other than those for members of parlia- ment who encourage restraint upon everybody apart from themselves) were for those employed in the civil service. These were usually non-contributory (i.e.
the employee made no contribution) and inflation-proof. By the early 1980s, inflation was running riot and it was apparent to the government of the day that unless drastic action was taken they might have to default on pensions.
So, getting inflation down became a priority and as the dual objective was to reduce the power of the unions, the method chosen was to deliberately create a high level of unemployment. This meant that hundreds of thousands of people lost their jobs and with inflation coming down, many pension schemes saw their surpluses increase.
Some ‘entrepreneurs’ took advantage of this phenomenon. What they did was to look for honestly run companies that had built up surpluses in their pen- sion scheme. They then made audacious takeover bids for these companies arguing that the current management team was sleepwalking to nowhere.
Once these entrepreneurs had gained control, they had a wholesale culling of
employees aged 50 or more, paying allegedly generous redundancy payments.
This increased the surplus in the company’s pension scheme, which was then transferred to the company. The company’s pension scheme was therefore nei- ther in surplus nor deficit and the company had a pot of money that was used to pay a huge dividend. The company was then sold.
The reason they could do this was that there was no way that pension funds could be ring fenced. The company had a legal duty to pay pensions as they fell due in accordance with the terms of the scheme. If therefore they had to make good pension deficits legally, the other side of the coin was that they could take out surpluses.
The directors with higher scruples nevertheless could not see the point of having pension schemes with huge surpluses, so they took ‘holidays’. What this meant was that although the employees continued to contribute, the company did not. Of course, although the company again made contributions once the surplus was gone, what many had not thought of was that there were swings and roundabouts and that sometimes surpluses were required to cover future deficits.
It is true to say that governments’ refusal to pass legislation to ring-fence pen- sion schemes is one of the scandals of our time. A small number of companies have been forced into liquidation because they could not meet their pension liabilities, leaving pensioners will little or no pension after years of saving for one.
By the twenty-first century, many companies realised that the combination of no surpluses to carry forward in their pension scheme, reduced investment returns and people living longer meant that it was unlikely such schemes would ever move into surplus. So what they did was to close salary-related schemes to new employees and instead offer them a money purchase scheme. Under these schemes, both the employee and the employer make regular contributions, where neither party take a holiday. The money saved and then invested builds up a ‘pot’ that is then used to finance the employee’s pension. This time the pension fund is ring-fenced because there cannot be any surplus or deficit;
the pension is entirely dependent upon the value of the pot at the date of retirement.
companies at each year end must show details of their pension scheme showing both assets and liabilities.
On the assets side, companies show the amounts held in their pension scheme, comprising equities, bonds, gilts and cash, together with the expected return on these financial instruments. The liabilities are shown as the present value of the scheme’s liabilities, as computed by the company’s actuaries. Where liabilities exceed assets it means there is a deficit and companies show their funding plan to meet such deficit.
Companies sometimes address this deficit by making regular payments into their pension fund. When this happens, the payment will be shown in the Cash Flow Statement, but not in the Income Statement. There may be some charge somewhere in the Income Statement relating to pensions and pension liabilities, but often the disclosures are difficult to interpret. This is yet another reason why the Income Statement as presented under IFRS is not investor friendly as far as shareholders are concerned. Investors are primarily interested in ‘earnings’ defined as the profit available to them and it must be obvious that the net profit shown in the Income Statement does not belong to them if a chunk had to be paid out to reduce the deficit in the company’s pension scheme. However, at least such deficit is shown in the Balance Sheet, so it is now known. In Figure 3.1, note 5 demonstrates these fundamental changes.