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When is an Asset not an Asset? Demystifying the Pension

The ‘pension asset ceiling adjustment’ sometimes appears in the footnotes to accounts, as an adjustment to the balance sheet value of a pension asset or liability. However, it’s one of those quirky areas of accounting which isn’t well understood…why does a pension asset need a ceiling? And why is it sometimes also applied to pension liabilities?

What is the Asset Ceiling?

The aim of the pension asset ceiling is to make sure that a company’s balance sheet properly reflects how the value of any defined benefit deficit or surplus is affected by a pensions scheme’s rules and funding requirements. These rules and regulations can mean that the ‘normal’ calculation of a pension liability or asset – the difference between the fair value of the scheme assets and the present value of the projected benefit obligation (PBO) – is in adequate. This is particularly the case when the scheme rules state that any surplus in the scheme belongs to the scheme members[1], rather than the company.

To explain why this is, let’s look at the two possible effects that an asset ceiling can have on the balance sheet: (i) reducing a pension asset and (ii) increasing the size of a pension liability.

1. Reducing a Pension Asset

The fair value of the scheme assets and the present value of the PBO are volatile numbers. Therefore, at certain points in time, it is possible that the value of the scheme assets will exceed the value of the PBO. If the scheme rules state that the surplus in the pension scheme belongs to the scheme members, rather than the company, then an asset ceiling adjustment is required to prevent the company recognizing a pension asset on the balance sheet; this ‘asset’ doesn’t benefit the company in any way so it isn’t their asset to recognize.

For example, if a pension scheme has assets of 120, the value of the PBO is 100 and the scheme rules state that any surplus belongs to the scheme members then the pension disclosures in the notes would show:

So, in this example, the asset ceiling prevents the company from recording a pension asset in the balance sheet, as the surplus doesn’t ‘belong’ to the company.

2. Increasing the Size of a Pension Liability

Pension regulation in most countries (including the UK and US) requires periodic assessment of pension scheme funding (typically every 3 years). If the scheme is underfunded, the company is required to commit to additional funding payments over a number of years to eliminate the deficit (this is often referred to as a recovery plan).

However, in the years between the funding assessments, changes in the value of the scheme assets or the value of the PBO may result in the committed recovery payments exceeding the size of the pension deficit. If the scheme rules prevent the company from avoiding these payments AND any surplus in the pension scheme belongs to the scheme members, rather than the company, then the asset ceiling would increase the size of the pension liability to reflect the PV of the remaining recovery payments, as these are now considered onerous payments.

For example, let’s assume a company has scheme assets of 80 and a PBO of 140 at its funding valuation (i.e. a funding deficit of 60) so has agreed to recovery payments of 20 per year for the next 3 years. The scheme rules state that recovery payments cannot be avoided once committed and any scheme surplus belongs to the scheme members.

A year later, the pension deficit falls to 30 as the scheme assets have increased in value (and also because the company has made its first recovery payment), but the company is still committed to making the remaining recovery payments of 40. The pension disclosures in the notes would show:

So, in this example, the asset ceiling ensures that the balance sheet liability reflects the value of the future pension payments, if this is higher than the value of the scheme deficit.

Why Does the Asset Ceiling Affect Some Companies but Not Others?

There are two reasons for this. Firstly, remember that the asset ceiling will only have an effect when the scheme is already in surplus, or the current recovery plan would result in a surplus. This situation is surprisingly common at the moment, with many pension assets benefiting from buoyant equity markets, whilst the companies are still locked in to punitive recovery plans agreed during the QE program.

Secondly, it’s important to note that the asset ceiling applies only where a surplus ‘belongs’ to the scheme members. If the scheme rules allow the company to benefit from the surplus, then the asset ceiling would not be relevant – hence why the asset ceiling will affect some companies but not others.

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[1] We have simplified the terminology here – the accounting standard actually refers to whether or not the company can obtain any ‘economic benefits in the form of refunds from the plan or reductions in future contributions to the plan’.

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