Pension scheme financial reporting – a way forward? April 2017 Document Classification – KPMG Public Introduction to Pension scheme financial reporting – A way forward We are now into our second year of financial reporting for pension schemes under FRS 102 and the revised SORP. The changes introduced in 2015 were the most significant in the last 30 years and I am sure many will welcome the relative calm of second year reporting compared with the somewhat unchartered and choppy waters of first year adoption. This is helped by there being no new requirements for the 2017 reporting season compared to 2016. So this publication is not an update on our full pension scheme accounts guide publication and is not intended to be a comprehensive set of example accounts. Instead we have taken the opportunity to take stock of how the changes went, taking feedback from pension scheme accountants, pension managers and trustees. In a nutshell, some thought the changes were a step in the right direction; others that the new disclosures were too lengthy; and some felt that the changes had not made pension accounts more relevant to users. And this is the big challenge, how to make pension accounts more relevant and useful. The introduction of FRS 102 and the revised SORP has given us the opportunity to go some way to meet this challenge. We now have a more principles based standard in FRS 102 and the SORP provides options in a number of areas. Compared to the strict statutory disclosure regime we have worked under for many years we now have greater flexibility. Therefore this publication seeks to take the first step in exploring this flexibility, building on pension disclosures we have seen emerging combined with best practice in general financial reporting whilst seeking to make the content of the financial statements more relevant to trustee investment strategy. We have done this by: — Adopting a format for the notes to the financial statements that groups disclosures by common area, for example all information about contributions is contained in one note covering accounting policies, numerical analysis and SORP disclosures; — Disclosing investment market risks by reference to trustee strategic portfolio allocations at a summary level; and — Distinguishing the disclosure of investment market risks from investment credit risks on the basis that market risks relate to fair value and cash flow exposures whereas credit risk relates to security of investments. We have not prepared this publication to promote further change in the short term, but to stimulate discussion and debate which we hope will eventually lead to further improvements in pension scheme financial reporting. However, if you did want to adopt some or all of the disclosures herein we believe they meet the requirements of FRS 102 and the SORP. I hope you find this publication of interest. Kevin Clark Associate Partner Document Classification – KPMG Public © 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. ABC Pension scheme Fund account Notes Total Total 2018 2017 £’000 £’000 Contributions receivable: 3 employer 6,786 66 employee 70 400 Individual transfers in 18 7 Other income 25 - 6,899 473 Benefits payable 4 (10,730) (9,629) Payments to and on account of leavers (80) (106) Other payments (38) (37) Administrative expenses (36) (41) (10,884) (9,813) Net (withdrawals) from dealings with members (3,985) (9,340) Investment income 5 4,587 3,574 Change in market value of investments 7.5 7,683 536 Investment management expenses (378) (381) Taxation 6 (14) (12) Net return on investments 11,878 3,717 Net increase/(decrease) in the fund during 7,893 (5,623) the year Net assets of the scheme at 6 April 73,844 79,467 Net assets of the scheme at 5 April 81,737 73,844 The notes on pages X to X form part of these Financial Statements. Document Classification – KPMG Public 1 © 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. ABC Pension scheme Statement of Net Assets (available for benefits) At 5 April 2018 Notes 2018 2017 £’000 £’000 Investment assets: 7.5 Equities 20,636 17,411 Bonds 48,306 44,224 Property 4,700 3,844 Pooled investment vehicles 7.6 7,386 7,685 Derivatives 7.7 355 345 AVC investments 7.10 316 260 Cash 27 26 Other investment balances 7.9 407 314 82,133 74,109 Investment liabilities: Derivatives 7.7 (25) (13) Other investment balances 7.9 (400) (307) Total investments 81,708 73,789 Current assets 67 152 Current liabilities (38) (97) Total net assets of the Scheme at 5 April 81,737 73,844 The notes on pages X to X form part of these Financial Statements. The Financial Statements summarise the transactions of the Scheme and deal with the net assets at the disposal of the Trustees. They do not take account of obligations to pay pensions and benefits which fall due after the end of the Scheme year. The actuarial position of the Scheme, which does take account of such obligations, is dealt with in the Report on Actuarial Liabilities included on page […] and these Financial Statements should be read in conjunction with that Report. Signed for and on behalf of the Trustees of the ABC Group Pension Scheme on 16 September 2018. A Rook B Dane Document Classification – KPMG Public 2 © 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Notes (Forming part of the financial statements) 1 Basis of preparation The Financial Statements have been prepared in accordance with Financial Reporting Standard 102 – the Financial Reporting Standard applicable in the UK and Republic of Ireland issued by the Financial Reporting Council and with the guidance set out in the Statement of Recommended Practice (SORP) (revised November 2014). 2 Core Accounting policies i. The accounts are prepared on an accruals basis. ii. The functional and presentational currency of the Scheme is Sterling. Balances denominated in foreign currencies are translated into Sterling at the rate ruling at the year-end date. Asset and liability balances are translated at the bid and offer rates respectively. Transactions denominated in foreign currencies are translated at the rate ruling at the date of the transaction. Differences arising on investment balance translation are accounted for in the change in market value of investments during the year. 3 Contributions receivable The Scheme closed to future accrual from 6 April 2017 and normal contributions have therefore ceased. Deficit funding contributions are being paid by the Employer into the Scheme for a period of three years in accordance with a recovery plan in order to improve the Scheme’s funding position. The amounts to be paid are: 2018: £6,786,000; 2019: £5,800,000; 2020: £5,800,000. Accounting policies: i. Employee normal contributions are accounted for when deducted from pay, with the exception of contributions deducted from auto-enrolled members during the opt out period which are accounted for on the earlier of receipt or the expiry of the opt out period. Employer normal contributions which are expressed as a rate of salary are accounted for on the same basis as employees’ contributions, otherwise they are accounted for in the period they are due under the Schedule of Contributions. ii. Employer deficit funding contributions are accounted for on the due dates on which they are payable in accordance with the Schedule of Contributions and Recovery Plan under which they are being paid. Contributions receivable comprise: 2018 2017 £’000 £’000 Employer: Normal - 66 Deficit Funding 6,786 - Members: Normal - 331 Additional Voluntary Contributions 70 69 6,856 466 Document Classification – KPMG Public 3 © 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Employer normal contributions include £nil (2017: £49,000) of contributions payable to the Scheme under salary sacrifice arrangements made available to certain members by the Employer. Current assets include £50,000 (2017: £40,000) of contributions due from the Employer. 4 Benefits payable Benefits payable comprise benefits due to Scheme members and their dependents under the Deed and Rules of the Scheme. These comprise mainly monthly pensions and lump sums on retirement. Taxation arising on benefits paid or payable is in respect of members whose benefits exceeded the lifetime or annual allowance and who elected to take lower benefits from the Scheme in exchange for the Scheme settling their tax liability. Accounting policies: i. Benefits are accounted for in the period in which they fall due for payment. Where there is a choice, benefits are accounted for in the period in which the member notifies the Trustees of their decision on the type or amount of benefit to be taken or, if there is no member choice, they are accounted for on the date of retirement or leaving. ii. Opt outs are accounted for when the Scheme is notified of the opt out. iii. Individual transfers in or out are accounted for when paid or received which is normally when member liability is accepted/discharged. Benefits payable comprise: 2018 2017 £’000 £’000 Pensions 10,345 9,379 Commutations and lump sum retirement benefits 245 250 Purchase of annuities 45 - Lump sum death benefits 75 - Taxation where lifetime or annual allowance exceeded 20 - 10,730 9,629 Current liabilities include £25,000 (2017: £35,000) in respect of benefits payable to members. 5 Investment income Investment income comprises mainly dividends from equities and interest on bonds held directly by the Scheme. Investment income arising from the underlying investments of pooled investment vehicles is rolled up and reinvested within the pooled investment vehicles. This is reflected in the unit price and reported within ‘Change in Market Value’. Investment income includes interest bought and sold on bond transactions. Accounting policies: i. Dividends from quoted securities are accounted for when the security is declared ex-div. ii. Rents are earned in accordance with the terms of the lease. iii. Interest is accrued on a daily basis. iv. Investment income is reported net of attributable tax credits but gross of withholding taxes which are accrued in line with the associated investment income. Irrecoverable withholding taxes are reported separately as a tax charge. Document Classification – KPMG Public 4 © 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Investment income receivable comprises: 2018 2017 £’000 £’000 Dividends from equities 1,413 379 Income from bonds 3,074 3,087 Net rental income 99 107 Interest on cash deposits 1 1 4,587 3,574 Net rental income is stated after deduction of £10,000 (2017: £10,000) of property related expenses. 6 Tax The ABC Group Pension Scheme is a registered pension scheme for tax purposes under the Finance Act 2004. The Scheme is therefore exempt from taxation except for certain withholding taxes relating to overseas investment income. Tax charges are accrued on the same basis as the investment income to which they relate (see Note 5(iv) above). 7 Investments 7.1 Strategy The main investment objective of the Scheme is to maintain a portfolio of suitable assets of appropriate liquidity which will generate investment returns to meet, together with future contributions, the benefits payable under the Trust Deed and Rules as they fall due. The Trustees set the investment strategy taking into account considerations such as the strength of the Employer covenant, the long term liabilities and the funding agreed with the Employer. The investment strategy is set out in its Statement of Investment Principles (SIP). The current strategy is to hold broadly: — 60% in investments that move in line with the long term liabilities of the Scheme. This is referred to as Liability Driven Investment (LDI) and comprises UK and overseas government and corporate bonds and interest rate swaps the purpose of which is to hedge against the impact of interest rate movement on long term liabilities. — 40% in return seeking investments comprising UK and overseas equities, equity futures, investment property, hedge funds and private equity. — 15% of the above in overseas currencies. To achieve this the Trustees have put in place a currency hedging strategy using forward foreign exchange rates. The actual allocations of investments measured at fair value will vary from the above due to market price movements and intervals between rebalancing the portfolio which takes place quarterly. Actual allocations at the Scheme’s year-end are shown below: 2018 2017 % % LDI portfolio 63 64 Return Seeking portfolio 37 36 100 100 Overseas Currency exposure 17 14 Document Classification – KPMG Public 5 © 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. The Trustees have authorised the use of derivatives by their investment managers for efficient portfolio management purposes as part of their investment strategy for the Scheme. 7.2 Investment risks FRS 102 requires the disclosure of information in relation to certain investment risks. These risks are set out by FRS 102 as follows: Market risk: this comprises currency risk, interest rate risk and other price risk. — Interest rate risk: this is the risk that the fair value or future cash flows of a financial asset will fluctuate because of changes in market interest rates. — Other price risk: this is the risk that the fair value or future cash flows of a financial asset will fluctuate because of changes in market prices (other than those arising from interest rate risk or currency risk), whether those changes are caused by factors specific to the individual financial instrument or its issuer, or factors affecting all similar financial instruments traded in the market. — Currency risk: this is the risk that the fair value or future cash flows of a financial asset will fluctuate because of changes in foreign exchange rates. Credit risk: this is the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation. The Scheme has exposure to these risks because of the investments it makes to implement its investment strategy. The Trustees manage investment risks, including credit risk and market risk, within agreed risk limits which are set taking into account the Scheme’s strategic investment objectives. These investment objectives and risk limits are implemented through the investment management agreements in place with the Scheme’s investment managers and monitored by the Trustees by regular reviews of the investment portfolios. Further information on the Trustees’ approach to risk management and the Scheme’s exposures to market and credit risks are set out below. This does not include AVC investments, as these are not considered significant in relation to the overall investments of the Scheme. a. Market risk A summary of Scheme market risk exposures by strategic asset allocations is set out below: 2018 2017 Market risk Foreign £’000 £’000 Interest rate risk Other price risk exchange risk LDI portfolio 51,173 46,929 Return seeking 30,219 26,600 portfolio Total investments 81,392 73,529 Significant exposure Some exposure No exposure Document Classification – KPMG Public 6 © 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. i. Interest rate risk Interest rate risk arises principally in relation to the LDI Portfolio. The LDI Portfolio comprises investments whose value changes with interest rates changes and is intended to match changes in member liabilities. ii. Other price risk Other price risk arises principally in relation to the Scheme’s Return Seeking Portfolio. The Scheme manages the exposure to other price risk by constructing a diverse portfolio of investments across various markets. iii. Currency risk The Scheme is subject to currency risk because some of the Scheme’s investments are held in overseas markets. The Trustees limit overseas currency exposure through a currency hedging policy. At the year-end, the unhedged proportion of Scheme net assets held in currencies other than Sterling was 15% (2017: 10%). b. Credit risk The Scheme is subject to credit risk as the Scheme invests in bonds, OTC derivatives and has cash balances. The Scheme also invests in pooled investment vehicles and is therefore directly exposed to credit risk in relation to the instruments it holds in the pooled investment vehicles and is indirectly exposed to credit risk arising on the financial instruments held by the pooled investment vehicles. Analysis of direct credit risk 2018 Investment grade Non-investment grade Unrated Total £’000 £’000 £’000 £’000 Bonds 30,500 17,806 - 48,306 OTC Derivatives 255 - - 255 Cash 27 - - 27 PIVs - - 7,386 7,386 30,782 17,806 7,386 55,974 2017 Investment grade Non-investment grade Unrated Total £’000 £’000 £’000 £’000 Bonds 31,548 12,676 - 44,224 OTC Derivatives 260 - - 260 Cash 26 - - 26 PIVs - - 7,685 7,685 31,834 12,676 7,685 52,195 Credit risk arising on bonds held directly or through pooled investment vehicles is mitigated by investing in government bonds where the credit risk is minimal, or corporate bonds which are rated at least investment grade. Credit risk arising on derivatives depends on whether the derivative is exchange traded or over the counter (OTC). OTC derivative contracts are not guaranteed by any regulated exchange and therefore the Scheme is subject to risk of failure of the counterparty. The credit risk for OTC swaps is reduced by collateral arrangements (see note 7.7 (i)). Credit risk also arises on forward foreign currency Document Classification – KPMG Public 7 © 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. contracts. There are no collateral arrangements for these contracts but all counterparties are required to be at least investment grade. Cash is held within financial institutions which are at least investment grade credit rated. The Scheme’s holdings in pooled investment vehicles are unrated. Direct credit risk arising from pooled investment vehicles is mitigated by the underlying assets of the pooled arrangements being ring-fenced from the pooled manager, the regulatory environments in which the pooled managers operate and diversification of investments amongst a number of pooled arrangements. Trustees carry out due diligence checks on the appointment of new pooled investment managers and on an ongoing basis monitor any changes to the regulatory and operating environment of the pooled managers. An analysis of pooled investment vehicles by type and legal nature is given in note 7.6. 7.3 Investment Fair Value Hierarchy The fair value of financial instruments has been determined using the following hierarchy: Level 1: the unadjusted quoted price in an active market for identical assets or liabilities which the entity can access at the measurement date; Level 2: inputs other than quoted prices included within Level 1 which are observable (i.e. developed using market data) for the asset or liability, either directly or indirectly; Level 3: inputs which are unobservable (i.e. for which market data is unavailable) for the asset or liability. A fair value measurement is categorised in its entirety on the basis of the lowest level input which is significant to the fair value measurement in its entirety. Investment Fair Value accounting policies: The approach to fair value determination in accordance with the above hierarchy for the main investment types is: i. The majority of listed investments are stated at the bid price at the date of the Statement of Net Assets. ii. Fixed interest securities are stated at their clean prices. Accrued income is accounted for within investment income. iii. Unquoted securities are included at fair value estimated by the Trustees based on advice from the investment manager. iv. Pooled investment vehicles are stated at bid price for funds with bid/offer spreads, or single price where there are no bid/offer spreads as provided by the investment manager. v. Properties are included at open market value as at 5 April 2016 determined in accordance with the Royal Institution of Chartered Surveyors’ Appraisal and Valuation Standards and the Practice Statement contained therein. The properties have been valued by George and Co Ltd, Chartered Surveyors, who have recent experience in the locations and class of the investment properties held by the Scheme. vi. Exchange traded derivatives are valued using market quoted prices. vii. Over the counter (OTC) derivatives are valued using pricing models and relevant market data as at the year-end date Document Classification – KPMG Public 8 © 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.