The finances of the European Patent Office - Merpel takes a look

Merpel was in the process of deciding between duck with animal derivative sauce and fisherman’s feast when another type of derivative caught her eye.  Leaving her saucy decision to the side, she though she’d paw through the 2013 financial statements of the European Patent Office. Readers can find them here [pdf].

How does the EPO have a balance sheet of a small profit, larger comprehensive income, assets of nearly €8 bn and liabilities of €12.4 bn?  The answer boils down to its pensions liability. All of this is of great interest to EPO employees and contracting states.

Unlike the occasional bank, the EPO cannot go bankrupt, as contracting states are obliged to finance any deficit. Renewal fees from EPO granted patents contribute the majority of many offices’ revenues.   For national offices, the EPO is both a major source of income and possibly their biggest liability.

Employees are no doubt interested, as recent strikes demonstrate, and the true financial position of the EPO has been an issue in contention in the current employee unrest.  EPO employees are also in an unusual position where they are highly skilled but have few non-EPO employment options.

Pensions

How did the EPO get to this position?  In 2009, the defined benefit liability (which includes pensions) was only €5.9 bn (even in 2013 Euros, that is only €6.8 bn) compared to the current estimate of €11.1 bn.

Projecting the gains and losses associated with the pension’s liability is an art, not a science (Merpel sniffs at this as her crystal ball always predicts when dinner will arrive.)  There are assumptions and uncertainties in financial projections that can change. For example, an increase in one month of life expectancy at retirement age increases the EPO’s pensions liability by nearly €11 million (this perplexes Merpel, surely every cat has nine lives?)

However, the answer lies in discount rates. The main change between estimates in 2009 and 2013 is that the discount rates used to value future pension obligations dropped from 5.3% in 2009 to 3.9% in 2013.

 How are these magical discount rates set?  The EPO uses actuaries who calculate rates using the interest rates of corporate bonds.  In the aftermath of the 2008 financial crisis, governments began dropping their interest rates and corporate returns followed.  Quantitative easing kicked in, returns dropped further and we now have ballooning pensions deficits across Europe.

For readers who drifted off in the last paragraphs, here is the headline: investment returns have gone way down, so the amount of money need to fund future payments (pensions) has gone way up.

Renewal fees

Unusually, the EPO cannot include future renewal fees in its statements.  This is despite the fact that renewal fees, not procedural fees, cover the costs for EPO-granted patents. However, renewal fees are not a legal obligation and are not counted in all statements.  At the same time, the EPO is required to take them into account when setting its procedural fees.  The 2013 statement estimates future renewal fees as €3.5 bn.

Merpel thinks this is a tricky situation to be in, but it is probably fine as long as patent applications continue to increase.  She also sees this as prudent, as Tesco’s strategy of timing costs and incomes has made her rethink her sardine supplier.

Other mew-sings

How can the EPO afford a new building?  This is where the financial world of numbers splits from the practical world of bricks. Accounting calculates wear and tear on buildings as a cost (depreciation.)  The Hague building has been depreciated to zero as it is at the end of its useful life.  The new building will be listed, not at its market value, but as an asset equal to its price tag minus any depreciation. This can make the gleaming building a bargain, as the annual depreciation may be less than the equivalent rent.

Finally, what about assets of nearly €8 bn? Just over €5 bn of this is the pensions fund itself.  The other €2.8 bn are a mix of tangible and intangible assets, bonds, home loans to staff and other assets.  These assets represent the savings account for the EPO, which has a stabilising influence and serves as a rainy day fund. The question remains whether the pensions liability truly is a storm.

Overall, the EPO faces future incomes that are fairly fixed (patent fees) and costs that are volatile and have seen unprecedented increases (pensions.)   Additionally, it can’t include the bulk of its income (renewal fees), estimated to be €3.5 bn.  This still leaves €8 bn + €3.5 bn = €11.3 bn < €12.4 bn.  Readers may be right to withhold final judgement, as the past decade has demonstrated how wrong financial predictions can be.

What might change this?  Improvement in the economy could reduce liability and increase total fee income.  Yet life expectancy and higher health care expenses are increasing and may increase the pension liability.

Before she returns to her dinner deliberation, Merpel notes that she is not an actuary and hopes that that informed readers will correct her if she’s got the wrong end of the catnip. An enigma wrapped in a tasty conundrum, the EPO’s statements are food for thought.