DB SOLUTIONS Industry Watch Pension accounting standard changes could lead to a shift in risk philosophy Subjectivity and timing of expected return on assets The expected return on assets to determine pension expense is a management best estimate based on the plan’s asset mix. It also reflects a return premium for investments in equities before it is earned, which encourages an equity-bias asset mix. Extensive smoothing of assets Canadian corporations are busy dealing with the Under current reporting standards, a smoothed asset transition to International Financial Reporting Standards value could be used for the purposes of determining (IFRS) effective January 1, 2011. One implication is that expected return. The greater volatility of a high-equity pension disclosures in financial statements will lead to asset mix compared to a low-equity asset mix is largely greater transparency of changes in the funded status of a hidden due to this smoothing effect. This will change defined benefit (DB) pension plan. This transparency when IFRS is adopted in 2011. could lead to a shift in philosophy by Canadian DB plan sponsors whose current asset mix has an equity bias. Together these characteristics support the current equity bias of DB plans, since the expected return However, what’s brewing in the next wave of potential premium reduces current pension expense, while the reporting changes may be the real catalyst for a shift in actual volatility of returns can be reduced through philosophy. The International Accounting Standard smoothing. Board (IASB) is currently deliberating changes to pension accounting, which could drive sponsors concerned Pension Accounting 2013 about accounting impacts to consider de-risking DB Under the new standard, IFRS will put the actual funded plans by reducing equity allocations. A new standard is status on the balance sheet. The IASB has signaled that expected to be effective by 2013. the next revision of International Accounting Standard (IAS) 19 will require immediate recognition of all The future accounting changes are in response to a gains/losses in the balance sheet, leading to significant number of criticisms of existing standards: volatility for plans with an equity bias. Distorted reflection of funded status The IASB is considering which elements of gains/losses Due to amortization of gains/losses in the pension would be recognized immediately through the income expense calculation, there is often a major difference statement, and which would be recognized only through between what’s reflected on the balance sheet and the Other Comprehensive Income (OCI). actual funded status of the plan. This has resulted in situations where a plan sponsor has a large prepaid asset on the balance sheet, when the pension plan actually has a deficit. The deficit is only disclosed in the footnotes. Following the December 2009 and January 2010 IASB Out with the old in with the new meetings, it is reported the IASB has tentatively agreed The accounting changes will make equities less that: attractive than they currently are in a DB plan asset mix Gain and loss recognition strategy. Companies concerned about balance sheet All gains/losses should be recognized in OCI (and not on volatility will reduce allocations to equities and increase the income statement); and allocations to matching bond assets. This move will increase the expected long-term accounting and funding Net DB plan asset or liability costs of providing the benefits. A “net interest” approach where interest income or cost is determined based on the net DB plan asset or liability A unique consideration is to reduce risk through the (i.e., surplus or deficit). purchase of traditional annuities. There is nothing new about annuities. They have been used by plan sponsors These two decisions will be reflected in an Exposure for decades when winding up a pension plan. What is Draft that according to the IASB will be released by the new is the use of traditional annuities to transfer middle of 2010. The new standards will have major pension risks for ongoing DB plans from the plan sponsor accounting implications and will lead to a fundamental to an insurance company. reassessment of the current equity bias of DB plans. Annuities provide some merits over reducing risk by Accounting implications investing in matching bonds: There are four key implications: Transfer of risk 1. Pension expense will go up Annuities provide DB plan sponsors the ability to Currently the assumption for the long-term expected transfer investment and longevity risks off a company’s return on assets is typically higher than the discount rate balance sheet to the insurer. due to the ability to reflect an anticipated equity return premium. With a net interest approach, there will not Longevity risk of bonds be a higher rate for the asset return assumption as a Bonds can only hedge the investment risk and not the result of investment in equities. longevity risk. 2. Pension expense will be relatively stable Bond investing keeps risk in the plan While pension expense will be higher, it will be relatively With bonds, the assets and liabilities are retained by the stable, reflecting the current service cost, plan DB plan, so the company maintains the risk (albeit lower amendment costs, and net interest on the surplus or than equities). deficit. Smaller plan can maintain some risk 3. Higher actual returns from equity will only indirectly Transferring the liabilities (and assets) to the insurer impact expense reduces the size of the pension plan, which may afford If all gains/losses are recognized in the OCI and not in sponsors the ability to maintain an equity bias for the the income statement, higher returns on equities will not smaller assets that remain. directly reduce pension expense, but would only indirectly impact pension expense by increasing the There will be no single solution or quick fix to addressing surplus, or reducing the deficit. the future changes in the pension accounting standards. However, the ability to transfer pension liability risk 4. Balance sheet volatility will increase if equity bias is from the sponsoring company to an insurer offers a maintained unique solution to consider. Volatility in the balance sheet will reflect the volatility of pension funded status (through OCI). If the current For further information how IAS 19 changes could equity bias is maintained, the funded status will be impact your company, contact your accountant or directly influenced by the rise and fall of the equity pension consultant. markets.