DB SOLUTIONS Industry Watch

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					 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
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
                                                              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).
                                                                  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.