In Brief. November A plain and simple overview of the Invitation to Comment on Discount Rate Guidance. Project objective:

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1 November 2017 In Brief A plain and simple overview of the Invitation to Comment on Discount Rate Guidance This is an overview of the key details outlined in PSAB s Invitation to Comment, Employment Benefits: Discount Rate Guidance in Section PS 3250 Project objective: The project stage: Next steps: To issue a new employment benefits standard to replace the following sections in the PSA Handbook: PS 3250, Retirement Benefits; and PS 3255, Post-employment Benefits, Compensated Absences and Termination Benefits. This second Invitation to Comment, issued in November 2017, is part of PSAB s Employment Benefits project. PSAB Issued the first Invitation to Comment, Employment Benefits: Deferral Provisions in Sections PS 3250 and PS 3255, in November The Board has decided to publish an invitation to comment document on each key issue because these are complex issues. Potential implications of PSAB s decisions on these issues can be significant. PSAB plans to publish a third invitation to comment document that will focus on plans with risk-sharing features different from the traditional defined benefit and defined contribution plans. The Board plans to consider responses to the three invitation to comment documents when developing a statement of principles, prior to issuing an exposure draft of the proposed employment benefits standard.

2 Why PSAB Undertook this Project The current pension standard in the PSA Handbook was developed more than two decades ago. Many things have happened in the accounting world since then. International and national accounting standard setters in the public and private sectors have updated their employee benefits standards over the past ten plus years. Most standard setters have moved away from the deferral and amortization approach of pension accounting. Many standard setters require the use of the market yields of high-quality bonds to determine the benefit obligation of both funded and unfunded plans. Pension plans in the public sector have also evolved over the years. The financial crisis, historically low interest rates, aging plan members and increasing longevity have led to pension reform in some jurisdictions. Some employers have moved away from the traditional defined benefit plans to share more risk with plan members. The new shared risk plans may contain features such as contribution ceiling, target benefit, contingent benefit and contingent contribution that depend on the funding status of the plan. The accounting implications of these features were not specifically considered in the development of the current standard. 2

3 What key issues will PSAB s Employment Benefits project address? The key issues PSAB s Employment Benefits project will address are: the deferral provisions in the standards; the discount rate guidance for determining accrued benefit obligation; the accounting for non-traditional employment benefit plans, which includes, but not limited to, target benefit plans or shared risk plans; accounting for multi-employer defined benefit plans; and other issues that may arise throughout the project. 3

4 What does current Section PS 3250 say about discount rate?. The standard does not prescribe which discount rate an entity should use to estimate accrued benefit obligation. The standard refers to two discount rate bases in the examples that illustrate that actuarial assumptions should be internally consistent. The discount rate examples are plan asset earnings and cost of borrowing. Which discount rates do public sector entities use? In practice, public sector entities often use the expected return on plan assets to estimate the benefit obligation of fully funded and partially funded benefit plans. The entity s cost of borrowing is often used to estimate the benefit obligation of unfunded benefit plans. 4

5 Why does PSAB need to review discount rate guidance? Lack of specific guidance The lack of specific guidance in Section PS 3250 in the PSA Handbook means that public sector entities are allowed to use plan asset earning rates to estimate their benefit obligations. Other publicly accountable enterprises in Canada are required to use market yields of highquality corporate bonds to estimate their benefit obligations. Under the current low interest rate environment, the expected return on plan assets is often higher than the yields of high-qualify bonds. As a result, there are criticisms that the higher discount rates have resulted in public sector entities reporting a more positive financial position. Concerns about current practice Other standard setters have rejected discount rate based on plan asset earnings. Some point out that assets with a higher expected return carry more risks. Entities that invest in riskier plan assets would report a lower benefit obligation. Using the expected return of plan assets as the discount rate essentially assumes that the expected return has been earned. In reality, the expected return may not be achieved. An entity s obligation to make future benefit payments are not affected by whether they are backed by assets or how much those assets are expected to earn. Some are also concerned that entities may use more aggressive investment return assumptions to present lower benefit obligation. 5

6 Most standard setters do not use cost of borrowing as discount rate Entities that have a lower credit rating would report a lower benefit obligation because of a higher cost of borrowing. Entities would report a gain (that is, a decrease in the benefit obligation) when their credit rating deteriorates. There are also challenges for entities that do not borrow or are not allowed to borrow in determining a proxy of the cost of borrowing. 6

7 Are there alternatives? This Invitation to Comment identifies alternative discount rate approaches that can be any of the following six discount rate bases, reflecting a current, an average, or a projected rate view. Alternative Discount Rate Bases Expected return on plan assets Expected return of an effective hedge portfolio Possible Views Current Average Projected Market yield of high-qualify debt instruments Market yield of risk-free debt instruments Entity s cost of borrowing Effective settlement rate The expected return on plan assets reflects the entity s best estimate assumption about the investment return, either of the plan assets currently held in the benefit plan, or expected from the investment strategy of the plan. The expected return of an effective hedge portfolio reflects the investment return of a portfolio of replicating assets that match the economic risks of the benefit obligation. The market yield of high-quality debt instruments reflects the investment return of a portfolio of debt instruments that received among the highest credit ratings. The market yield of risk-free debt instruments reflects the investment return of a portfolio of debt instruments that pose no risk of default to the holder. The entity s cost of borrowing reflects the borrowing rate the entity can obtain for its debts or other borrowings. The effective settlement rate reflects the rate implicit in the costs of releasing the entity from its accrued benefit obligation. 7

8 A current rate reflects the economic conditions and market expectations at the reporting date, including the current expectations about the periods future benefit payments are expected to be made. An average rate is the average of the applicable rate of the recent or distant past. A projected rate is a forward-looking rate that focuses on the periods future benefit payments are expected to be made. 8

9 Should the same discount rate apply to all benefit plans? This Invitation to Comment identifies three possibilities when applying any chosen discount bases/ views. 1. Apply the same discount rate bases/views to the entire benefit obligation of all benefit plans regardless of their funding policy. 2. Apply different discount rate bases/views to benefit plans based on their funding policy. This means a discount rate basis/view applies to fully and partially funded plans, and a different discount rate basis/view applies to unfunded plans. 3. Apply different discount rate bases/views based on a benefit plan s funding level.this means a discount rate basis/view applies to the funded portion of the benefit obligation, and a different discount rate basis/view applies to the unfunded portion of the benefit obligation. Alternative applications Same discount rate basis/view Different discount rate bases/ views based on funding policy Fully funded plans Partially funded plans One or more discount rate bases/views Discount rate basis/view A Unfunded plans Discount rate basis/view B Different discount rate bases/ views based on funding level Discount rate basis/ view A Composite rate = A X funded obligation + B X unfunded obligation Discount rate basis/view B 9

10 Next Steps The deadline for comments is March 9, During the comment period, PSAB staff are available to discuss the document with a wide range of parties. How can I comment on the document? You can answer all questions or just a selected few. Respondents are asked to submit their comments electronically via an online response form or sent via Word document to info@psabcanada.ca. All comments will be a matter of public record and posted online at unless confidentiality is requested. Stay informed PSAB issues its agendas ahead of its meetings, which will indicate when it will discuss your feedback on this document. Get the dates of upcoming meetings and review our agendas via the PSAB calendar. Stay up to date on this project via the online project page, participate in the January 16, 2018 Employment Benefits Discount Rate webinar and read three different perspectives on the discount rate issue via CPA Canada s monthly enewsletter, Member News between December 2017 and February 2018 (also available via the project page). Please contact: Lydia So, MBA, CPA, CA Principal, Public Sector Accounting Board Phone: +1 (416) lso@psabcanada.ca 10